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New Tax Regulations Seek to Ameliorate Harsh Effects of Commercial Activity Limitation Under Section 892 Sovereign Tax Exemption
New Tax Regulations Seek to Ameliorate Harsh Effects of Commercial Activity Limitation Under Section 892 Sovereign Tax Exemption
New Tax Regulations Seek to Ameliorate Harsh Effects of Commercial Activity Limitation Under Section 892 Sovereign Tax Exemption
New Tax Regulations Seek to Ameliorate Harsh Effects of Commercial Activity Limitation Under Section 892 Sovereign Tax Exemption
New Tax Regulations Seek to Ameliorate Harsh Effects of Commercial Activity Limitation Under Section 892 Sovereign Tax Exemption
New Tax Regulations Seek to Ameliorate Harsh Effects of Commercial Activity Limitation Under Section 892 Sovereign Tax Exemption
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New Tax Regulations Seek to Ameliorate Harsh Effects of Commercial Activity Limitation Under Section 892 Sovereign Tax Exemption


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  • 1. November 8, 2011 New Tax Regulations Seek to Ameliorate Harsh Effects of Commercial Activity Limitation Under Section 892 Sovereign Tax ExemptionTax Policy Client Alert On November 2, 2011, the U.S. Treasury and Internal Revenue Service issuedThis Alert provides only proposed regulations (the “Proposed Regulations”) under section 892 of the Internalgeneral information and Revenue Code of 1986, as amended (the “Code”), which provides an exemption from U.S. federal income tax for certain categories of U.S. source income when that incomeshould not be relied upon as is received by a foreign government. The Proposed Regulations represent the firstlegal advice. This Alert may major overhaul of regulations issued in 1988 (the “Existing Regulations”) and generallybe considered attorney focus on issues related to the so-called “commercial activity” limitation, which hasadvertising under court and particular relevance for those entities that qualify for the section 892 exemption asbar rules in certain “controlled entities” of a non-U.S. sovereign. This memorandum contains a brief overview of the section 892 exemption and a summary of the Proposed Regulations.jurisdictions. The Proposed Regulations are subject to a 90-day public comment period before theyFor more information, contact are finalized. While the Proposed Regulations may be changed in one or moreyour Patton Boggs LLP respects as a result of submissions made during the comment period, the Proposedattorney or the authors listed Regulations may, as discussed below, be relied upon until final regulations are issued.below. I. Overview of the Section 892 Exemption Section 892 provides an exemption from U.S. federal income tax for certain categoriesDonald V. Moorehead of U.S. source income when that income is received by a foreign government. section 892 exemption applies to income from investments in the United States in (1) stocks, bonds and other domestic securities; and (2) financial instruments held in theRichard E. execution of the foreign government’s financial or monetary policy. It also applies to interest on deposits in banks in the United States of monies belonging to the foreignLindsay M. Fainé The section 892 exemption does not apply to any income (1) derived from a “commercial activity,” whether conducted within or outside the United States; (2)WWW.PATTONBOGGS.COM received by a “controlled commercial entity” or received (directly or indirectly) from a controlled commercial entity; or (3) derived from the disposition of an interest in a controlled commercial entity. For purposes of the section 892 exemption, the term “foreign government” includes both integral parts and controlled entities of a non-U.S. sovereign. In the case of a controlled entity, the section 892 exemption is conditioned on a requirement that the entity not engage, directly or indirectly, in any “commercial activity” (as that term is defined in the Existing Regulations).1 This commercial activity limitation is applied on a global basis and not merely to investments and other activities in or with respect to the United States. Moreover, under the Existing Regulations, there is no de minimis exception to the commercial activity limitation. Thus, as the result of this so-called “all
