Last week, I introduced Section 892 regulations, which address the taxation of U.S. income earned by foreign governments. In a nutshell, Section 892 exempts foreign governments’ income from investing in U.S. stock, bonds and certain financial instruments; other types of income are not exempt.


To prevent unwary governmentally controlled entities who inadvertently conducted a small amount of commercial activities from losing Section 892 exemption, the proposed regulations allow a government controlled entity to continue to claim Section 892 benefits, as long as:

  1. the commercial activities are not more than a reasonable failure on the part of the entity and
  2. the entity takes prompt action to discontinue and record the commercial activities.

To satisfy the reasonableness test, the proposed regulations require the assets used in the commercial activity do not exceed 5% of the value of the entity’s worldwide assets, and the income from such activity does not exceed 5% of its gross income. In addition, the entity must implement adequate policy and procedure to monitor its worldwide activities. The income from the commercial activities is not exempted under Section 892.

Commercial Activities Exceptions

 For the purpose of Section 892, if a government controlled entity engages in any commercial activity anywhere in the world, the entity loses Section 892 benefits. The existing regulations enumerated a number of exceptions. For example, passive investing and trading under certain circumstances are not considered commercial activities. The proposed regulations further expand the commercial activity exceptions. For example, the proposed regulations eliminate the requirement that financial instruments must be held in the execution of governmental financial or monetary policy.

The IRS did not explain the reason for such a restriction on financial instruments in the existing regulations. In fact, investment in stocks, bonds and other securities is not subject to similar restrictions. Investing in financial instruments, which includes forward, futures, option contracts, and swap agreements, should be no more commercially active than investing in stocks and bonds. As such, the proposed regulations eliminate such restrictions on financial instruments. So, under the new regulations, investing and trading financial investments will not be considered a commercial activity, regardless where such financial instruments are held.

Furthermore, the proposed regulations clarify that the mere disposition of a U.S. real property interest does not constitute commercial activity.  Under Section 897(a)(1), a non U.S. person must treat gain or loss from disposition of any U.S. real property as if the gain was effectively connected with a U.S. trade or business, and is taxed at regular rates.  Normally, a U.S. trade or business would rise to the level of commercial activities. The proposed regulations explicitly reverse this rule, and state that mere disposition of passive investment in U.S. real property interest will not give rise to commercial activities.  However, gain from the disposition of any U.S. real property is not exempted under Section 892.

Partnership Attribution Rule

Under existing Section 892 regulations, commercial activities of a partnership are attributable to both general partners and limited partners.  So if a government controlled entity is a limited partner in a partnership that conducts any commercial activities anywhere in the world, the controlled entity will be disqualified from all Section 892 benefits.  This is true even if that entity does not have any management rights or powers, never participates in the partnership’s actual operation, and otherwise never engages in any commercial activities. As a result, the partnership attribution rule discourages foreign governments investing in partnerships, even as a limited partner.

The new proposed regulations provide an exception to the attribution rule for limited partners.  Commercial activities of a partnership will not be attributable to a limited partner if the limited partner does not have rights or powers to participate in the management and conduct of the partnership’s business at any time during a taxable year, except for consent rights in the case of extraordinary events, such as admission of new partners and the dissolution of a partnership.  However, even a partnership’s commercial activities will not be attributable to a limited partner, and the limited partner’s share of the partnership income derived from commercial activities will not be exempted under Section 892.

Foreign government investment, especially through Sovereign Wealth Funds, provides important sources of capital for economic growth in the U.S. By expanding the exceptions to the “commercial activities prohibition”, the proposed regulations will encourage foreign government’s capital inflow without creating an unfair advantage for government entities competing with private industries in active business.


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