The US Internal Revenue Service recently proposed changes to Section 892 of the US tax code, which could have a significant impact on foreign government entities, sovereign wealth funds (SWFs), and public pension funds (PPFs) seeking tax exemptions for their investment activities. While commercial activities will never be tax-exempt, the line between investment and commercial activities is now being redefined by the IRS.
SWFs and PPFs have traditionally relied on Section 892 exemptions for their US investment income. However, the proposed changes could potentially make them liable to pay taxes on some or all of their US investment income. The amendments suggest that certain debt acquisitions could be classified as commercial activities, jeopardizing the tax-exempt status of these entities.
For example, directly originated private credit, which is a significant portion of SWFs’ portfolios, may no longer qualify for tax exemptions under the proposed regulations. The IRS is removing loans from the list of investments not considered commercial activities, raising concerns for SWFs engaged in direct lending activities.
Additionally, the proposed regulations introduce ‘safe harbors’ for certain debt investments, such as government and corporate bonds. However, for other debt instruments, SWFs may need to pass a ‘facts-and-circumstances’ test to prove that the expected returns are solely based on capital investments and not on lending or origination activities.
Moreover, the regulations could impact SWFs organized as ‘controlled entities,’ as any commercial activity, even outside the US, could eliminate their Section 892 exemptions. This could have far-reaching implications for SWFs engaging in direct investments or co-investments in the US market.
In the private equity space, the use of special-purpose vehicles or ‘blockers’ to mitigate tax liabilities may also be affected by the proposed changes. The definition of ‘effective control’ over these blockers is evolving, potentially impacting the tax-exempt status of SWFs and PPFs holding stakes in these entities.
While the exact implications of the proposed regulations remain uncertain, they could prompt SWFs and PPFs to reconsider their investment strategies in the US market. With comments open until February 13, the final outcome is yet to be determined. It remains to be seen how these changes will shape the landscape of private market investments for foreign government entities in the future.
