IRS Clarifies Foreign Government Tax Exemptions

by Leroy Baker, Tax-News.com, Washington

07 November 2011

The Internal Revenue Service (IRS) has released a notice of proposed rulemaking that is intended to provide guidance as to when the income of foreign governments and international organizations from investments in the United States will be deemed to be exempt from taxation under section 892 of the Internal Revenue Code.

Section 892 exempts from US income taxation certain qualified investments, including income from investments in financial instruments, derived by a foreign government. The term ‘foreign government’ is defined to mean only the integral parts or controlled entities of a foreign sovereign, and the exemption from US income tax does not apply to income derived directly from the conduct of any commercial activity.

Income received by the foreign government indirectly through a controlled commercial entity, or from the disposal of any interest in a controlled commercial entity, is also not exempt from tax. A ‘controlled commercial entity’ is defined as an entity owned by the foreign government that meets certain ownership or control thresholds and that is engaged in commercial activities anywhere in the world.

Accordingly, presently, an integral part of a foreign sovereign that derives income from both qualified investments and from the conduct of commercial activity is eligible to claim the tax exemption with respect to the income from qualified investments, but not with respect to the income derived from the conduct of commercial activity. In contrast, if a controlled commercial entity engages in commercial activities anywhere in the world, it is treated as such, and none of its income (including income from otherwise qualified investments), or any income from it (for example, dividends), qualifies for exemption from tax.

It has been commented that this ‘all or nothing’ rule represents an unnecessary administrative and operational burden for foreign governments and a trap for unwary foreign governments that inadvertently conduct a small level of commercial activity.

As a consequence, the IRS, in the proposed rules, provides that an entity will not be considered to engage in commercial activities if it conducts only inadvertent commercial activity, and has also included a safe harbour.

The safe harbour provision states that a controlled entity’s failure to avoid the conduct of commercial activity during a taxable year will usually be considered reasonable if the value of the assets used in the activity does not exceed 5% of the total value of the assets reflected on the entity’s balance sheet, and the income earned by the entity from the commercial activity does not exceed 5% of the entity’s gross income.

Furthermore, while section 892 currently rules that commercial activities of a partnership are attributable to its general and limited partners, it has been said that the rule causes many controlled entities of foreign sovereigns to forego making investments in foreign partnerships or other foreign entities that do not invest in the US out of concern that such investments, for example in managed investment vehicles, might cause those controlled entities to be treated as controlled commercial entities in the US.

The IRS has therefore been asked to modify the partnership attribution rule to provide that the activities of a partnership will not be attributed to a foreign government if that government holds a minority interest, as a limited partner, in the partnership; and has no greater rights to participate in the management and conduct of the partnership’s business than would a minority shareholder in a corporation conducting the same activities as the partnership.

The IRS has agreed and, under the new section 892, an entity that is not otherwise engaged in commercial activities would not be treated as engaged in commercial activities solely because it holds an interest as a limited partner in a limited partnership. However, the controlled entity partner’s distributive share of partnership income attributable to such commercial activity will be considered to be derived from the conduct of commercial activity, and therefore will not be exempt from taxation under section 892.

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