The Internal Revenue Service (IRS) has issued proposed regulations under Section 892 of the Internal Revenue Code (available here) that generally provide favorable clarifications and modifications of the rules governing eligibility for the Section 892 tax exemption of a controlled entity of a foreign sovereign that is not an integral part of such foreign sovereign (“controlled entity”), such as many sovereign wealth funds. Specifically, under the proposed regulations, a controlled entity will not be subject to the so-called “all or nothing” rule that would cause it to forfeit its eligibility for the Section 892 tax exemption solely as a result of inadvertent commercial activity, investments in partnerships as a limited partner, investments in partnerships engaged in certain trading activities and no other commercial activities, investments in financial instruments, or dispositions of U.S. real property interests (“USRPIs”). Pursuant to the Preamble, taxpayers may rely on these proposed regulations until final regulations are issued.
Section 892 exempts from U.S. income taxation certain investment income from stocks, bonds and other securities derived by a foreign government, where a “foreign government” is defined as an integral part of a foreign sovereign, or a controlled entity. Sovereign wealth funds often constitute controlled entities, or they make investments through special purpose vehicles that constitute controlled entities. However, the Section 892 exemption does not apply to income derived from the conduct of commercial activity or derived from or by a controlled commercial entity (“controlled commercial entity”).
Under rules in the current regulations in effect since 1988, a controlled commercial entity is a controlled entity engaged in commercial activities anywhere in the world, directly or indirectly through a partnership. Accordingly, under the so-called “all or nothing” rule, none of the income derived by or from a controlled entity engaged in any commercial activity anywhere in the world (i.e., a controlled commercial entity) is eligible for the Section 892 exemption. This rule has been roundly criticized as a trap for the unwary who inadvertently conduct small levels of commercial activity as well as an unnecessary administrative and operational burden for foreign governments.
Highlights Of The Proposed Regulations
The proposed regulations clarify and modify the determination of whether a controlled entity is engaged in commercial activities anywhere in the world and is, therefore, a controlled commercial entity. As mentioned above, taxpayers may rely on these proposed regulations until final regulations are issued. Highlights include the following—
In addition, the proposed regulations clarify that a controlled entity will not be treated as engaged in commercial activities solely because it holds an interest as a (general or limited) partner of an entity classified as a partnership for U.S. federal income tax purposes that effects transactions in stocks, bonds, other securities, commodities or financial instruments for the partnership’s own account and is not a dealer. Under the current regulations, it is unclear whether such activity results in the attribution of commercial activity to controlled entity partners.
Patrick B. Fenn is Co-head of the tax practice group in the New York office and was one of the founding partners of that office in April 1993. Mr. Fenn focuses on providing taxation advice to domestic and offshore investment funds and to fund managers. In addition, he has extensive experience in the area of international taxation and has been involved in the structuring of major inbound and outbound multijurisdictional mergers and acquisitions.
Stephen M. Jordan, a Partner in the New York office, focuses on the tax-efficient structuring of domestic and cross-border debt and equity investments. Mr. Jordan regularly advises investment funds, high-net-worth individuals and multinational corporations, including financial institutions, on the tax implications of international private equity investments; financial products; and domestic and cross-border mergers, acquisitions and restructurings.
Stuart E. Leblang, a Partner, is the Co-head of Akin Gump's tax practice. Mr. Leblang also serves on the firmwide management committee. Mr. Leblang’s practice includes planning and negotiation of domestic and international business transactions, corporate and financial tax counseling, and representation of clients on tax legislative and policy issues before the U.S. Congress, the U.S. Department of Treasury and other federal agencies. He also focuses on various investment-fund-related matters.
Robert P. Rothman, Senior Counsel, advises clients on the tax aspects of a wide range of business transactions. He is particularly experienced in corporate mergers, acquisitions, leveraged buyouts, organizations, reorganizations, spin-offs, recapitalizations, redemptions, distributions, liquidations and other transactions involving both publicly and privately owned corporations.