Sovereign wealth funds (SWFs) represent a significant source of investor funds for private equity funds. By some estimates, SWFs have nearly $5 trillion of funds under management.1 An important part of planning for SWF investment in funds is to ensure that U.S. source interest and dividends are exempt from U.S. withholding taxes. The Internal Revenue Code long has provided such an exemption for interest and dividends received by foreign governments. Temporary regulations were issued in 1988. After 24 years, Treasury has issued proposed regulations that, in some cases, should ease investment by SWFs in private equity funds.
Taxation of Investment Income Generally
Generally, U.S. source dividends and interest (such as dividends and interest paid by U.S. corporations) received by foreign persons and corporations are subject to income tax in the United States. The tax is imposed at a flat 30 percent on the gross income, without the benefit of deductions. Bilateral income tax treaties may reduce or eliminate this tax rate. The tax is collected by way of withholding by the U.S. payor (or, by a partnership in the case of an investment by a U.S. partnership or foreign partnership that has entered into an agreement with the Internal Revenue Service to withhold tax).
The U.S. generally does not tax capital gains or "portfolio interest" received by foreign persons. A significant exception to this general rule is for capital gains on the sale of U.S. real property interests, including certain stock of U.S. corporations that qualify as "U.S. real property holding corporations." These gains are taxed at the U.S. graduated tax rates that apply to U.S. tax residents. Similarly, income, including capital gain that is effectively connected to a U.S. trade or business (ECI) is taxed at the U.S. graduated tax rates that apply to U.S. tax residents. However, investing and trading in stocks and securities have long been specifically excluded from the definition of engaging in a trade or business in the United States.
Without a special exemption, foreign governments and sovereign wealth funds would be subject to tax in the United States on dividends from U.S. corporations, U.S. source interest not qualifying as portfolio interest (including interest from entities more than 10 percent owned by the interest recipient) and gains from the sale of stock of U.S. real property holding companies.
Exemption for Foreign Governments
Section 892 of the U.S. Internal Revenue Code (the Code) exempts from tax income from stocks, bonds and U.S. securities owned by foreign governments; financial instruments held in the execution of governmental financial or monetary policy; and interest on deposits in banks in the U.S. For this purpose, the temporary regulations on point (the Temporary Regulations) indicate that a foreign government includes integral parts of the government and entities that are wholly owned and controlled by a foreign sovereign (i.e., controlled entities), in each case, so long as certain requirements are satisfied. Sovereign wealth funds often are controlled entities of foreign governments. The distinction between integral parts and controlled entities of foreign governments can have a significant impact on the taxation of U.S. source investment income (as discussed below in more detail).
In addition to providing the exemption described above, Section 892 provides that a foreign government will be treated as a foreign corporation for purposes of the income tax laws. It further provides that foreign governments are treated as foreign corporations for purposes of applying bilateral income tax treaties. This clarification is helpful, as it allows a foreign government to avail itself of the benefits of treaties with the United States where the income tax exemption is not otherwise available.
Commercial Activities Negate the Exemption
The generous exemption from tax does not apply to any income (a) derived from the conduct of any commercial activity anywhere in the world; (b) received by a controlled commercial entity; (c) received, directly or indirectly, from a controlled commercial entity or (d) derived from the disposition of any interest in a controlled commercial entity. The statute defines a controlled commercial entity as an entity engaged in commercial activities anywhere in the world if the foreign government holds, directly or indirectly, an interest in the entity (a) constituting at least 50 percent (determined by vote or value) of the interests in such entity, or (b) which provides the foreign government with effective control of such entity. As discussed above, many SWFs are controlled entities.
This means that if the SWF that is a controlled entity is engaged in commercial activities anywhere in the world, regardless of the extent or profitability of such activities, U.S. source interest and dividends received by such SWF will not be exempt from tax. Said another way, one dollar of income from commercial activities will negate the exemption. For this reason, SWFs investing in private equity funds (which typically are treated as partnerships for U.S. tax purposes) typically are careful to ensure that the funds avoid engaging in commercial activities.
What Are Commercial Activities?
Generally, the existing Temporary Regulations and the Proposed Regulations provide that all activities (wherever conducted) that are ordinarily conducted for current or future production of income or gain are commercial activities. This is true even if the activity would not rise to the level of a trade or business. Thus, even if activities in the United States would not subject a foreign corporation to net basis tax in the United States (i.e., because the activities do not rise to the level of a trade or business in the United States), those activities may be sufficient to constitute commercial activities.
There are some important exceptions to this broad definition of commercial activities. In particular, investments in stocks, bonds, securities, loans, financial instruments and the holding of bank deposits and net leases are excluded from the definition of commercial activities. Additionally, holding real property that is not income-producing (other than upon its sale or from an investment in net leases on the real property) is not considered to be a commercial activity. Transferring securities under a loan agreement meeting certain requirements is treated as an investment and, thus, not a commercial activity. The Proposed Regulations clarify that an activity will not cease to be an investment activity merely because of the volume of transactions of that activity or because of other unrelated activities. Moreover, effecting transactions in stocks, bonds, other securities, commodities or financial instruments for a foreign government’s own account does not constitute a commercial activity, even if such activity constitutes a trade or business (i.e., trading) for other purposes of the Code.
Regarding investments in real estate, the Proposed Regulations draw an important distinction. Although the gain from the sale of U.S. real property interests (e.g., a building in New York City) is not exempt from tax, the disposition itself does not amount to a commercial activity (which otherwise could taint a controlled entity such that interest and dividends would not be entitled to the exclusion at all). Moreover, gains from the sale of stock of a U.S. real property holding corporation derived by a foreign government or controlled entity are exempt from tax, even though such gain typically is treated as ECI.
