U.S. Income Taxation of Foreign Governments: IRS Issues Proposed Regulations on the U.S. Taxation of the U.S. Investment Income of Foreign Governments and Entities Wholly Owned by Foreign Governments

Sullivan & Cromwell LLP - November 3, 2011

Under Section 892 of the Internal Revenue Code, a foreign government is exempt from U.S. federal income taxation on certain investment income. Entities wholly owned by a foreign government – such as sovereign wealth funds and pension plans – that meet certain requirements are generally able to rely on the same exemption. If, however, a wholly owned entity engages in commercial activities anywhere in the world, the wholly owned entity is not eligible for this exemption.

Proposed regulations issued by the Internal Revenue Service on November 2, 2011 (the “Proposed Regulations”), if finalized, would modify, and generally limit, the circumstances in which a controlled entity would be considered to be engaged in commercial activity and therefore be ineligible for this exemption. If finalized, the Proposed Regulations would:

  • make several clarifications to the definition of “commercial activity” including: (i) clarifying that only the nature of the activity, rather than its purpose, determines whether activity is commercial; (ii) providing that the definition of “commercial activity” is broader than the definition of “trade or business” under U.S. tax law; and (iii) clarifying that a sale of a U.S. real property interest, by itself, does not constitute commercial activity even if the gain from that sale would be subject to U.S. taxation;
  • provide that a controlled entity is not considered to conduct commercial activity solely on account of (i) being a limited partner in a partnership that conducts commercial activity, so long as the controlled entity does not participate in the management of the partnership or the conduct of its business; and (ii) an ownership interest in a partnership that engages in the trading of stock, bonds, other securities, commodities or financial instruments if such trading is for the partnership’s own account;
  • provide that inadvertent commercial activity of a controlled entity will not cause the entity to be treated as a controlled commercial entity, so long as certain requirements are met; and
  • clarify that status as a controlled commercial entity is tested annually.

Even though certain activities may not constitute “commercial activities” (for example, certain activities conducted through limited partnerships), a foreign government or controlled entity may nonetheless be subject to U.S. federal income tax on the income from such activities.

The Proposed Regulations would apply on and after the date the regulations are published as final in the Federal Register. Entities may, however, rely upon the Proposed Regulations until final regulations are issued. The Internal Revenue Service has requested comments on the clarity of the Proposed Regulations and how the Proposed Regulations could be made easier to understand.