Late in 2025, Treasury and the IRS released a guidance package under Section 892 of the Internal Revenue Code, which exempts foreign governments—including sovereign wealth funds—from tax on certain income derived from passive U.S. investments. The package includes both final and proposed regulations addressing key interpretive questions.
Section 892 draws a line between investment activity and commercial activity. Notably, the exemption from tax does not apply to income derived from a "commercial activity" (whether conducted within or outside the United States), or to income earned by (or from the sale of an interest in) a "controlled commercial entity."
The final regulations largely adopt proposed rules issued in 1988, 2011, and 2022 and clarify the scope of several existing rules, while the proposed regulations focus on unresolved questions related to lending activity and effective control. In doing so, Treasury has formalized guidance in an area of tax law that has seen relatively little regulatory attention in recent years.
Among other changes, the final regulations expand the definition of "financial instrument" to better align with the trading safe harbor, eliminate the long-standing per se rule treating U.S. real property holding corporations as engaged in commercial activity, and refine the inadvertent commercial activity exception and the related safe harbor.
Overall, the rules define "commercial activity" broadly. In general, commercial activity includes any activity that would constitute a U.S. trade or business and, in certain cases, even activities that would not otherwise rise to the level of a U.S. trade or business.
Commercial activity
A key open question has been whether lending activity necessarily constitutes commercial activity, or whether commercial activity is limited to more traditional, public-facing banking activities.
The proposed regulations begin to address this question by clarifying when the acquisition of debt by a foreign government is treated as a commercial activity and introduce two safe harbors. Under the first safe harbor, the acquisition of debt will not constitute commercial activity if the debt is registered under the Securities Act of 1933 (the "Securities Act") and the underwriters of the offering are not related to the acquirer. The second safe harbor applies to acquisitions of debt on an established securities market, provided that the acquirer does not purchase the debt from the issuer and does not participate in negotiating the issuance of the debt.
Outside these safe harbors, whether a debt acquisition is treated as an investment (and therefore is not commercial activity) depends on the facts and circumstances. The preamble explains that factors are relevant "to the extent they indicate that the entity's expected return from acquiring the debt is exclusively a return on its capital rather than including a return on activities it conducts."
The proposed regulations provide a non-exclusive list of eight relevant factors, including:
- Whether the acquirer solicited prospective borrowers;
- Whether the acquirer materially participated in negotiating the debt;
- Whether the acquirer is entitled to compensation for services;
- The form of the debt and the issuance process (for example, whether the debt is a bank loan or a privately placed security);
- The percentage of the debt acquired relative to other investors;
- Whether the acquirer holds an equity interest in the issuer;
- The relative value of that equity interest compared to the acquired debt; and
- Whether the debt is treated as acquired in connection with a significant modification where there was a reasonable expectation that the original debt would default.
Open questions remain, including whether the Securities Act safe harbors should extend to offerings conducted under foreign securities laws, and how acquisitions of distressed debt, broadly syndicated loans, revolving credit facilities, and delayed-draw debt obligations should be analyzed.
Controlled commercial entities
The proposed regulations also address when a foreign government is treated as having effective control over an entity engaged in commercial activities, and confirm that a partnership cannot be a controlled commercial entity for this purpose. More broadly, effective control is determined under a facts-and-circumstances analysis and focuses on whether the foreign government has control over the entity's operational, managerial, board-level, or investor-level decisions. The "mere right to be consulted" with respect to these matters does not constitute effective control.
Importantly, effective control is not determined solely by reference to equity ownership. In some cases, creditor rights may be sufficient to give rise to effective control. Attribution rules apply among related entities, such that rights held by multiple related parties may be taken into account in the aggregate. Treasury has requested comments on when related entities should be treated as functionally independent (and therefore analyzed separately), as well as when a minority ownership interest should be presumed not to constitute effective control (for example, where the holder's rights are subject to overriding consent or veto rights held by others).
Looking ahead
Treasury officials have indicated that they are seeking input on how market participants distinguish between investment activity and commercial activity in practice. It remains to be seen whether this Section 892 framework will inform analysis in adjacent areas, such as offshore lending.
Comments on the proposed regulations are due by February 13, and we'll continue to track developments on this market-driven guidance in Brass Tax.
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