  • 2. or nothing” rule, the slightest commercial activity undertaken directly or indirectlyanywhere in the world – even inadvertently – converts the controlled entity into acontrolled commercial entity and results in its forfeiture of the section 892 exemption inits entirety. For controlled entities there are thus two issues that arise under section892 with respect to proposed investments and other income producing activities;namely, whether the income and gain generated by the investment or other activity willbe eligible for the section 892 exemption2 and whether the investment or activityinvolves a commercial activity that will be treated as having been undertaken, directlyor indirectly, by the controlled entity. The Proposed Regulations address issues relatedto the second of these questions – the scope of the commercial activity limitation – anddo not make any changes to the provisions of the Existing Regulations that define thetypes of U.S. source income that are eligible for the section 892 exemption. II. Summary of the Proposed RegulationsA. What is a “Commercial Activity”?1. General Definition of Commercial Activity. Subject to five enumerated exceptions,the Existing Regulations contain a very broad definition of the term “commercialactivity.” Specifically, that term is defined to include “all activities (whether conductedwithin or outside the United States) which are ordinarily conducted by the taxpayer orby other persons with a view towards the current or future production of income orgain.”3The Proposed Regulations continue this rule, but with two important clarifications.4First, only the “nature” of an activity and not the “purpose” or “motivation” of the section892 entity for undertaking the activity will determine whether an activity will beclassified as a commercial activity. Second, an activity may be classified as acommercial activity even if it does not constitute a trade or business under section 162(relating to deductible business expenses) or does not constitute (or would notconstitute if undertaken in the United States) the conduct of a U.S. trade or businessfor purposes of section 864(b).2. Investments in Financial Instruments as Commercial Activities. The ExistingRegulations contain two exceptions for investment-type transactions. The first of these,which is commonly referred to as the “investment” exception, provides that the term“commercial activity” does not include investments in stock, bonds and othersecurities, as well as certain other types of investment transactions, including“investments in financial instruments held in the execution of governmental financial ormonetary policy.”5 The second exception, which is commonly referred to as the“trading” exception, provides that the term “commercial activity” does not includeeffecting transactions in stocks, securities or certain commodities for the government’sown account, but makes no reference to trading financial instruments.6 Neitherexception applies to “dealers” or to transactions undertaken as part of a “banking,financing, or similar business.”7The Proposed Regulations amend both the investment exception and the tradingexception to provide that neither investing nor trading in financial instruments will beclassified as a commercial activity, whether or not the instruments are held in theexecution of governmental financial or monetary policy.8 The Proposed Regulationscontinue the provision of the trading exception that limits the definition of“commodities” to “commodities of a kind customarily dealt in on an organized
  • 3. commodity exchange, but only if the transaction is of a kind customarily consummatedat such a place.”9The provisions of the Proposed Regulations relating to financial instruments apply onlyfor purposes of the commercial activity limitation and, consistent with the language ofsection 892 itself, the exemption continues to apply only with respect to income andgain attributable to those financial instruments that are held in the execution ofgovernmental financial or monetary policy. Thus, under the Proposed Regulations asunder current law, to the extent income or gain from financial instruments that are notheld for these purposes is U.S. source income, a section 892 entity may be required tofile a U.S. tax return and pay U.S. tax with respect to that income or gain.3. Certain Real Estate Investments as Commercial Activities. Under section 897(a)(1)(part of the so-called FIRPTA provisions of the Code), if a non-resident alien individualor a foreign corporation realizes gain on the sale or other disposition of a United Statesreal property interest (a “USRPI”), the gain is subject to U.S. tax as income that iseffectively connected with a U.S. trade or business.10 The Proposed Regulations clarifythat an entity that disposes of a USRPI will not be treated as engaged in a commercialactivity solely by reason of that disposition. The Preamble to the Proposed Regulationsstates that “[t]he Treasury Department and the IRS believe that an entity that onlyholds passive investments and is not otherwise engaged in commercial activitiesshould not be deemed to be engaged in commercial activities [and thus ineligible forthe section 892 exemption] solely by reason of the application of section 897(a)(1).”For this reason, the Proposed Regulations provide that a disposition, including adeemed disposition under section 897(h)(1), of a USRPI will not be treated as acommercial activity.11 Significantly, however, the gain derived from the disposition of aUSRPI that is not stock in a United States real property holding corporation will notqualify for the section 892 exemption;12 as a result, section 892 entities may berequired to file a U.S. tax return and pay U.S. tax on any such gain.4. Investments in Partnerships as Commercial