Background

While non-US persons generally are subject to US taxation on receipt of certain US source income (e.g., dividends), Section 892 exempts foreign governments from this tax for certain enumerated types of income. However, Section 892 does not exempt from such tax income derived from the conduct of any commercial activity, income received by or from a controlled commercial entity, or income derived from the disposition of an interest in a controlled commercial entity.

Generally, both the “integral parts” of a foreign government and its “controlled entities” are considered foreign governments for purposes of the exemption. A principal distinction between an integral part of a foreign government and a controlled entity of a foreign government is that if a controlled entity becomes a “controlled commercial entity,” it loses the benefits of Section 892 entirely, whereas if an integral part of a foreign government engages in commercial activity, it loses the benefits of Section 892 only with respect to income from the commercial activity and not with respect to any other qualifying income. A controlled commercial entity is any entity that is owned 50% or more (directly or indirectly) by a foreign government or with respect to which the foreign government possesses effective control (discussed further below) and is engaged in any commercial activity worldwide during the taxable year.

Selected aspects of the final regulations

Definition of “commercial activities”

Consistent with prior guidance, the final regulations provide that all activities (whether conducted within or outside the United States) ordinarily conducted for the current or future production of income or gain are commercial activities, unless an exception applies.

The final regulations further provide that (unless an exception applies) commercial activities include activities that constitute a trade or business for purposes of Section 162 and activities that constitute (or would constitute if undertaken in the US) a US trade or business for purposes of Section 864(b). However, the preamble to the final regulations makes clear that, consistent with prior guidance, the term “commercial activities” as used in Section 892 has a broader meaning than “trade or business” under Sections 162 and 864 and is not limited to such activities. In other words, activity that may not constitute a trade or business under Sections 162 or 864 may nevertheless be treated as commercial activity under Section 892. (See discussion of debt investments below.)

Consistent with prior guidance, the final regulations provide that effecting transactions (for a foreign government’s own account and other than as a dealer) in stocks, securities, or commodities does not constitute commercial activity. The final regulations also clarify that effecting transactions (for a foreign government’s own account and other than as a dealer) in financial instruments that are derivatives generally within the scope of Prop. Reg. 1.864(b)-1(b)(2) does not constitute commercial activity. In the reasoning of the Treasury and the IRS, investing and trading in such financial instruments generally involve only putting capital at risk and do not involve activity such as structuring the instrument, in contrast to the structuring of bespoke, non-market standard derivatives. Additionally, the final regulations confirm that effecting transactions (for a foreign government’s own account and other than as a dealer) in partnership equity interests does not itself constitute commercial activity, but rather only results in commercial activity income if the partnership conducts commercial activity that is attributed to the holder.

USRPHC per se rule limited to domestic corporations

Temporary regulations issued in 1988 provided that an entity will be deemed to be engaged in commercial activity if it is a USRPHC as defined in Section 897(c)(2) (the USRPHC per se rule). Generally, a USRPHC is any corporation if the fair market value of its US real property interests (which may include interests in domestic USRPHCs) equals or exceeds 50% of the sum of the fair market value of its US and non-US real property interests and other trade or business assets.

The USRPHC per se rule created a trap for the unwary, whereby an entity holding only passive assets and a single minority interest in a domestic USRPHC could be classified as a controlled commercial entity. In 2022, the Treasury and the IRS issued proposed regulations that would exclude from the USRPHC per se rule any entity that would be a USRPHC solely by reason of its direct or indirect ownership interest in one or more other corporations that are not controlled by the foreign government (the minority interest exception). (For a further discussion of the 2022 proposed regulations, see our prior alert.)

The final regulations retain the minority interest exception (with certain modifications) with respect to domestic corporations but now entirely exclude all foreign corporations from the application of the USRPHC per se rule. As a result, the USRPHC per se rule is now applicable only to domestic corporations, although the minority interest exception may still be applicable (e.g., in the case of a foreign government’s domestic holding company that invests solely in minority interests of USRPHCs).

Inadvertent commercial activity exception

The final regulations largely adopt the “inadvertent commercial activity” exception in the 2011 proposed regulations, under which an entity will not be treated as having conducted commercial activity if three conditions are met: the failure to avoid the activity was reasonable, the activity is promptly cured, and adequate records are maintained.

