by Joel D. Almquist, Won-Han Cheng, Thomas F. Holt, Jr., Scott D. Newman, Theodore L. Press, Charles H. Purcell, Roger S. Wise
Section 892 provides a U.S. tax exemption to foreign governments (as defined below) for certain types of U.S.-source investment income. Because all non-U.S. persons are exempt from U.S. tax on income from trading in stocks and securities for their own accounts, bank deposit interest, and (under the portfolio interest exemption) most U.S.-source interest, the main benefit of the section 892 exemption is for U.S.-source dividends (which would otherwise be subject to U.S. withholding tax at a rate of 30%, or a lower treaty rate, if available).
A “foreign government” means the integral parts or controlled entities of a foreign sovereign. Sovereign wealth funds generally qualify as foreign governments under section 892, as do many foreign governmental pension plans.
The section 892 exemption does not apply to “commercial activity income” or to income received by, or from, a “controlled commercial entity”. The policy behind these exceptions is that foreign governments should not be allowed to use their exempt status to compete unfairly with for-profit businesses. If a controlled entity engages in commercial activities anywhere in the world, it will be treated as a controlled commercial entity and will not qualify for the section 892 exemption with respect to any of its income.
This “all or nothing” rule can be a trap for a controlled entity investing in private funds because a controlled entity is generally treated as being engaged in any commercial activity conducted by a partnership in which it is a partner.
Proposed tax regulations issued on November 3 will make it easier for foreign governments, their instrumentalities and controlled entities – including sovereign wealth funds – to invest in U.S. private funds without losing the U.S. tax exemption provided under section 892 because of income from commercial activities. The proposed regulations limit the “all or nothing” approach of the current regulations (temporary regulations issued in 1988), under which a small amount of commercial activity income can cause an entity to lose the exemption with respect to all of its income. Taxpayers are permitted to rely on the proposed regulations until they are published in final form.