Activities. Under the ExistingRegulations, the commercial activities of a partnership (other than a publicly tradedpartnership) are attributable to its general and limited partners.13 Under the ProposedRegulations, this rule is continued, but subject to an exception under which a section892 entity that is not otherwise engaged in commercial activities will not be treated asso engaged solely because it holds an interest as a limited partner in a limitedpartnership.14 For this purpose, a limited partnership interest is defined as an interestin an entity that is properly classified as a partnership for U.S. federal income taxpurposes, but only if the holder of the limited partnership interest in question does not,under either the law of the jurisdiction in which the partnership is organized or thepartnership’s governing instrument, have a right to participate in the management andconduct of the partnership’s business at any time during the partnership’s taxableyear.15The proposed limited partner rule applies only for purposes of determining whether thesection 892 entity is engaged in commercial activities. The section 892 entity’sdistributive share of the partnership’s income attributable to the non-exempt activitiesof the partnership will not be exempt under section 892.16 Thus, if the income is U.S.source income, the section 892 entity may have to file a U.S. tax return and pay on that income.5. Partnership Trading Activity. The Proposed Regulations extend the protection of therevised ”trading” exception (as discussed above) to section 892 entities that are
  • 4. members of a partnership that effects transactions in stocks, securities, certaincommodities or financial instruments for the partnership’s own account.17 As a result, asection 892 entity that is a partner (including a general partner) in such a partnershipwill not be deemed to be engaged in commercial activities so long as the partnership’sactivity is itself exempt under the trading exception. This new rule does not apply,however, if the partnership is classified as a “dealer” in stocks, securities, commoditiesor financial instruments.B. Inadvertent Violations of the Commercial Activity LimitationThe Proposed Regulations contain a special provision that ameliorate the effects of the“all or nothing” rule in certain cases.18 Specifically, an entity is not treated as engagedin commercial activities (and therefore classified as a controlled commercial entity thatis outside the scope of the section 892 exemption) if its only commercial activitiesqualify as “inadvertent.” For this purpose, a commercial activity is “inadvertent” only if(1) the failure to avoid engaging in the commercial activity is “reasonable;”19 (2) thecommercial activity is promptly “cured;”20 and (3) certain record maintenancerequirements are satisfied.21The Proposed Regulations provide a safe harbor under which a section 892 entity’sfailure to avoid engaging in a commercial activity will be treated as “reasonable” if (1)the value of the assets used in, or held for use in, the commercial activity does notexceed five percent of the total value of the assets reflected on the entity’s balancesheet for the taxable year as prepared for financial accounting purposes; and (2) theincome earned by the entity from the commercial activity does not exceed five percentof the entity’s gross income as reflected on its income statement for the taxable yearas prepared for financial accounting purposes. Importantly, the proposed safe harborwill apply only if the section 892 entity has “adequate written policies and operationalprocedures” in place to monitor its activities on a global basis.In the case of a commercial activity that qualifies as “inadvertent” under thesestandards, the income attributable to the activity will retain its character as commercialincome and will not be exempt under section 892. Thus, if the income or gain is U.S.source income, the section 892 entity may be required to file a U.S. tax return and payU.S. tax on that income or gain.C. Year-by-Year Approach to Violations of Commercial Activity LimitationThe Existing Regulations do not expressly address the question of whether a violationof the commercial activity limitation in one taxable year will result in the loss of thesection 892 exemption for that year and all future years. The Proposed Regulationsclarify this issue by providing that the determination of whether a controlled entity iseligible for the section 892 exemption will be made on an annual basis, with the resultthat an entity will not be classified as a “controlled commercial entity” (and thus asineligible for the section 892 exemption) solely because it engaged in a commercialactivity in a prior taxable year.22D. Effective Date and Reliance on Proposed RegulationsBy their terms, the Proposed Regulations apply from the date they are published infinal regulations in the Federal Register. However, the Preamble to the ProposedRegulations states that “[t]axpayers may rely on the proposed regulations until finalregulations are issued.”