The final regulations refine key aspects of this framework. For the reasonableness requirement, the analysis is limited to activities occurring during the current and immediately preceding tax year (to the extent relevant). The final regulations also introduce a facts‑and‑circumstances test for determining whether an entity’s policies and procedures are adequate to prevent commercial activities and further provide that a failure is not reasonable if employees responsible for compliance (now expanded beyond management‑level personnel) do not make reasonable efforts to follow and enforce the policies and procedures.

Qualified partnership interest exception

The 2011 proposed regulations included a so-called “limited partner exception,” whereby an entity not otherwise engaged in commercial activities would not be deemed to be engaged in commercial activities solely because it holds an interest as a limited partner in a limited partnership, provided it does not have rights to participate in the management and conduct of the partnership’s business. Nevertheless, the holder’s distributive share of income from the partnership would not be exempt under Section 892 to the extent that the partnership derived such income from the conduct of commercial activity.

The final regulations finalize this exception (with modifications), providing that the exception is not limited to limited partnership interests in state law limited partnerships and introducing the defined term “qualified partnership interest” (QPI). For purposes of the exception, the holder of a QPI must (1) have limited liability, (2) not possess the legal authority to bind or to act on behalf of the partnership, (3) not control the partnership (i.e., have 50% ownership or effective control), and (4) not have rights to participate in the management and conduct of the partnership’s business.

The final regulations also provide further guidance as to what constitutes “rights to participate in the management and conduct of a partnership’s business,” which are defined as “rights to participate in the day-to-day management or operation of the partnership’s business.” Such rights include the right to participate in ordinary-course personnel decisions, or to take active roles in formulating the partnership’s business strategy or in respect of the acquisition or disposition of a specific investment. However, such rights generally do not include the right to monitor or protect the partner’s capital investment (e.g., oversight and supervision rights regarding major strategic decisions, such as amendment of the partnership agreement or non-ordinary course deviations from previously determined investment parameters).

Additionally, under a new safe harbor, a holder will be deemed to hold a QPI if at all times during the partnership’s taxable year the holder (1) has no personal liability for claims against the partnership, (2) has no right to enter into contracts or act on behalf of the partnership, (3) is not a managing member or managing partner and does not hold an equivalent role under applicable law, and (4) does not directly or indirectly own more than 5% of either the partnership’s capital interests or its profits interests.

With respect to tiered partnership arrangements, the final regulations provide that the QPI exception applies from the bottom up. For example, if a foreign government holds an interest in an upper-tier partnership, which in turn holds a QPI in a lower-tier partnership, the lower-tier partnership’s commercial activities will not be attributed to the upper-tier partnership, even if the foreign government’s interest in the upper-tier partnership is not a QPI (although income from such activities will not be exempt under Section 892).

If a foreign government holds multiple interests in the same partnership (e.g., through multiple controlled entities), all such interests are aggregated for purposes of the QPI exception. If any such interest does not qualify for the QPI exception, then none of the interests will qualify.

Selected aspects of the proposed regulations

Acquisition of debt

The proposed regulations introduce a new framework for determining whether a debt investment constitutes commercial activity. Under this framework, an acquisition of any obligation treated as debt for US federal tax purposes (including by an agent or person otherwise acting on behalf of the acquirer) would be treated as a commercial activity unless the acquisition is (1) characterized as an investment for purposes of Section 892 under one of two safe harbors or under a facts-and-circumstances test (each discussed in further detail below) and (2) undertaken in a non-dealer capacity. Consistent with the definition of “commercial activities” described above, the preamble to the proposed regulations states that whether a debt acquisition is characterized as an investment for purposes of Section 892 would be, unless otherwise provided, determined without regard to whether the debt acquisition is treated as a trade or business for US federal tax purposes.

Safe harbors:

• Registered offerings. Acquisitions of debt in offerings registered under the Securities Act of 1933, as amended, would be characterized as investment activity (not commercial activity), provided that the underwriters are not related to the acquirer.
• Qualified secondary market acquisitions. Acquisitions of debt traded on an established securities market would be characterized as investment activity (not commercial activity), provided (1) the acquirer does not purchase the debt from the issuer or participate in the negotiation of the terms or issuance of the debt and (2) the acquisition is not from a person that is under common management or control with the acquirer (unless the prior acquisition qualified as investment activity).

