Recent Regulations On The US Taxation Of Foreign Governments

Overview

In December 2025, the Treasury Department released Final and Proposed Regulations under p 892, intended to clarify the scope of income received by foreign governments that is treated as derived from "commercial activities."¹

By way of background, p 892 generally exempts foreign governments and their integral parts and certain controlled entities, including many sovereign wealth funds, from U.S. income and withholding tax on certain qualified income. The exemption does not apply to income derived from a "commercial activity" or received by or from a "controlled commercial entity" (or CCE) or from the disposition of the same. A CCE is an entity engaged in commercial activities if a foreign government holds (directly or indirectly) any interest in such entity that (by value or voting interest) (a) constitutes 50% or more of the total interests in such entity or (b) provides the foreign government with "effective control" of the entity.

While the Final Regulations have been generally well received and seen as achieving their goal of clarifying the scope of the relevant rules, the Proposed Regulations have been criticized as potentially overbroad, particularly with respect to their treatment of certain debt transactions and effective control.

The Final Regulations apply to taxable years beginning on or after December 15, 2025, and the Proposed Regulations will apply to taxable years beginning on or after finalization, although both sets of regulations are permitted to be applied to open taxable years.

The following are some of the key points addressed in the Final Regulations and the Proposed Regulations, which are discussed in more detail below:

• clarification of the scope of "commercial activity";
• clarification of the scope of "controlled commercial entities," including adjustments to the per se CCE rule for USRPHCs and the attribution of commercial activities of partnerships to their partners;
• when acquisition of debt may constitute a commercial activity; and
• the "effective control" standard for determining CCE status.

1. The final regulations

Clarification of "commercial activity"

The Final Regulations broadly define "commercial activities," confirming that the scope of the term is broader than "trade or business" under ps 864(b) and 162. The Final Regulations adopt exclusions from the definition of "commercial activities" originally set forth in regulations proposed in 2011, with certain clarifications.

The Final Regulations exclude investments in financial instruments (forwards, futures, options, swaps and similar instruments, including derivatives (within the scope of the proposed regulations under p 864(b))), from the term "commercial activities" and provide an exception from commercial activities for certain trading activities. This reflects a slight taxpayer-favorable expansion on the approach of the 2011 proposed regulations.

The Final Regulations also expand the commercial activity exception for the holding of bank deposits to bank deposits in any currency.

The Final Regulations clarify that holding a partnership interest for one's own account and not as a dealer is not itself a commercial activity, though, as discussed below, a commercial activity of the partnership may be attributed to the partner in determining CCE status. The Final Regulations do not modify the rule that a foreign government's distributive share of partnership income attributable to commercial activities is not exempt under p 892.

Treasury declined requests to exclude fees earned as a passive investor in a private equity or private credit fund from commercial activity income.

Controlled commercial entities

Certain USRPHCs as CCEs

The Final Regulations provide that a U.S. real property holding corporation (USRPHC) is treated as a per se CCE. The Final Regulations, however, limit this rule to domestic corporations, thus eliminating a controversial rule from the 1988 temporary regulations that also treated as a per se CCE a foreign corporation that would be a USRPHC if it had been organized in the United States, which created the burden of monitoring the real property holding company status of non-U.S. corporations.² The Final Regulations also make certain clarifications to a minority interest exception that went into effect with the 2022 proposed regulations (which excepts a corporation that is a USRPHC solely by reason of its direct or indirect ownership interest in one or more other corporations that are not controlled by the foreign government).

Inadvertent commercial activity exception

The Final Regulations retain, clarify and relax an "inadvertent" commercial activity exception, first adopted in the 2011 proposed regulations. This rule generally permits an entity to be treated as not engaged in a commercial activity for purposes of determining the entity's CCE status in the case of a reasonable failure to avoid conducting the commercial activity, a prompt cure and adherence to record maintenance requirements. The inadvertent commercial activity income is not itself exempt.