  • 5. This Alert provides only general information and should not be relied upon as legal advice. This Alert may also be considered attorney advertising under court and bar rules in certain jurisdictions. WASHINGTON DC | NORTHERN VIRGINIA | NEW JERSEY | NEW YORK | DALLAS | DENVER | ANCHORAGE DOHA, QATAR | ABU DHABI, UAE1 A “controlled entity” is defined as an entity that is separate in form from a foreign sovereign orotherwise constitutes a separate juridical entity if it meets certain requirements. These include that it bewholly-owned by the foreign sovereign, organized under the laws of the foreign sovereign by which it isowned and its assets pass to the foreign sovereign when it is dissolved. Treas. Reg. section 1.892-2T(a)(3). A controlled entity is classified as a “corporation” for U.S. tax purposes.2 As a practical matter, given the general tax rules applicable with respect to passive non-U.S.investors, the section 892 exemption generally is essential only with respect to (1) avoiding the U.S.withholding tax on dividends from non-controlled U.S. corporations; (2) avoiding the U.S. withholdingtax on those types of U.S. source interest (i.e., contingent interest and interest from related but non-controlled obligors) that are not eligible for the general withholding exemption applicable to “portfoliointerest”; and (3) avoiding the U.S. tax otherwise imposed under the FIRPTA provisions of the Code onthe disposition of interests in certain U.S. real property holding corporations.3 Treas. Reg. section 1.892-4T(b).4 Treas. Reg. section 1.892-4T(b).5 Treas. Reg. section 1.892-4T(c)(1)(ii).6 Treas. Reg. section 1.892-4T(c)(1)(ii).7 Treas. Reg. section 1.892-4T(c)(1)(ii) and (iii).8 Prop. Treas. Reg. section 1.892-4(e) (setting forth the “dealer” and “banking” business limitations).9 Prop. Treas. Reg. section 1.892-4(e)(ii).10 Under section 897(c)(1), a USRPI includes (1) an interest in real property located in the United Statesor the Virgin Islands and (2) any interest (other than an interest solely as a creditor) in any U.S.corporation that is a United States Real Property Holding Corporation (a “USRPHC”) during aprescribed time period. In general, a USRPHC is, with certain exceptions, a corporation the value ofwhose USRPIs equals or exceeds 50 percent of the value of the sum of its USRPIs, its non-U.S. realproperty interests and its other assets if used or held for use in a trade or business. See section897(c)(2).11 Under section 897(h) and with certain exceptions, if a real estate investment trust (a “REIT”) or otherqualified investment entity (as defined) makes a distribution to a non-resident alien individual or aforeign corporation that is attributable to the sale by the distributing entity of USRPI, the gain is taxed tothe recipient as if it were effectively connected with the conduct of a U.S. trade or business. Such a rulewas provided on the ground that, since REITs and other qualified investment entities are not subject toU.S. tax if they distribute substantially all their income to their equity holders, gain on the sale of aUSRPI by such an entity would be entirely exempt from U.S. tax.12 In Notice 2007-55, the IRS announced that it would issue regulations under which the section 892exemption for gain on the sale of stock does not override section 897(h). The Proposed Regulations areconsistent with such an approach and the limitation to dispositions by a covered REIT or other qualifiedinvestment entity of a direct interest in U.S. real property is consistent with provisions of the ExistingRegulations. See Treas. Reg. section 1.892-3T(a)(1).13 Treas. Reg. section 1.892-5T(d)(3). In addition, under section 875(1), a non-resident alien individualor foreign corporation that is a member of a partnership is treated as engaged in any U.S. trade orbusiness in which the partnership is engaged. In contrast, the commercial activities of a corporationgenerally are not, however, attributed to its shareholders and likewise shareholders of a corporation aregenerally not treated as engaged in any U.S. trade or business in which the corporation is engaged.14 Prop. Treas. Reg. section 1.892-5(d)(i) and (iii).15 Prop. Treas. Reg. section 1.892-5(d)(iii)(B), which also provides that rights to participate in themanagement and conduct of a partnership’s business do not include consent rights in the case ofextraordinary events such as the admission or expulsion of a general or limited partner, disposition ofall or substantially all of the partnership’s property outside the ordinary course of the partnership’sactivities, merger or conversion.
  • 6. 16 Prop. Treas. Reg. section 1.892-5(d)(iii) states that “pursuant to sections 875, 882, and892(a)(2)(A)(i), a foreign government member’s distributive share of partnership income will not beexempt from taxation under section 892 to the extent that the partnership derived such income from theconduct of a commercial activity.”17 Prop. Treas. Reg. section 1.892-5(d)(ii).18 Prop. Treas. Reg. section 1.892-5(a)(2).19 Prop. Treas. Reg. section 1.892-5(a)(2)(ii) specifies a general facts and circumstances test for thisdetermination, subject to a continuing due diligence requirement to identify commercial activities and,as noted in the text, provides a safe harbor for reasonableness determinations.20 Prop. Treas. Reg. section 1.892-5(a)(2)(iii) specifies that a timely cure will be considered to havebeen made if the conduct of the commercial activity is discontinued within 120 days after its discovery.21 Prop. Treas. Reg. section 1.892-5(a)(2)(iv).22 Prop. Treas. Reg. section 1.892-5(a)(3).