On November 3, 2011 the U.S. Internal Revenue Service (the
"Service") published proposed regulations (the
"Proposed Regulations") under Section 892 of the U.S.
Internal Revenue Code (the "Code"). Section 892 of
the Code generally exempts foreign governments and their controlled
entities (including certain pension funds) from U.S. tax on
dividends and interest received from (and gains realized with
respect to) non-controlled U.S. entities, provided the controlled
entity is not engaged in commercial activities anywhere in the
world. The Proposed Regulations make a number of significant
changes to the circumstances in which a controlled entity of a
foreign government would be considered to be engaged in commercial
activities that would prevent access to the benefits of Section 892
of the Code. These changes generally make it easier for a
controlled entity to avoid being considered to be engaged in
The Proposed Regulations will not be effective until final regulations are published in the Federal Register, though the preamble to the Proposed Regulations states that taxpayers are permitted to rely on the Proposed Regulations until they are finalized. The Service has asked for comments on the Proposed Regulations and the final regulations will likely be modified in some fashion in response to the received comments.
Specifically, if finalized in their current form, under the Proposed Regulations:
- A controlled entity would not be considered to be engaged in commercial activities if it only conducts "inadvertent" commercial activity. In order for activity to be considered to be "inadvertent", three requirements need to be met: (i) the failure to avoid the activity must be reasonable, (ii) the failure must be promptly cured, generally within 120 days of its discovery, and (iii) adequate written procedures and operational policies must be in place to monitor the entity's worldwide activities. A safe harbor is provided where the failure to avoid conducting commercial activity would be considered to be reasonable if the income from the commercial activity represents 5 percent or less of the entity's income and the assets used in the inadvertent activity represent 5 percent or less of the entity's assets. Controlled entities with significant assets and income may have an easier time meeting the percentage test of the safe harbor.
- The determination of whether an entity is engaged in commercial activities would be made on an annual basis. As a result, an entity would not be considered to be engaged in commercial activities due to commercial activities conducted (or income earned) in a prior year. However, an entity will be considered to be conducting commercial activities in a particular year even if the activities were terminated earlier in the same year (unless the inadvertent exception applies).
- Whether an activity constitutes a commercial activity or a non-profit or governmental activity would be determined on an objective basis, without regard to the intent of conducting the activity.
- Investments in financial instruments, while not producing income considered exempt under Section 892, generally would not be considered to be a commercial activity (previously this specific exception applied explicitly only if the investments in financial instruments were made as part of the pursuit of governmental financial or monetary policy).
- A disposition of a United States real property interest, while not producing income considered exempt under Section 892, would not be considered to be the conduct of a commercial activity.
- A controlled entity that holds an interest as a "limited partner" in a partnership would not be attributed commercial activities of the partnership. An interest would be considered a limited partnership interest for this purpose only if the interest is a minority interest (less than 50 percent) and does not have any rights to participate in the management of the partnership under local law or under the governing instruments of the partnership. Specified veto rights over certain extraordinary transactions would not be considered a right to participate in management. A limited partner's share of the commercial income of the partnership would not be exempt under section 892, however.
- A controlled entity that invests in a partnership that trades stocks and securities but is not a dealer would not be considered to be engaged in commercial activities (previously there was some uncertainty whether the controlled entity would be considered to be trading "for its own account" in this circumstance).
A number of issues that were brought to the Service's
attention were not addressed by the Proposed Regulations, including
ambiguity regarding the disposition of a partnership interest under
the current regulations and the "deeming" rule that
causes a controlled entity to be treated as engaged in commercial
activities if it would satisfy the test for being a United States
real property holding corporation. These issues will likely be
brought to the Service's attention in comments and may be
addressed in the final version of the Proposed Regulations.
However, the Service may choose not to address these issues as part
of this regulatory project.
In summary, the principal consequence of the Proposed Regulations are that a controlled entity will generally be able to more easily avoid being considered to be engaged in commercial activity. In order to take advantage of two of the most important liberalizing rules of the Proposed Regulations, a controlled entity will want to make sure to develop and implement written operational procedures so that it will be eligible for the exception available for "inadvertent" commercial activity (as well as limit the holding of such activity to 5 percent of its assets to access the safe harbor), and ensure that its investments in partnerships are considered "limited" partnership interests so that it will not be attributed commercial activities of the partnership.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.