Sovereign Wealth Investing in the US

To the point 

• Sovereign wealth funds are an important source of capital and fund managers are responding with strategic partnerships and unique investment opportunities.
• The U.S tax law affords SWFs tax exemptions on certain income under IRC Section 892. Careful analysis and structuring is required to effectively navigate the intricacies of Section 892 to achieve tax efficiencies.
• SWFs may also trigger Corporate AMT tax in certain investment structures.
  

Introduction

Sovereign Wealth Funds (SWFs) have become an increasingly important player and significant source of capital in the US investment landscape. SWFs are looking for bespoke products and seeking active engagement to secure a more meaningful influence over investment decisions. For asset managers, the opportunity to collaborate with SWFs confers more than access to substantial capital. It also presents the challenge of navigating complex regulatory environments, including US tax law, so SWFs can avoid tax pitfalls and achieve new tax efficiencies.

SWFs are pursuing more than just good returns; they want to participate actively in investment strategies, co-invest in select deals, and gain direct access to investment professionals. To win mandates and foster long-term collaboration, asset managers are responding accordingly. They are offering strategic partner relationships with SWFs, and some are customizing those relationships by structuring management fee and performance fee arrangements at the relationship level rather than on a product-by-product basis. This demonstrates the scale and importance of the relationship with SWFs in the ever-evolving US investment landscape. They may also provide SWF staff with training and knowledge-sharing sessions to further bolster relations and credibility.  Finally, asset managers may offer co-investment opportunities with side-by-side investments thereby providing unique investments through an alignment of interests. Combined, these efforts recognize SWFs as sophisticated investors with long-term objectives and governance needs and acknowledge that successful partnerships require a holistic approach with a higher level of engagement.

 Critical to these partnerships is understanding and complying with US tax regulations, particularly Section 892 of the Internal Revenue Code. US-based private equity funds looking to attract investment from SWFs are well served by being conversant with Section 892 and understanding potential benefits and structuring considerations. Section 892 affords tax exemption from foreign governments and can enable SWFs to achieve attractive returns by investing in US private equity funds. For these purposes, a foreign government is defined as only the integral parts or controlled entities of a foreign government. Many SWFs invest in US opportunities through a controlled entity of the foreign government to meet the requirements for this exemption. Section 892 offers an advantage to SWFs by exempting most types of passive income from US federal income tax. The statute exempts income from investments in stocks, bonds, or other securities, as well as income from financial instruments held in the execution of the foreign government’s financial or monetary policy, and of course interest from deposits held in US banks. The exemption also applies to income generated from the ownership of stocks in real estate investment trusts that would otherwise be subject to taxation under the Foreign Investment in Real Property Tax Act. When structured properly, US real estate and real estate funds can attract investments from SWFs since they have the added potential benefit of providing tax efficiency.

The Section 892 exemption is not all-encompassing. Consequently, careful and thoughtful structuring is necessary to mitigate tax friction and preserve the exemption. Income derived from commercial activities (commercial activity income or CAI), as well as income earned or received by controlled commercial entities (CCE), are not eligible for exemption under Section 892. If a controlled entity engages in commercial activity, it risks losing its Section 892 exemption on all US-sourced income.

Blocker entities are used to safeguard SWFs against the allocation of CAI. While an integral part of the government garnering CAI would still be eligible for the Section 892 exemption on other qualifying income, a controlled entity’s ability to claim a Section 892 exemption on its other income might be jeopardized if it acquires the status of a CCE. Careful structuring is essential to ensure that no CAI is attributable to a controlled entity. There are proposed regulations that can be relied upon that may provide relief for a controlled entity that receives inadvertent CAI.

When determining the form of the structure, it is important to avoid “tainting” Section 892 qualifying income by creating CCEs. In general, a CCE is any entity of the government, whether inside or outside the United States, that is engaged in commercial activities and in which the government holds directly or indirectly 50 percent or more of the total value, or voting power of the entity; or holds directly or indirectly sufficient interest (by value or vote) or any other interest in such entity that provides the foreign government with effective practical control of such entity. Staying below the 50 percent ownership threshold is a mechanical exercise in structuring. Care should be taken to ensure that a SWF does not have effective practical control through a thorough analysis of facts and circumstances. 

