IRS releases proposed and final regulations affecting foreign governments

On December 15, the U.S. Internal Revenue Service issued both proposed regulations and final regulations under Section 892 of the U.S. Internal Revenue Code relating to the taxation of income of foreign governments from investments in the United States.

This bulletin discusses some of the key takeaways of the Proposed Regulations and Final Regulations.

Proposed Regulations

The Proposed Regulations introduce several concerning changes affecting Section 892 entities that invest in loans¹:

• They would treat all acquisitions of debt—including (but not limited to) at original issuance—as generating commercial activity income (CAI) unless the acquisition fits within one of two safe harbors treating the acquisition as an investment (the Safe Harbors) or under a facts and circumstances test.
• The Safe Harbors primarily cover the acquisitions of debt only in registered debt offerings and acquisitions of debt on an actual secondary market, leaving most other debt acquisitions to be evaluated within the facts and circumstances test. The Proposed Regulations provide a non-exclusive list of relevant factors to be analyzed under the facts and circumstances test and appear to be narrower than the guidelines that many Section 892 investors had been operating under previously.
• The language of the Proposed Regulations would eliminate the idea that a Section 892 investor has a limited number of “bullets” before lending is treated as giving rise to CAI, which many Section 892 investors previously relied on.
• The preamble suggests that these rules are unique to Section 892 and don’t necessarily provide insight into how the IRS views loan origination for Section 864 purposes (ECI).
• The Treasury Department requests comments on whether there are “any” circumstances where acquisitions of distressed debt, broadly syndicated loans, revolving credit facilities and delayed draw debt obligations should be treated as permitted investments, implying that these may all otherwise be treated as commercial activity.
• Although the Proposed Regulations provide an example indicating that shareholder debt can qualify as a permitted investment if the shareholder debt is not “significant” relative to the equity interest, such a test could impose strict limits on the amount of shareholder debt that could be put in place by a Section 892 investor.
• The overall impact of the Proposed Regulations strongly supports the idea that a Section 892 investor who engages in lending transactions should do so through a separate platform.

The Proposed Regulations would also introduce several concerning changes to the definition of “effective practical control” (now referred to as “effective control”) over an entity, which would render Section 892 unavailable with respect to income received from the controlled entity:

• The preamble states that the Treasury Department and the IRS are of the view that it is necessary and appropriate to define the term “effective control” broadly to include circumstances in which a foreign government would have control over the operational, managerial, board-level or investor-level decisions of an entity.
• The Treasury Department requests comments on whether there are “any” situations where a holder of a minority equity interest having veto or blocking rights should not result in being treated as having effective control, implying that such rights create a risk of being treated as having effective control. This could potentially cause Section 892 to be unavailable in many common joint venture scenarios (e.g., where there is a two- or three-party joint venture to own a blocker or REIT, or where the Section 892 investor has material veto rights):
  • Example 4 of the Proposed Regulations suggests that having the “unilateral” right to appoint or dismiss a manager of a corporation or its officers could create effective control. This could lead to issues in joint ventures where, in a default or conflict scenario, the Section 892 investor has the right to terminate and/or replace the manager.
  • Example 5 provides that having “alone” the right to “unilaterally” veto certain major decisions could create effective control.
    • It is unclear whether “alone” in this context means the Section 892 investor is the only investor with a veto right, or merely that the Section 892 investor can exercise that right without anyone else’s consent, and other investors can do the same. In any case, the use of both “alone” and “unilaterally” may suggest that only the former is problematic (e.g., only in situations where the Section 892 investor is the only shareholder with veto rights is there a problem).
    • It is also unclear whether the veto must cover all the items listed in the example (some of which are similar to the issues that the court in Alumax focused on) or if merely having the right to veto one or two is enough to constitute effective control.
    • The list in the example includes having the right to veto all of the following: dividend distributions, material capital expenditures, sales of new equity interests in the corporation and the corporation’s operating budget.

