Final and Proposed Section 892 Regulations

Summary

On December 15, 2025, Treasury and the IRS issued Final Regulations and further Proposed Regulations under Section 892 of the Code addressing when foreign governments are treated as engaged in commercial activities and when entities are classified as controlled commercial entities (“CCEs”). The rules revise and finalize portions of Proposed Regulations that were issued in 1988, 2011, and 2022, and include several notable taxpayer-unfriendly modifications on which affected taxpayers should consider submitting comments.

The Final Regulations are generally consistent with earlier proposed guidance, albeit with certain changes. However, the Proposed Regulations adopt rules regarding whether a foreign government has “effective control” of a particular entity and when certain activity with respect to debt may constitute commercial activity that rely even more heavily on facts and circumstances. This may mean that if the Proposed Regulations are finalized as proposed, it will be more challenging for sovereign wealth funds and other governmental entities to have certainty that an entity is not a CCE or otherwise engaged in “commercial activity,” except in situations where a Section 892 investor has very limited governance rights and investor protections. Likewise, the ability of Section 892 investors to invest in credit investments other than SEC-registered securities, debt acquired in the secondary market, and perhaps shareholder loans may become more limited.

Although the Proposed Regulations will not be effective until after they are finalized, they do not contain a “grandfather” or similar rule for existing investments. Therefore, it may be prudent for Section 892 investors to consider whether any existing investments have governance rights or other features that may be affected if the Proposed Regulations are finalized.

Background

Under Section 892, U.S.-source investment income earned by a foreign government is generally exempt from U.S. federal income taxation.[1] However, the Section 892 exemption does not extend to income earned by a foreign government from commercial activities, received by or from a CCE, or derived from the disposition of an interest in a CCE.[2] Under current law, an entity is generally a CCE if that entity is engaged in commercial activities, and a foreign government either (i) holds (directly or indirectly) an interest representing 50% or more of the value or voting power in that entity, or (ii) has “effective control” over that entity.[3]

At present, the main guidance under Section 892 consists of proposed regulations issued in 1988 (the “1988 Proposed Regulations”),[4] temporary regulations issued in 1988 (the “1988 Temporary Regulations”),[5] proposed regulations issued in 2011 (the “2011 Proposed Regulations”),[6] and further proposed regulations issued in 2022 (the “2022 Proposed Regulations”).[7] The 2011 Proposed Regulations were significant in part because they contained an exception for inadvertent commercial activity (the “Inadvertent Activities Exception”)[8] and an exception for investments in limited partnerships (the “Limited Partner Exception”).[9] The 2022 Proposed Regulations were also significant because they proposed a relaxation of the former “per se” rule for U.S. real property holding corporations (“USRPHCs”), which deemed any entity that was a USRPHC (or would be a USRPHC if it were a domestic corporation) to be a CCE if it was controlled by a foreign government.

The Final Regulations

The Final Regulations largely adopt the changes that were made in the 2011 Proposed Regulations and the 2022 Proposed Regulations, with certain adjustments. The discussion below highlights key changes made by the Final Regulations.

Definition of “Commercial Activity”

Consistent with the 1988 Temporary Regulations and 2011 Proposed Regulations, the Final Regulations include a broad definition of commercial activities, which encompasses any activity ordinarily conducted for income or gain, even if not a U.S. trade or business under Section 864(b), unless that activity is specifically exempted.[10] In addition, the Final Regulations state that activities that constitute a “trade or business” under Section 162 or Section 864(b) are commercial activities for purposes of Section 892, except as expressly provided otherwise.[11]

Like prior guidance, the Final Regulations provide that commercial activities do not include investment activities, cultural events, governmental functions, non-profit activities, and purchasing goods for the foreign sovereign’s use.[12] In response to comments to the 2011 Proposed Regulations, the final regulations expand the activities that are not deemed commercial to include investments in financial instruments such as derivatives, as well as the holding of bank deposits in any currency.[13] The Final Regulations do not provide significant guidance on the making of loans, which are instead addressed in the Proposed Regulations.

In addition, and also generally consistent with the 2011 Proposed Regulations, the Final Regulations state that trading, in a non-dealer capacity, in stocks, bonds, other securities, partnership equity interests, commodities, or financial instruments for a foreign government’s own account does not constitute commercial activity.[14] The Final Regulations modify this rule to specifically include trading in partnership equity interests.[15]

The Final Regulations also generally follow the rule, which was included in the 2011 Proposed Regulations, that whether an entity is a CCE is determined separately for each taxable year. However, the Final Regulations significantly modify this rule to also take into account an entity’s activities during its immediately preceding taxable year to the extent relevant in characterizing the activities in the current taxable year.[16]

It is noteworthy, however, that the Final Regulations declined to adopt several amendments that were requested during the public comment process, including recommendations that:

• lending not be treated as a commercial activity unless an entity makes loans to the general public or more than five loans per year (and as discussed below, the Proposed Regulations indicate that even one loan per year can amount to “commercial activity”);
• fee income received as a passive investor in a private fund not be treated as “commercial activities” income; and
• commercial activities be limited to those activities that would constitute a “trade or business” as defined under Section 864.