Annual CCE determination

The Final Regulations clarify the 2011 proposed regulations' rule that an entity engaged in commercial activities at any time during a taxable year would be considered a CCE for the entire year (provided the foreign government satisfies the applicable control requirement). First, the Final Regulations clarify that the relevant taxable year is that of the entity itself. Second, the Final Regulations clarify that an acquirer in an acquisition to which p 381(a) applies — certain asset reorganizations and subsidiary liquidations — generally does not succeed to the commercial activity of the target corporation unless the acquirer directly carries on that commercial activity after the transaction (except if the target's taxable year does not close or the acquisition is between two corporations controlled by the same foreign sovereign).

Commercial activities of partnerships

The Final Regulations generally adopt the 2011 proposed regulations' attribution of a partnership's commercial activities to its partners for purposes of determining whether the partner is a CCE, subject to exceptions for non-dealer trading activity (which the Final Regulations retain from the 2011 proposed regulations) and limited partnership interests, which the Final Regulations replace instead with a "qualified partnership interest" exception.

The qualified partnership interest exception, which generally has been welcomed as an improvement to the 2011 proposed regulations formulation, requires that a holder of a qualified partnership interest not (1) have personal liability for claims against the partnership; (2) have the right to enter into contracts or act on behalf of the partnership; (3) have rights to participate in the management and conduct of the partnership's business; or (4) control the partnership. The first two requirements are consistent with the statutory rights of a limited partner in a partnership but apply regardless of the legal form of the entity or the governing law.

The Final Regulations also adopt a qualified partnership interest exception safe harbor for any holder who, at all times during the partnership's taxable year, satisfies the first two requirements set forth above and (1) is not a managing member or managing partner, and does not hold an equivalent role under applicable law, and (2) does not directly or indirectly own more than 5% of either the partnership's capital interests or the partnership's profits interests.

In the case of tiered partnerships, the qualified partnership interest exception is generally determined on a bottom-up basis. An upper-tier partnership that holds a qualified partnership interest in a lower-tier partnership is not attributed the lower-tier partnership's commercial activities, whereas an upper-tier partnership that holds a non-qualified partnership interest in a lower-tier partnership is attributed the lower-tier partnership's commercial activities.

2. The proposed regulations

As discussed below, industry players have expressed concern that the approach of the Proposed Regulations, particularly with respect to debt and effective control, disrupts widely used approaches to financing and structuring U.S. investments. In response to such criticism, on January 17, 2026, Treasury Secretary Scott Bessent posted that the "recent notice of proposed rulemaking under §892 was issued in response to sovereign investors' requests for greater clarity and certainty. Treasury has received feedback from stakeholders that will inform any final regulations on these technical U.S. tax rules. We will preserve established market practices and continue to support current and future sovereign wealth fund investment in the United States as we drive economic growth for the benefit of all Americans." On February 17, 2026, a spokesperson for the Treasury Department confirmed that industry concerns regarding the Proposed Regulations will be addressed, telling reporters, "We are revising the proposal to address key issues and ensure it supports stable, long-term capital flows." In light of these comments, the Proposed Regulations may change significantly prior to finalization.

Debt

The 2011 proposed regulations provided that loans and investments in stocks, bonds and other securities are generally not commercial activities unless held for trading activities or in a banking, financing or similar business. Since that time, there has been uncertainty as to the circumstances under which loan origination or otherwise acquiring debt, including at original issuance, constitutes commercial activity. Treasury and the IRS acknowledge the highly factual nature of the inquiry.

Solely for purposes of p 892 (and with no inference intended for other purposes of the Code), the proposed regulations would provide as a general rule that an acquisition of debt is treated as a commercial activity unless the acquisition is characterized as investment activity under either of two safe harbors or under a facts and circumstances test, provided that any acquisition of debt undertaken as a dealer would constitute commercial activity.

Registered offering safe harbor

The first safe harbor would treat acquisitions of bonds or other debt securities acquired in an offering registered under the Securities Act of 1933, as amended, as investment activity, provided that the underwriters of the offering are not related to the acquirer within the meaning of ps 267(b) and 707(b).