Definition of Controlled Commercial Entities and the Inadvertent Commercial Activities Exception
The Proposed Regulations follow the statute in defining a controlled commercial entity as an entity (including a corporation, partnership, trust, pension trust or estate) that is engaged in commercial activities (whether conducted within or outside the United States) if the foreign government meets the ownership test. The ownership test is satisfied if either the foreign government holds (directly or indirectly) 50 percent or more (determined by vote or value) of the total interests in the entity, or owns another interest in such entity that provides the foreign government with effective practical control of the entity.
Commentators raised the concern that the inadvertent conduct of commercial activities, even if de minimis, could taint the entity as a controlled commercial entity, such that income would not be eligible for the tax exemption. The Proposed Regulations attempt to prevent this, by providing that an entity will not become a controlled commercial entity as a result of the conduct of inadvertent commercial activities. In order to qualify for inadvertent activities relief, (a) the conduct of the commercial activity must be reasonable in light of all the facts and circumstances, (b) the commercial activity must be promptly cured (cure within 120 days of discovery is considered prompt), and (c) adequate records of each discovered commercial activity and the remedial action taken to cure that activity must be maintained.
In determining whether the conduct of commercial activities is reasonable, due regard will be given to the number of commercial activities during the taxable year and in prior years, as well as the amount of income earned from, and assets used in, the conduct of the commercial activities in relationship to the entity’s total income and assets. The Proposed Regulations provide that a failure to avoid commercial activity will not be considered reasonable unless there is continuing diligence to prevent the entity from engaging in commercial activities anywhere in the world. This must be evidenced by having adequate written policies and operational procedures in place to monitor the entity’s worldwide activities. The Proposed Regulations contain a safe harbor. So long as the written policies and operational procedures are in place to monitor the entity’s worldwide activities, failure to avoid commercial activity will be considered reasonable if the value of the assets used in, or held for use in, all commercial activities does not exceed 5 percent of the total value of the assets reflected on the entity’s balance sheet for the taxable year, and the income earned from the commercial activity does not exceed 5 percent of the entity’s gross income as reflected on its income statement for the taxable year.
Impact of Commercial Activities through Partnerships
Generally speaking, for tax purposes, a partnership is considered an aggregate of its partners. For this reason, partners are taxed on their share of the income as it is earned by the partnership. The character of income (e.g., as capital or ordinary income) flows through and retains its character in the hands of the partners. Moreover, the partners in a partnership that is engaged in a trade or business in the United States are considered to be engaged in such trade or business, and ECI of the partnership is considered to be ECI in the hands of foreign investors. Thus, it is not surprising that the Proposed Regulations take the position that the commercial activities of an entity classified as a partnership will be attributable to its partners for purposes of determining whether the exemption is available.
The Proposed Regulations clarify that an entity not otherwise engaged in commercial activities will not be considered to be engaged in commercial activities solely because the entity is a member of a partnership that invests or trades in stocks, bonds, securities, commodities or financial instruments for the partnership’s own account. Essentially, the investing and trading activities in which a SWF may engage directly without taxation may be done through a partnership.
The Proposed Regulations depart from the general flow-through treatment applicable to partnerships in a meaningful and helpful way. The Proposed Regulations provide that an entity will not be deemed to be engaged in commercial activities solely because it holds an interest as a limited partner in a limited partnership. For example, if a limited partnership is engaged in a brokerage business (which activity is considered to be a commercial activity), a controlled entity that is a limited partner therein will not be considered to be engaged in a commercial activity. Notably, the Proposed Regulations point out that the income that flows through will not be exempt from tax if it is derived from the conduct of a commercial activity. However, the importance of the limited partner exemption is that this will not taint the entity as a controlled commercial entity.
The Proposed Regulations contain a special definition of a limited partnership interest that looks beyond the mere ownership of an interest defined as a limited partnership interest under local law or the limited partnership agreement. An interest will be considered that of a limited partner if the partner does not have rights to participate in the management and conduct of the partnership’s business at any time during the partnership’s taxable year under the law of the jurisdiction in which the partnership is organized or under the governing agreement. For this purpose, rights in the management and conduct of the partnership’s business do not include consent rights in the case of extraordinary events such as the admission or expulsion of general or limited partners, amendment of the limited partnership agreement, or dissolution of the partnership, disposition of substantially all of the partnership’s property, merger or conversion.
Effective Date of the Proposed Regulations
The Proposed Regulations are proposed to be effective as of the date they become final. However, the preamble to the Proposed Regulations provides that taxpayers may rely on the Proposed Regulations until final regulations are issued.
Pepper Perspective: SWFs are likely to continue to be an important source of capital, and the exemption from tax on investment income derived in the United States provides a significant incentive for SWFs to deploy their capital in the United States directly, or through investment funds that invest in the United States. The Proposed Regulations are important in that they prevent the inadvertent conduct of commercial activities from negating the tax exemption. The provision of the Proposed Regulations that excludes commercial activities of a limited partnership from flowing through to a SWF limited partner and tainting it goes a significant way to ease the investment by SWFs in investment funds. There still are some unanswered questions. Importantly, the Proposed Regulations do not specify whether having a position on the advisory board of a private equity fund will prevent a limited partnership interest from being treated as such. Overall, the Proposed Regulations contain some welcome relief.
1 Sovereign Wealth Fund Rankings, Sovereign Wealth Fund Institute, http://www.swfinstitute.org/fund-rankings (Last visited May 21, 2012).
Steven D. Bortnick