Limited Partner Exception

The final regulations also include a “qualified partnership interest” exception, which is a modified version of the Limited Partner Exception in the 2011 Proposed Regulations. Under this exception, an entity not otherwise engaged in commercial activity will not be a CCE solely by virtue of holding a “qualified partnership interest,” which generally includes any interest in a partnership so long as the holder of the interest does not (a) have unlimited liability for partnership obligations, (b) have the right to bind or act on behalf of the partnership, (c) have control of the partnership or (d) participate in the management or conduct of the partnership’s business.

Many of the differences between the “qualified partnership interest” rules and the formerly proposed Limited Partner Exception are technical. One substantive change, however, is that while the 2011 Proposed Regulations provided that consent rights for extraordinary events (e.g., admission of a partner, amendment of the partnership agreement, dissolution, merger, or conversion) would not be treated as the right to participate in management, the Final Regulations rely on a facts and circumstances inquiry, and do not directly specify that certain rights would not indicate management participation. The Final Regulations indicate that an investor in a qualified partnership may have oversight and supervision rights in the case of major strategic decisions (provided that the investor does not have “effective control” over the partnership), such as: admission or expulsion of a partner; hiring or firing key strategic personnel; amendment of the partnership agreement; dissolution, merger, or conversion of the partnership; unusual and non-ordinary course deviations from previously determined investment parameters; extending the term of the partnership’s governing agreement; and disposition of all or substantially all of the partnership’s property outside of the ordinary course of the partnership’s activities.[17] It is unclear whether “oversight and supervision rights” can, at least in some cases, include consent or “blocking” rights. As discussed below, however, the Proposed Regulations provide that certain consent or blocking rights could be treated as giving rise to effective control.

In addition, the Final Regulations adopt a safe harbor, under which partnership’s activities are not attributed to a foreign government investor, which at all times during the partnership’s taxable year (1) has no personal liability for the debts of the partnership, (2) has no rights to enter into contracts on behalf of the partnership, (3) is not a managing partner, and (4) does not hold more than 5% of either the partnership’s capital interests or profits interest.[18]

The “qualified partnership” rules also contain rules for tiered partnerships. Under these provisions, an upper-tier partnership that holds a qualified partnership interest in a lower-tier partnership is not attributed the lower-tier partnership’s commercial activities.[19] Conversely, an upper-tier partnership that holds a non-qualified partnership interest in a lower-tier partnership is attributed commercial activity conducted by the lower-tier partnership.[20]

Per Se Rule

Under the former per se rule in the 1988 Temporary Regulations, a USRPHC (or a foreign entity that would be a USRPHC if it were a domestic corporation) that was controlled by a foreign government was automatically a CCE.[21] This rule created potential complications for Section 892 investors because if they concentrated their U.S. real estate holdings in specific holding companies, those entities (even though such entities only owned minority interests in USRPHCs and otherwise would not have been CCEs) could have been deemed to be CCEs. The 2022 Proposed Regulations would have limited this rule by providing an exemption for 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.[22] This rule was included in the Final Regulations. In addition, under the Final Regulations, the per se rule only applies to domestic corporations.[23]

Inadvertent Activities Exception

The Final Regulations include an Inadvertent Activities Exception, which is broadly consistent with the similar exception in the 2011 Proposed Regulations but makes several modifications. Consistent with the 2011 Proposed Regulations, the availability of the Inadvertent Activities Exception is limited to entities with “adequate written policies and operational procedures.”[24] The Final Regulations provide additional guidance on what factors will be used to determine whether these policies are “adequate.”[25] In addition, while the 2011 Proposed Regulations focused on whether management-level employees undertook reasonable efforts to establish and enforce compliance procedures, the Final Regulations require compliance by all employees who have oversight responsibilities, whether or not those employees are management-level.[26] The Final Regulations also extend the cure period to 180 days from the date of discovery of commercial activity (as compared to 120 days in the 2011 Proposed Regulations).[27]

The Proposed Regulations

The Proposed Regulations focus on three topics: (i) whether acquiring a debt instrument amounts to “commercial activity,”  (ii) the circumstances in which a foreign government will have “effective control” over an entity for purposes of determining whether that entity is a CCE, and (iii) the definition of a “foreign government.”