Qualified secondary market acquisition safe harbor

The second safe harbor would treat a qualified secondary market acquisition of debt as investment, and not commercial, activity. Qualified secondary market acquisitions include acquisitions of debt traded on an established securities market, provided that the acquirer does not purchase the debt from the issuer, participate in negotiation of the terms or issuance, or acquire the loan from a person under common management or control (unless that person acquired the debt as investment under these rules).

Facts and circumstances test

The foregoing safe harbors may be unavailable to private debt that is not traded, in which case the foreign government should consider the facts and circumstances test. Investment-like facts and circumstances would indicate that the entity's expected return from acquiring the debt is exclusively a return on its capital rather than also a return on activities it conducts. The proposed regulations provide a nonexclusive list of the relevant factors, including:

1. Whether the acquirer solicited prospective borrowers, or otherwise held itself out as willing to make loans or otherwise acquire debt at or in connection with its original issuance;
2. Whether the acquirer materially participated in negotiating or structuring the terms of the debt;
3. Whether the acquirer is entitled to non-interest, non-OID compensation;
4. The form of the debt and the issuance process;
5. The percentage of the debt issuance acquired by the acquirer relative to other purchasers;
6. The percentage of equity in the debt issuer held or to be held by the acquirer and the value of such equity relative to the amount of debt acquired; and
7. If debt is deemed to be acquired in a significant modification under Treas. Reg. §1.1001-3, whether there was, at the time of acquisition of the original debt, a reasonable expectation, based on objective evidence — such as a decline in the financial condition or credit rating of the debt issuer between the time of original issuance and the time of the acquisition of the original unmodified debt — that the original unmodified debt would default.

Regarding factors 2 and 6, examples set forth in the Proposed Regulations conclude that making even a single loan that the foreign government structures and negotiates (i.e., in violation of factor 2) to an issuer in which it did not own any equity and that does not satisfy the safe harbors is a commercial activity. On the other hand, where a foreign government owned 80% of the issuer's equity (with a value that was double the amount of debt), similar activity was considered investment.

Regarding factor 7, examples in the Proposed Regulations provide that a significant modification of a loan acquired in a secondary market was a commercial activity where the foreign government was a member of the borrower's creditor's committee and materially participated in negotiating and structuring the debt modification, but was not a commercial activity absent such creditor committee role; in each case, there was no expectation, based on objective indications, of default.

As noted above, industry commentators have argued that the safe harbors are too narrow for many private credit investments and that the facts and circumstances test is too obscure and strict.

Effective control test for CCEs

As noted above, a CCE is an entity engaged in commercial activities if a foreign government holds (directly or indirectly) any interest in such entity that (by value or voting interest) (1) constitutes 50% or more of the total interests in such entity or (2) provides the foreign government with effective control of the entity. The Proposed Regulations would clarify the meaning of "effective control."

The Proposed Regulations provide generally that effective control is achieved by any interest in the entity that, either separately or in combination, results in control over the operational, managerial, board-level or investor-level decisions of the entity, taking into account all of the facts and circumstances. Interests may include equity interests, voting power in the entity, debt interests, contractual rights in or arrangements with the entity or with holders of equity or other interests in the entity, certain business relationships with the entity or with other interest holders in the entity, regulatory authority over the entity, or any other arrangement or relationship that provides influence over the entity's operational, managerial, board-level or investor-level decisions. This aspect of the Proposed Regulations has also drawn questions from tax practitioners and members of the industry, particularly around the extent to which veto or consent rights, including rights that are relatively standard for passive minority investors, may constitute effective control and exactly which rights, if any, are determinative or afforded the most weight in the analysis.

A foreign government has per se effective control over an entity if the government (or an entity it controls) is the managing partner or managing member (or an equivalent role) of such entity.

Footnotes

1. Section references are to the Internal Revenue Code of 1986, as amended.

2. As a result, foreign government pension funds that are not formed in the U.S. need not monitor their own USRPHC status for purposes of the USRPHC per se rule (though a USRPHC owned by a qualified foreign pension fund may still constitute a CCE if the foreign government satisfies the applicable control requirements with respect to that indirectly owned USRPHC).

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.