Proposed Regulations Providing Guidance on the Taxation of the Income of Sovereign Wealth Funds from Investments in the U.S.
On November 3, 2011, the IRS issued proposed treasury regulations providing additional guidance for determining when a foreign government's U.S. sourced investment income is exempt from U.S. taxation. These proposed regulations would be effective on the date published as final regulations, although taxpayers may rely on these proposed regulations now to the extent they do not contradict current regulations.
Generally, foreign persons — including individuals, partnerships, corporations, estates, trusts, and governments — are subject to U.S. tax on U.S. sourced income. IRC Section 892 provides an exemption for certain types of income earned by a foreign government.
Under IRC Section 892 and the existing temporary regulations, income earned by a foreign government is generally exempt from tax when that income is received from
- Investments in stocks, bonds or other U.S. securities,
- Financial instruments held in the execution of governmental financial or monetary policy, or
- Interest on deposits in banks in the U.S. of moneys belonging to such foreign government.
However, income from commercial activities is not exempt. Further, no income earned from or derived on the disposition of an interest in a controlled commercial entity is exempt1 . Thus, if a foreign governmental entity such as a sovereign wealth fund ("SWF") earns income from a controlled commercial entity that includes investment type income, that investment income will also be taxable.
SWF investors often prefer investing in an onshore partnership and not an offshore corporate fund to take advantage of the exemption described above from tax on certain investment income, while at the same time minimizing any U.S. withholding taxes2. In cases where there is an expectation that a fund investment may generate trade or business/commercial income, which would cause a foreign investor to be subject to U.S. taxation on a net basis, a corporate entity may be used to hold that investment. Such a corporation would pay tax on the net income from the trade or business activity and undertake tax return filings in its own name, but would otherwise shield the foreign investor from both the direct imposition of income tax and the related tax filings that would otherwise be required. However, in the case of a SWF investor, the corporation could be a controlled commercial entity , with the result that the income is taxable and the commercial activity is attributed to the SWF with respect to all income from investments held directly or indirectly by the controlled commercial entity. For this reason, controlled commercial activities are preferably held at the lowest level of investment ownership possible in a SWF's chain of ownership, so that otherwise qualified exempt investments are not disqualified through direct or indirect ownership underneath a controlled commercial entity.
For purposes of determining whether an entity is a controlled commercial entity as a result of engaging in commercial activities, the proposed regulations modify the definition of commercial activity by providing for a de-minimus rule, further expanding the trading of financial instruments for one's own account exception, excluding certain income from real property dispositions, and providing for a limited partner exception.
To conform the treatment of financial instruments [including derivatives] to the treatment of physical stocks and securities, the proposed regulations remove the requirement that financial instruments must be held or traded for financial or monetary policy when applying the commercial activities test. However, income and gains from these financial instruments is still not exempt from tax under Sec. 892, although such income and gains may be exempt from withholding taxes under other statutory or treaty provisions. Further, the proposed regulations also provide that gain derived from the disposition of a U.S. real property interest is not a commercial activity, although the gains may still be taxable to a SWF investor.
The limited partner exception provides that an entity that is not otherwise engaged in commercial activities will not be treated as engaged in them solely by reason of holding an interest as a limited partner in a limited partnership which is engaged in commercial activities . In this case, the exception is not limited to the legal form of the entity being a limited partnership. That is, the regulations provide that solely for purposes of this exception (without inference for any other section of the Code), an interest is held as a limited partner in a limited partnership if the partner does not have rights to participate in the management and conduct of the partnership's business in an entity classified as a partnership for federal income tax purposes. This exception means that a SWF investor can hold an interest in a commercial activity through a partnership interest (including an LLC or Ltd properly classified as a partnership), though this does not change the fact that the SWF's distributive share of all income attributable to such commercial activity is subject to tax. Additionally, if the partnership is itself a controlled commercial entity, this exception does not apply and all income from such partnership is disqualified from exemption under Sec.892.
For additional information or questions, please contact:
National Managing Partner, Asset Management Tax
Deloitte Tax LLP
+1 212 436 2165
1 A controlled commercial entity is defined as an entity which is engaged in commercial activities (either in or outside the U.S.) that the foreign government holds an interest of 50% or more in or one that the foreign government has effective control of. Commercial activities are those which are ordinarily conducted by a person with a view towards the current or future production of income or gain. An activity may be considered a commercial activity even if that activity does not constitute the conduct of a trade or business under other provisions of the IRC. Investing in stocks, bonds, and other securities and trading in stocks, securities, or commodities for its own account (even through another party - such as a hedge fund) are not commercial activities.
2 The withholding tax imposed on offshore corporate funds is done based on the fund's domicile and status without looking through to its shareholders. So, in effect, the SWF investor could suffer a withholding tax on income earned through an offshore corporate vehicle that would be exempt if received directly. In contrast, partnerships would look-through to the status of the partners and treat the income as if received directly by the SWF to determine if a withholding tax is due unless the partnership itself was engaged in commercial activity.