A debt acquisition that does not satisfy either of the safe harbors may be characterized as investment activity based on the relevant facts and circumstances, including:

• Whether the acquirer solicited prospective borrowers or otherwise held itself out as willing to make loans or otherwise acquire debt at or in connection with its original issuance.
• Whether the acquirer materially participated in negotiating or structuring the terms of the debt.
• Whether the acquirer is entitled to compensation (whether or not labeled as a fee) that is not treated as interest (including original issue discount) for US federal tax purposes.
• The form of the debt and the issuance process, including, for example, whether the debt is a bank loan or instead a privately placed debt security pursuant to Regulation S or Rule 144A under the Securities Act.
• The percentage of the debt issuance acquired by the acquirer relative to the percentages acquired by other purchasers.
• The percentage of equity in the debt issuer held or to be held by the acquirer.
• The value of that equity relative to the amount of the debt acquired.
• If debt is deemed to be acquired in a debt-for-debt exchange as a result of a significant modification, whether there was, at the time of acquisition of the original unmodified debt, a reasonable expectation, based on objective evidence, such as a decline in the financial condition or credit rating of the debt issuer between original issuance and the time of the acquisition of the original unmodified debt, that the original unmodified debt would default.

The Treasury and the IRS have requested comments on whether the proposed regulations should include additional factors or examples of transactions undertaken by foreign government investors, including acquisitions of distressed debt, broadly syndicated loans, revolving credit facilities, and delayed-draw debt obligations.

In the preamble to the final regulations discussed above, the Treasury and the IRS explicitly rejected the suggestion that making loans to the general public or making a particular minimum number of loans constitutes a necessary condition for debt acquisitions to be commercial in character. Further to this point, an example in the proposed regulations concludes that a single loan, which the foreign government negotiated and funded at original issuance, to a borrower in which the foreign government does not own equity constitutes commercial activity.

In contrast, another example concludes that, where the foreign government owned 80% of a foreign corporation’s equity interests, which had a total value of $100 million, and lent $50 million to the foreign corporation, the loan does not constitute commercial activity (in part) because the foreign government owned a substantial percentage of the equity interests in the debt issuer and acquired an amount of debt that is not significant relative to the value of its equity investment. This example raises questions about how other shareholder loans, such as “levered blocker” arrangements, may be treated (e.g., if the foreign government owns 100% of the debt issuer but the debt-to-equity ratio is higher, or if the foreign government owns a smaller percentage of the debt issuer but the loan is funded pro rata by the owners).

Another example indicates that participation on a creditors’ committee that materially participated in negotiating and structuring the terms of the workout of a defaulted loan (resulting in a significant modification) results in commercial activity, even though there were no objective indications at the time of purchase that the borrower would default.

Definition of “effective control”

The proposed regulations would provide that, generally, effective control is achieved by any interest in the entity that, either separately or in combination, results in control over the operational, managerial, board-level, or investor-level decisions of the entity. A foreign government would not need to hold any particular amount of – or any – equity in an entity to have effective control. Interests in an entity may include:

• Equity interests
• Debt interests
• Voting power in the entity
• Contractual rights in or arrangements with the entity or with holders of equity or other interests in the entity
• Certain business relationships with the entity or with other interest holders in the entity
• Regulatory authority over the entity
• Any other relationship that provides influence over the entity’s operational, managerial, board-level, or investor-level decisions

Under a special per se rule, a foreign government would be deemed to have effective control of an entity if the foreign government is, or controls an entity that is, a managing partner or managing member of such entity, or holds or controls an entity that holds an equivalent role with respect to such entity under local law applicable to the entity.

The Treasury and the IRS have requested comments as to when a minority interest holder should not be treated as having effective control if managerial or board-level decisions are subject to veto rights of the holder and other holders (e.g., consent rights or supermajority requirements).

If you have any questions about the IRS’s final and proposed regulations, please reach out to the authors or your regular McDermott Will & Schulte lawyer.