Section 892 provides for foreign governments an exemption from U.S. tax on income from (a) investments in the U.S. in stocks, bonds and other securities; (b) investments in the U.S. in financial instruments held in the execution of governmental financial or monetary policy; and (c) interest on deposits in U.S. banks. A foreign government’s income is not exempt from U.S. tax if it is (a) derived from the conduct of any commercial activity; (b) received by a controlled commercial entity or received (directly or indirectly) from a controlled commercial entity; or (c) derived from the disposition of any interest in a controlled commercial entity. A “controlled commercial entity” is an entity that is controlled by a foreign government and engages in commercial activity.
In 1988, the U.S. Department of the Treasury promulgated temporary regulations under section 892 (the “1988 Regulations”) to provide guidance to foreign governments. On November 2, 2011, the IRS issued the Proposed Regulations to address some of the concerns that tax practitioners had raised under the 1988 Regulations.
Broadly speaking, if adopted, the Proposed Regulations would mitigate the effects of the existing rules in three ways. First, the Proposed Regulations would narrow the scope of the definition of a commercial activity, with the result that foreign governments would have more clarity on the behavior that constitutes commercial activity. Second, the Proposed Regulations would provide that inadvertent commercial activity would not cause the rest of an entity’s income to potentially be subject to U.S. taxation. Third, the Proposed Regulations provide that a foreign government would not be treated as engaged in commercial activity even if it is allocated commercial activity income from certain partnerships, which may simplify the manner in which foreign governments invest in private equity funds and other partnerships.
Definition Of Commercial Activity
Under the 1988 Regulations, there has been uncertainty about the standard for determining whether an activity is a commercial activity. Under the Proposed Regulations, activity “ordinarily conducted for the current or future production of income or gain” would be considered commercial activity, unless an exception applies. Furthermore, the purpose of the activity would be irrelevant, and the definition of a commercial activity is not tied to the definition of a trade or business for purposes of sections 162 and 864(b).
Under the Proposed Regulations, a foreign government’s investments, any trading activity surrounding those investments and dispositions of U.S. real property interests would not be considered commercial activity, regardless of the volume of transactions. Investments include stocks, bonds and other securities, as well as loans, financial instruments, the holding of net leases on real property, the holding of real property that is not producing income and bank deposits. For this purpose, trading activity involves transactions in stocks, bonds, other securities, commodities or financial instruments for a government’s own account, unless those transactions are undertaken as a dealer.
Notwithstanding the exceptions listed above, under the Proposed Regulations, any investment made in the course of a banking, financing, or similar business would constitute a commercial activity.
Certain Non-Commercial Activity Still Subject To Tax
Although the income from the above-described investing and trading activity would not constitute income from a commercial activity under the Proposed Regulations, the income from such activity is not necessarily tax-exempt to a foreign government or its controlled entity. Accordingly, income from certain types of investments, including investments in financial instruments not held in the execution of governmental financial or monetary policy, would remain taxable under section 892 (although it might be exempt under other provisions of the Code). Also, although an actual or deemed disposition of a U.S. real property interest would not be considered a commercial activity, income derived from such a disposition might not qualify for an exemption from tax under section 892.
Exception For Inadvertent Commercial Activity
Under the 1988 Regulations, any commercial activity undertaken by an entity controlled by a foreign government causes that entity to become a controlled commercial entity, regardless of the level of commercial activity. The Proposed Regulations would provide an exception to this rule, and would permit a company to engage in inadvertent commercial activity without becoming a controlled commercial entity if certain conditions are met. For a commercial activity to be “inadvertent,” three different tests must be satisfied: (a) the failure to avoid conducting the activity must be reasonable; (b) the commercial activity must be cured promptly; and (c) records must be maintained.
Under the Proposed Regulations, the reasonableness of a failure to avoid conducting the activity would be based on the facts and circumstances surrounding the activity. The relevant facts and circumstances would include the amount of commercial activity in the current year and in prior years, the percentage of the entity’s assets used in the activity and the percentage of the entity’s income generated by the activity. They would also include the existence of written policies and procedures in place to monitor the entity’s activity as well as the enforcement of those policies and procedures.
The Proposed Regulations would also provide a safe harbor for the reasonable failure test described above. A failure to avoid conducting a commercial activity would be considered reasonable if (a) the value of the entity’s assets related to commercial activity is less than or equal to five percent of the total value of the entity’s assets for the taxable year and (b) the income earned by the entity from commercial activity is less than or equal to five percent of the entity’s total income for the taxable year. Even if this safe harbor is satisfied, the commercial activity would need to be cured promptly. This would require that the entity cease the commercial activity within 120 days of its discovery. Also, records would need to be maintained for as long as they are relevant for determining the entity’s status under section 892.
Although these rules would prevent the inadvertent commercial activity from tainting all of a company’s income, the income attributable to a commercial activity is taxable.
The 1988 Regulations attribute all of a partnership’s activity to a partner for purposes of section 892, except for investments in publicly traded partnerships. For example, this has meant that an entity could be deemed to be engaged in commercial activity by holding a limited partnership interest in a partnership over which it has no control. The general rule that a partnership’s activity is attributed to its partners would still apply under the Proposed Regulations, but the Proposed Regulations would mitigate the impact of this rule in two cases: first, for a trading partnership and, second, for a non-controlling interest as a limited partner in a partnership. The Proposed Regulations provide that an entity would not be considered to be engaged in commercial activity solely because it is a partner in a partnership that trades in stocks, bonds, other securities, commodities or financial instruments for the partnership’s own account, unless the partnership is a dealer in any of those items. The Proposed Regulations also provide that an entity would not be deemed to be engaged in commercial activity solely because it holds a qualifying limited partnership interest in a partnership that is engaged in commercial activity. A qualifying limited partnership interest is an interest with respect to which the entity holding the interest does not have the right to participate in the management and conduct of the partnership’s business. A foreign government would still be able to retain consent rights over extraordinary events without being deemed to be participating in the conduct of the partnership’s business. In the case of both the trading partnership exception and the non-controlling limited partner exception, the foreign government would be taxed on its share of any income that remains taxable under section 892.
Frequency Of Controlled Commercial Entity Determination
The Proposed Regulations clarify that the determination of an entity’s status as a controlled commercial entity would be made on an annual basis. This means that an entity would not be considered a controlled commercial entity because of commercial activity undertaken in a prior taxable year.
 Section references are to the Internal Revenue Code of 1986, as amended (the “Code”), unless otherwise specified. References to regulations are to the regulations promulgated thereunder.
James R. Brown and Hillel N. Jacobson are Partners in the Tax Department of Willkie Farr and Gallagher’s New York City office.