Investors in US real estate should be attentive to US real property holding corporation (USRPHC) regulations as defined in IRC Section 897(c)(2) or to those regulations governing a foreign corporation that would be treated as if it were a US corporation. USRPHCs are treated as being engaged in a commercial activity and therefore a CCE if the control requirements are met. Controlled entities should monitor the number of US real property interest owned to prevent the entity from becoming a CCE, what is commonly labeled the “basketing problem”. Proposed regulations would eliminate the USRPHC rule and that would ease some of the regulatory burdens on SWFs.

SWFs must also consider the rules governing the corporate alternative minimum tax (CAMT).  The CAMT rules are complex and broad and could entail unexpected results. US corporations are subject to CAMT if they are treated as “applicable corporations”. In general, a US corporation is an applicable corporation if its average “adjusted financial statement income” (AFSI) for a three taxable year period exceeds US$1 billion.  In addition, if a US corporation is a member of a “foreign parented multinational group” (FPMG), then the US corporation is an applicable corporation if (i) the average AFSI of the FPMG for a three taxable year period exceeds US$1 billion, and (ii) the AFSI of the US corporation for said three-year period exceeds US$100 million. AFSI is generally understood to be financial statement net income or loss, subject to certain adjustments. An interim safe harbor provides that such AFSI tests are not met based on thresholds of US$800 million and US$80 million (with limited adjustments to financial statement income or loss). 

For purposes of the AFSI tests, corporations that have a greater than 50 percent stock ownership connection (considering certain attribution rules) must group their AFSI together.  In addition, AFSI of greater than 50 percent related partnerships with trades or businesses would be considered. A FPMG generally requires certain types of consolidated financial statements that include at least one US corporation and one non-US corporation treated as the common parent. If a foreign corporation is engaged in a US trade or business, for US federal income tax purposes, then there will be a deemed US corporation and, thus, there could be a FPMG.

The investment structures and investments of a SWF could potentially have adverse consequences under the CAMT rules.  A SWF could be the parent of a greater than 50 percent related group, including US corporations indirectly owned through a partnership (e.g., a private equity fund). In such case, each of the US corporations would need to consider the AFSI of the other US corporations in making the determination of applicable corporation status.   

With respect to the FPMG rules, the CAMT statutory rules generally require members to be on the same consolidated financial statement which makes an FPMG less likely, although there could be a deemed FPMG based on US trade or business activity. However, the CAMT proposed regulations significantly expand the definition of a FPMG by applying certain financial accounting standards that could deem there to be consolidated financial statements, which can result in an FPMG.  The effect of a US corporation being included in a FPMG may make the AFSI tests for applicable corporation status easier to meet.

            Since the US tax environment is fluid and subject to legislative change, SWFs and asset managers should monitor it regularly. The One Big Beautiful Bill Act (OBBBA) was signed into law, an earlier iteration of the bill contained proposed provision Section 899. This provision was cast as a retaliatory tax policy aimed at foreign governments imposing “unfair” or “discriminatory” taxes on US companies-such as Digital Services Taxes and Pillar 2 Undertaxed Profits Rules. Section 899 introduced additional income tax and withholding taxes on payments. It would have effectively repealed the tax exemption under Section 892 for foreign governments of countries that impose an “unfair foreign tax”. Section 899 was subsequently removed from the OBBBA after an agreement was reached with G7 countries to exclude US companies from OECD Pillar 2 taxes. While Section 899 did not become law, it’s nevertheless a reminder of the precarious nature of tax exemptions for SWFs.

Conclusion 

As asset managers work to build relationships and attract investments from SWFs, it remains imperative that they have a full understanding of the tax regulations governing those investments. They want to provide SWFs with a robust and informed understanding of the complex requirements SWFs need to meet as they invest in the United States. Asset managers and their teams should be attentive to the specific criteria that dictate whether an SWF has met the requirements of Section 892 so it can preserve its tax-exempt status and also consider the impact of the CAMT rules. That requires careful structuring, planning, and monitoring of investments, transactions, and processes, all so that strong and mutually beneficial relationships can flourish.