Debt Investments

Under the Proposed Regulations, the acquisition of a debt instrument would be a “commercial activity”[28] unless either (i) one of two safe harbors (the first of which applies to SEC-registered offerings, and the second of which applies to secondary market acquisitions of debt traded on an established security market) is satisfied, or (ii) the acquisition qualifies as an “investment” based on all relevant facts and circumstances. The Proposed Regulations provide a non-exhaustive list of facts and circumstances that may be relevant:

• 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 labelled as a fee) that is not treated as interest (including original issue discount) for 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; and
• 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 Proposed Regulations include several examples that clarify how the relevant facts and circumstances would be analyzed in determining whether an acquisition of a debt instrument is considered an “investment.” In one noteworthy example, a foreign government is treated as engaged in commercial activity where it acquires a debt instrument at original issuance, materially participates in negotiations, and has no equity investment in the issuer, even though the foreign government extends only one loan per year.[29] Other examples suggest that participation on a creditors’ committee in connection with a debt restructuring, or potentially (although this is less clear) the acquisition of distressed debt even without participation in any creditors committee, can be sufficient to cause a foreign government to be engaged in “commercial activity.”[30]

Effective Control

Under the Proposed Regulations, an entity engaged in commercial activity would be a CCE if a foreign government has “effective control” (which represents a renaming of the current “effective practical control” concept) of that entity. “Effective control” would arise from any interest in the entity that, “directly or indirectly, either separately or in combination with other interests, results in control of the operational, managerial, board-level, or investor-level decisions of the entity.”[31] Although the Proposed Regulations state that “mere consultation rights with respect to operational, managerial, board-level, or investor-level decisions of an entity (such as extending the term of the entity’s investment period, change in control of the entity, or liquidation of the entity) do not alone give rise to effective control,” they also indicate that “the determination of effective control is made considering all of the facts and circumstances related to the interests in an entity.”[32]

While the Proposed Regulations appear to adopt a holistic, facts and circumstances analysis, the Proposed Regulations may introduce new uncertainty into whether various governance rights that are often held by significant (but less-than-50%) investors give rise to “effective control.” Notably, although the Proposed Regulations provide that an entity will be a CCE if a foreign government has control over “investor-level decisions,” they do not define what “investor-level decisions” are. In addition, while the IRS and Treasury Department have requested comments on this subject, it is unclear how certain “blocking” rights (such as consent thresholds that are high enough that a foreign government must be among the investors that approve an action, including for example a requirement that 80% of investors give consent to a decision to materially change an entity’s business, when a sovereign wealth fund owns 25% of an entity) should be evaluated under the Proposed Regulations. For example, consider a flat negative consent right over certain significant and unusual corporate actions, such as liquidation or a sale of substantially all of the assets, or a consent threshold that is high enough that a foreign government must be among the investors that approve an action, such as a requirement that 80% of investors give consent to a decision when a sovereign wealth fund owns 25% of an entity. The Proposed Regulations are unclear on whether or not such “blocking rights” give rise to effective control.

Under a special rule, the Proposed Regulations also deem a foreign government 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.[33]

The Proposed Regulations also state that an “interest” in an entity can include equity interests, debt interests, voting rights in the entity (including the power to appoint directors or managers, and to veto decisions), contractual rights in or arrangements with the entity (or with other interest holders in the entity), business relationships with the entity or with other interest holders in the entity (including as a major customer or a supplier having control over a strategic natural resource used in the entity’s business), regulatory authority over the entity, or any other interest in or other relationship with the entity that may provide influence over decisions relating to the entity’s operations, management, board-level, or investor-level matters.[34]

While this rule is generally consistent with prior guidance (which, among other things, states that “effective practical control” can be achieved through governmental control of a strategic resource that is used by an entity or by being a “substantial creditor”),[35] the Proposed Regulations include an example which illustrates the breadth of these rules.[36] In the example, the foreign government makes a loan, pursuant to which the borrower is subject to restrictions on the type of investments that it can make, asset dispositions, levels of future borrowing, and dividend distributions. In addition, the lender has veto rights over dividends and stock repurchases, additional borrowing, capital expenditures, the borrower’s annual operating budget, and the redemption of subordinated debt. It is not uncommon for commercial loan agreements to include similar restrictions on a borrower’s activity. Although a foreign government that makes such a loan as a minority participant in a consortium (where these rights are exercised by the lenders as a group, and not by the foreign government individually) would presumably not have “effective control” over a borrower, this example illustrates the diverse range of situations where a foreign government can have “effective control” under the Proposed Regulations. This example may also give rise to situations where it is possible to inadvertently fall into “effective control,” particularly in a rescue financing, where lenders may demand significant oversight rights with respect to the borrower, and where time is often of the essence. Such loans may also be offered to all shareholders on a pro rata basis initially, but if one or more shareholders declines to participate, a shareholder may be allocated a percentage of the company’s debt that is higher than its percentage of its equity. As a result, a foreign government investor that owns less than 50% of a company’s equity could end up with more than 50% of its debt, potentially turning the company into a CCE and making Section 892 unavailable for both interest and dividends.

