On December 12, the Treasury Department issued final Treasury Regulations (the “Final Regulations”) and proposed Treasury Regulations (the “Proposed Regulations”) that address various issues under Section 892 of the Internal Revenue Code (“Section 892”). In particular, the Final Regulations finalized a proposal from 2011 that permits foreign governmental investors to make certain passive investments in private funds without losing their exemption under Section 892.
A. Background
Section 892 provides that a foreign government, which is generally comprised of its integral parts and certain controlled entities, is exempt from U.S. federal income tax on certain U.S. income, generally interest, dividends, and certain other investment income. However, a foreign governmental entity that derives any income from a “commercial activity” is ineligible for the exemption under Section 892. Section 892 is often relied upon by foreign governmental investors, including sovereign wealth funds, in respect of their investments in private investment funds. The Final Regulations provide certainty that certain passive investments in private investment funds will not cause a foreign governmental investor to lose its exemption under Section 892.
B. The Final Regulations
The Final Regulations primarily address the determination of whether income is derived from “commercial activity” and whether an entity is a “controlled commercial entity.”
- The Renamed Limited Partner Exception
In 2011, the Treasury Department issued proposed regulations that addressed the definition of “commercial activity” for purposes of Section 892. These proposed regulations provided an exception to “commercial activity” for certain investments by a foreign government in limited partnerships (known as the “limited partner exception”).
In the Final Regulations, the “limited partner exception” is renamed the “qualified partnership interest exception” (the “QPIE”). The Final Regulations provide that an entity not otherwise engaged in commercial activity will not be treated as engaged in a commercial activity solely because it holds a “qualified partnership interest” in a partnership. While the QPIE prevents an entity from being treated as engaged in a commercial activity solely due to a qualified partnership investment, any commercial activity income derived by an entity from a qualified partnership interest is not exempt from taxation under Section 892.
Under the Final Regulations, a “qualified partnership interest” is defined as a partnership interest where the holder (1) has limited liability, (2) does not possess the legal authority to bind or to act on behalf of the partnership, (3) does not control the partnership, and (4) does not have rights to participate in the management and conduct of the partnership’s business at any time during the partnership’s taxable year. In addition, the Final Regulations contain a de minimis safe harbor that would apply to a holder that satisfies (1) and (2) above, is not a managing partner or managing member (or equivalent role) and holds not more than five percent of the capital or profits of a partnership.
The QPIE appears to specifically bless the participation of a foreign governmental entity on a limited partner advisory committee (an “LPAC”) commonly utilized in private investment funds. Participation in a typical LPAC would not constitute a right to participate in management or conduct of the partnership’s business; however, the rights of an LPAC in a specific private investment fund should be carefully reviewed to ensure they do not run afoul of the QPIE.
The finalization of the QPIE rules is welcome news to both fund managers and investors as it provides comfort that most passive investments in investment funds will not constitute a “commercial activity.”
- Controlled Commercial Entities
The Final Regulations provide a definition of “controlled commercial entity.” Any income derived by or from a controlled commercial entity or from the disposition of a controlled commercial entity is not eligible for the Section 892 exemption. An entity is treated as a controlled commercial entity if it is engaged in commercial activity and a foreign government holds, directly or indirectly, fifty percent or more of the entity (by value or vote) or holds, directly or indirectly, effective control of the entity.
To mitigate this harsh result, the Final Regulations provide a helpful exception for “inadvertent commercial activity” in the form of a three-part test: (1) the failure to avoid conducting commercial activity must be “reasonable,” which requires certain ongoing due diligence including adequate written policies and operational procedures, (2) the commercial activity must be timely cured and (3) certain records must be kept. In addition, provided that adequate written policies and operational procedures are in place, the Final Regulations contain a de minimis safe harbor which can be utilized to establish that the failure to avoid commercial activity during a taxable year was reasonable if the (1) value of the assets used in all commercial activity does not exceed five percent of the total assets of the relevant entity (based on a quarterly average) and (2) income earned by the entity from commercial activity does not exceed five percent of the entity’s gross income for the taxable year.
C. The Proposed Regulations
- Effective Control
The Proposed Regulations address the definition of “effective control,” as referenced above, regarding controlled commercial entities. Under the Proposed Regulations, a foreign governmental entity would be treated as having “effective control” of another entity if it holds any interest in any entity that “results in control of the operational, managerial, board-level, or investor-level decisions of the entity.” When making this determination, all rights are considered, including ownership interests, debt interests, voting rights (including veto rights), contractual rights or arrangements, business relationships and regulatory authority.
- Investments in Debt Instruments
The Proposed Regulations also address whether an investment in debt instruments is treated as a commercial activity for purposes of Section 892. The Proposed Regulations provide that an acquisition of debt is treated as a commercial activity unless it “qualifies as investment.” This provision raises significant questions as to whether many common activities of investment funds would be treated as a “commercial activity” under Section 892. Sovereign investors and fund managers should carefully consider these new Proposed Regulations when making investments.
Please see our memorandum published here for a more extensive discussion of this provision of the Proposed Regulations on debt investments.
D. Key Take-Aways
- The Final Regulations should enable foreign governmental investors to rely upon the QPIE when investing in private investment funds with more certainty and comfort.
- The Final Regulations provide helpful guidance regarding the treatment of controlled commercial entities.
- Fund managers should be wary of possible changes to what is considered a “commercial activity” if the Proposed Regulations are finalized.
Seward & Kissel LLP actively monitors changes to the legislative landscape and how any changes may impact the investment management industry. For additional information on recent income tax changes, please contact a member of Seward & Kissel’s Tax Department.
