Practical Tax Considerations for Sovereign Wealth Fund Investments in the U.S.

Introduction

... [Prop. Treas. Reg. §§ 1.892-4 and 1.892-5]... partly supplement and partly replace the current temporary regulations under IRC Section 892 that have been in place since 2002 (and earlier).

Importantly, the proposed regulations offer a few planning opportunities for [sovereign wealth funds] SWFs and provide long awaited guidance on certain areas that have been neglected by the government since 1988 and 2002, when the temporary regulations, currently in effect, were promulgated.

Notwithstanding the new regulations' status as proposed (possibly subject to change before being finalized), the preamble explicitly allows taxpayers to rely on provisions contained in those regulations, effectively trumping the temporary regulations to the extent there is any conflict.

A Brief Background

Sovereign wealth fund investment in the United States has more than quadrupled over the last decade. More recently, SWFs have been especially active during the economic downturn by injecting funds in U.S. financial institutions and continually expanding their investment portfolios to equity investments. Some estimate that SWFs' investments in the United States will reach over $15 trillion by 2015. Sovereign wealth fund investments came and they came for good; they see appealing opportunities to earn a healthy return on U.S. investments without being subject to U.S. tax. But, along with opportunities, SWFs have been facing significant uncertainties under the current tax regime, in many cases leading to traps for the unwary or unnecessary administrative burdens for knowledgeable taxpayers.

The recently issued proposed regulations contain favorable provisions for SWFs and address some of the pressing issues faced by SWFs, but, at the same time, the regulations fall short in addressing various important concerns.

Taxation of SWFs

A foreign government is treated as a corporate resident of its own country for U.S. federal income tax purposes and, but for the exemption discussed in this [commentary], is taxed as a foreign corporation. [26 USC § 892(a)(3); Treas. Reg. § 301.7701-2(b)(6).] IRC Section 892 generally exempts certain foreign government investment (that is, passive) income from U.S. tax.

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...[T]he proposed regulations change the limited partnership rule. The new limited partnership rule provides that an SWF may hold an interest in a limited partnership that is engaged in a commercial operation and not be treated as, itself, so engaged. [Prop. Treas. Reg. § 1.892-5(d)(5)(iii).] That rule only applies, however, so long as the foreign government is not engaged in management or conducting the business of the partnership any time during the tax year. In that respect, the partner's consent rights related to extraordinary events (such as the admission or expulsion of a partner, the dissolution of the partnership, or the sale of substantially all of the partnership's assets) are not considered rights to participate in the management of the partnership. [Prop. Treas. Reg. § 1.892-5(d)(5)(iii)(B).]

Furthermore, the proposed regulations have, in effect, repealed the "all or nothing" rule with respect to inadvertent commercial activities. The regulations now allow foreign governments to remove the commercial activity taint to the extent it is inadvertent. [Prop. Treas. Reg. § 1.892-5(a)(2).] Therefore, an SWF that engages in commercial activity inadvertently will not be treated as actually engaging in a commercial activity.

Treasury is obviously nervous about that new rule and has imposed operational restrictions on the SWF to ensure that the commercial activity is, in fact, inadvertent. One of those requirements is that the SWF continually monitor its operations to avoid inadvertent activity by, among other things, creating written policies and operational procedures. [
Prop. Treas. Reg. § 1.892-5(a)(2)(ii)(B).]

The proposed regulations provide a safe harbor pursuant to which a commercial activity will be considered reasonable and inadvertent if: (a) the written policies and operational procedures are in place, and (b) the total value of the assets used in the commercial activity are no more than five percent of the entity's total assets and the entity's income from the commercial activity is not more than five percent of the entity's gross income for the year. [Prop. Treas. Reg. § 1.892-5(a)(2)(C).] Overall, the entity must demonstrate that: (i) the failure to avoid the commercial activity was reasonable, (ii) the controlled entity cured the commercial activity in a timely manner (within 120 days from the date the commercial activity was discovered), and (iii) the controlled entity maintained adequate records and met other documentation requirements (you may recall that the entity must monitor its activities in the United States and worldwide and develop relevant policies and procedures)...

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Alexey Manasuev is a Senior Manager in U.S. Corporate Tax Group of Ernst & Young LLP in Toronto, Canada. He can be reached at: alexey.manasuev@ca.ey.com. The views and opinions in this publication are those of the author and do not necessarily represent the views and opinions of Ernst & Young LLP.

This publication contains information in summary form, current as of the date of publication, and is intended for general guidance only. It should not be regarded as comprehensive or a substitute for professional advice. Before taking any particular course of action, contact Ernst & Young or another professional advisor to discuss these matters in the context of your particular circumstances. We accept no responsibility for any loss or damage occasioned by your reliance on information contained in this publication.
 

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LEXIS users can access the complete commentary HERE. Additional fees may apply. (Approx. 7 pages.)

RELATED LINKS: For more information on sovereign wealth funds, see:

For discussion of U.S. real property holding corporations, see:

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