The preamble to the Proposed Regulations states that the principles of Treasury Regulations Section 1.892-5T(c)(1)(i) (which attribute an interest owned directly or indirectly by an integral part or controlled entity to the foreign sovereign) will apply for purposes of the “effective control” test. In general, the consequence of such attribution would be that the rights held by different controlled entities of the same foreign government (e.g., a retirement fund for public employees and a sovereign wealth fund) would be aggregated, even in situations where the entities have separate management and are subject to limitations on how much information can be shared between them. However, as discussed below, the IRS and Treasury Department are seeking comments on whether it may be appropriate to treat such entities as functionally independent, and therefore not aggregate their rights under the “effective control” test.

“Foreign Government” Definition

Although Section 892 does not define a “foreign government,” current guidance defines a “foreign government” to include both an integral part of a foreign government and any “controlled entity.” In general, a “controlled entity” is an entity that is separate in form from a foreign sovereign or otherwise constitutes a separate juridical entity if it satisfies certain requirements, including that it is wholly owned and controlled by a single foreign sovereign directly or indirectly through one or more controlled entities controlled by the foreign sovereign.[37]

The current regulations also provide that a “controlled entity” does not include partnerships or any other entity owned and controlled by more than one foreign sovereign.[38] The preamble to the Proposed Regulations states that the IRS and Treasury Department are aware this rule may be interpreted by taxpayers as referring only to partnerships owned by more than one foreign sovereign. However, the IRS and Treasury Department view such a result to be inappropriate because an entity treated as a partnership for Federal tax purposes generally is not subject to U.S. federal income tax. Therefore, the Proposed Regulations amend this definition to provide that a “controlled entity” does not include any entity treated as a partnership for Federal tax purposes.[39]

Applicability Dates

Both the Proposed Regulations and the Final Regulations apply to tax years beginning on or after December 15, 2025. Taxpayers may, however, apply the Final Regulations and the portions of the Proposed Regulations that relate to the definition of a “foreign government” to their open taxable years, subject to consistency requirements.

It should be noted that the Proposed Regulations do not contain a “grandfather” or similar rule. Therefore, investments that are (or were) made prior to the Proposed Regulations’ effective date may need to be disposed of or restructured before the end of the tax year in which the Proposed Regulations are finalized if such investments do not comply with the Proposed Regulations, or if the Proposed Regulations create sufficient uncertainty that such investments represent an unacceptable risk to their owner’s Section 892 eligibility.

Request for Comments

The Proposed Regulations specifically request comments on:

• The circumstances, if any, in which the debt acquisition safe harbor for purchases of SEC-registered debt should be extended to offerings registered under foreign securities laws in addition to the Securities Act.
• The circumstances, if any, in which the secondary market debt acquisition safe harbor should apply to an acquisition of debt that is not traded on an established securities market.
• The circumstances, if any, in which acquisitions of distressed debt, broadly syndicated loans, revolving credit facilities, and delayed-draw debt obligations should be treated as investments rather than commercial activities for purposes of Section 892.
• The circumstances, if any, in which a determination could be made that controlled entities are functionally independent of one another and therefore may be appropriately considered separately for purposes of an effective control analysis.
• The circumstances, if any, in which the holder of a minority equity interest in an entity should not be treated as having effective control (or as having at least 50% of voting power) of the entity if managerial or board-level decisions of the entity are subject to veto or “blocking” rights of the holder and other holders (for example, through consent rights, supermajority requirements, or otherwise).

The Proposed Regulations also generally request comments on all aspects of the Proposed Regulations. The deadline for submitting comments on the Proposed Regulations is February 13, 2026. A public hearing will be scheduled if requested by any person timely submitting comments.

Although the concepts of “commercial activities” and a “trade or business” (as defined in Sections 162 and 864(b) of the Code) are legally separate, they have historically been interpreted in similar ways. The Proposed Regulations represent new and potentially significant guidance, particularly with respect to debt investments, which could potentially be broadened in the future to also apply to the rules governing whether an entity is in a “trade or business.” Therefore, taxpayers that would be affected by the guidance in the Proposed Regulations if it were extended to the Section 162 or Section 864(b) concept of a “trade or business” may be interested in commenting on the Proposed Regulations even if they are not directly affected by the Proposed Regulations.