Overall, the new rules on effective control emphasize the benefits of having other avenues of exemption, such as access to Article XXI of the U.S.-Canada Income Tax Treaty and/or the Qualified Foreign Pension Funds (QFPF) exemption in joint ventures and other scenarios where there are significant veto and major decision rights.

The preamble helpfully confirms the rationale of certain private letter rulings granted on the per se rule that a business entity directly and indirectly wholly owned by a foreign government can be treated as a partnership for U.S. tax purposes and does not automatically become a “controlled entity” subject to U.S. tax. While the preamble is not technically part of the regulations, the language used, combined with the private letter rulings, would make it difficult for the IRS to assert that an entity indirectly owned by a single sovereign could never be treated as a partnership for U.S. tax purposes. As a practical matter, it should still be standard practice to structure to avoid the per se rule.

Final Regulations

• The preamble clarifies that the definition of commercial activities is broader than engaging in a trade or business and that an activity may be deemed to be a “commercial activity” even if not considered part of a “trade or business” for Section 864 purposes (which defines activities that can give rise to ECI).
• The preamble makes the same point as in the Proposed Regulations that making a single loan can constitute a commercial activity, thus effectively eliminating the “limited bullet” theory that some 892 investors relied on to exempt the origination of only a few loans a year.
• The Final Regulations finalize and clarify the position that most derivatives can be covered by the investment exception to commercial activity.
• The Final Regulations clarify that:
  • holding non-functional currency in a capacity other than that of a dealer or financial institution is not by itself commercial activity; and
  • holding and disposing of interests in a partnership is not by itself commercial activity.
• The preamble clarifies that receiving fee income through a private equity or similar fund may be commercial activity depending on the substance of the transaction and rejects comments to change the rule. This is consistent with advice to waive the right to receive excess fees when using a Section 892 investor. The preamble and Final Regulations do not shed any definitive light on the question of whether merely offsetting management fees is problematic, so the expectation is that there will be little change to market practices that treat an offset (without a refund) as acceptable for Section 892 investors.
• The Final Regulations eliminate the Deeming Rule that deemed a non-U.S. Section 892 eligible controlled entity to be engaged in commercial activities if it satisfied the U.S. Real Property Holding Corporations (USRPHC) test. The Deeming Rule was effectively already removed for QFPFs in the 2022 proposed regulations; the Final Regulations essentially apply this benefit to all Section 892 investors, whereas non-QFPF Section 892 investors previously only benefitted from the prior proposed regulations with respect to interests in non-controlled USRPHCs.
• The Final Regulations retain a helpful exception from the Deeming Rule for U.S. entities that would otherwise be considered commercial entities, allowing for the use of a controlled U.S. blocker to hold minority interests in USRPHCs (including REITs), which may be useful for Section 892 investors that are not QFPFs who want to use a blocker to block 897(h) distributions from REITs.
• The Final Regulations make certain clarifying changes to the inadvertent exception to commercial activity and limited partner exception, but leave many unanswered questions, particularly with respect to the limited partner exception.
• With respect to the inadvertent exception to commercial activity, the Final Regulations decline to adopt a de minimis rule for classifying commercial activity as inadvertent. The preamble also clarifies that an entity must have taken reasonable precautions to avoid commercial activity in order to rely on the exception, and that relying solely on tax or legal advice does not supersede the need to take reasonable efforts to establish, follow and enforce the applicable written policies and operational procedures to prevent commercial activity.
• The Final Regulations confirm that whether an entity is engaged in commercial activities is a year-by-year test, but activities conducted in the immediate prior year are relevant to the determination.
• The Final Regulations add a safe harbor for the limited partner exception that applies the exception automatically if certain conditions are met, including that the Section 892 investor (i) has no personal liability for claims against the partnership; (ii) has no right to enter into contracts or act on behalf of the partnership; (iii) is not a managing member or managing partner and does not hold an equivalent role under applicable law; and (iv) does not directly or indirectly own more than five percent of either the partnership’s capital interests or the partnership’s profits interests.