[Federal Register Volume 76, Number 213 (Thursday, November 3, 2011)]
[Proposed Rules]
[Pages 68119-68124]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-28531]


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 Proposed Rules
                                                 Federal Register
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 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
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  Federal Register / Vol. 76, No. 213 / Thursday, November 3, 2011 / 
Proposed Rules  

[[Page 68119]]



DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[REG-146537-06]
RIN 1545-BG08


Income of Foreign Governments and International Organizations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

-----------------------------------------------------------------------

SUMMARY: This document contains proposed Income Tax Regulations that 
provide guidance relating to the taxation of the income of foreign 
governments from investments in the United States under section 892 of 
the Internal Revenue Code of 1986 (Code). The regulations will affect 
foreign governments that derive income from sources within the United 
States.

DATES: Written or electronic comments and requests for a public hearing 
must be received by February 1, 2012.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-146537-06), Room 
5205, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
146537-06), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at http://www.regulations.gov (IRS REG-146537-06).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
David A. Juster, (202) 622-3850 (not a toll-free number); concerning 
submission of comments, contact Richard A. Hurst at 
[email protected].

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
(OMB) for review and approval under OMB approval number 1545-1053 in 
accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)). Comments on the collections of information should be sent to 
the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by January 3, 2012. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information;
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collections of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in this proposed regulation is in 
Sec. Sec.  1.892-5(a)(2)(ii)(B) and 1.892-5(a)(2)(iv). This information 
is required to determine if taxpayers qualify for exemption from tax 
under section 892. The collection of information is voluntary to obtain 
a benefit. The likely respondents are foreign governments.
    Estimated total annual reporting burden: 975 hours.
    Estimated average annual burden hours per respondent: 5 hours.
    Estimated number of respondents: 195.
    Estimated annual frequency of responses: 1.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed amendments to 26 CFR part 1 and to 
26 CFR part 602. On June 27, 1988, temporary regulations under section 
892 (TD 8211, 53 FR 24060) (1988 temporary regulations) with a cross-
reference notice of proposed rulemaking (53 FR 24100) were published in 
the Federal Register to provide guidance concerning the taxation of 
income of foreign governments and international organizations from 
investments in the United States. The proposed regulations contained 
herein supplement the cross-referenced notice of proposed rulemaking to 
provide additional guidance for determining when a foreign government's 
investment income is exempt from U.S. taxation.

Explanation of Provisions

    The Treasury Department and the IRS have recently received numerous 
written comments on the 1988 temporary regulations. The proposed 
regulations are issued in response to those comments.

Treatment of Controlled Entities

    Section 892 exempts from U.S. income taxation certain qualified 
investment income derived by a foreign government. Section 1.892-2T 
defines the term foreign government to mean only the integral parts or 
controlled entities of a foreign sovereign. The exemption from U.S. 
income tax under section 892 does not apply to income (1) Derived from 
the conduct of any commercial activity, (2) received by a controlled 
commercial entity or received (directly or indirectly) from a 
controlled commercial entity, or (3) derived from the disposition of 
any interest in a controlled commercial entity. Section 892(a)(2)(B) 
defines a controlled commercial entity 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

[[Page 68120]]

world. Accordingly, 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 section 892 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 entity (as defined in Sec.  1.892-2T(a)(3)) 
engages in commercial activities anywhere in the world, it is treated 
as a controlled commercial entity, and none of its income (including 
income from otherwise qualified investments) qualifies for exemption 
from tax under section 892. In addition, none of the income derived 
from the controlled entity (e.g., dividends), including the portion 
attributable to qualified investments of the controlled entity, will be 
eligible for the section 892 exemption. Several comments raised 
concerns that this so-called ``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. These 
comments have requested that the Treasury Department and the IRS revise 
Sec.  1.892-5T(a) to provide for a de minimis exception under which an 
entity would not be treated as a controlled commercial entity as a 
result of certain inadvertent commercial activity.
    In response to these comments, the proposed regulations at Sec.  
1.892-5(a)(2) provide that an entity will not be considered to engage 
in commercial activities if it conducts only inadvertent commercial 
activity. Commercial activity will be treated as inadvertent commercial 
activity only if: (1) The failure to avoid conducting the commercial 
activity is reasonable; (2) the commercial activity is promptly cured; 
and (3) certain record maintenance requirements are met. However, none 
of the income derived from such inadvertent commercial activity will 
qualify for exemption from tax under section 892.
    In determining whether an entity's failure to avoid conducting a 
particular commercial activity is reasonable, due regard will be given 
to the number of commercial activities conducted during the taxable 
year, as well as the amount of income earned from, and assets used in, 
the conduct of the commercial activity in relationship to the entity's 
total income and assets. However, a failure to avoid conducting 
commercial activity will not be considered reasonable unless adequate 
written policies and operational procedures are in place to monitor the 
entity's worldwide activities. The proposed regulations include a safe 
harbor at Sec.  1.892-5(a)(2)(ii)(C) under which, provided that there 
are adequate written policies and operational procedures in place to 
monitor the entity's worldwide activities, the controlled entity's 
failure to avoid the conduct of commercial activity during a taxable 
year will be considered reasonable if: (1) The value of the assets used 
in, or held for use in, the activity does not exceed five percent of 
the total value of the assets reflected on the entity's balance sheet 
for the taxable year as prepared for financial accounting purposes; and 
(2) the income earned by the entity from the commercial activity does 
not exceed five percent of the entity's gross income as reflected on 
its income statement for the taxable year as prepared for financial 
accounting purposes.
    Comments also requested further guidance on the duration of a 
determination that an entity is a controlled commercial entity. In 
response to these comments, the proposed regulations at Sec.  1.892-
5(a)(3) provide that the determination of whether an entity is a 
controlled commercial entity within the meaning of section 892(a)(2)(B) 
will be made on an annual basis. Accordingly, an entity will not be 
considered a controlled commercial entity for a taxable year solely 
because the entity engaged in commercial activities in a prior taxable 
year.

Definition of Commercial Activity

    Section 1.892-4T of the 1988 temporary regulations provides rules 
for determining whether income is derived from the conduct of a 
commercial activity, and specifically identifies certain activities 
that are not commercial, including certain investments, trading 
activities, cultural events, non-profit activities, and governmental 
functions. Several comments have expressed uncertainty about the 
applicable U.S. standard for determining when an activity will be 
considered a commercial activity, a non-profit activity, or 
governmental function for purposes of section 892 and Sec.  1.892-4T.
    Section 1.892-4(d) of the proposed regulations restates the general 
rule adopted in the 1988 temporary regulations that, subject to certain 
enumerated exceptions, all activities ordinarily conducted for the 
current or future production of income or gain are commercial 
activities. Section 1.892-4(d) of the proposed regulations further 
provides that only the nature of an activity, not the purpose or 
motivation for conducting the activity, is determinative of whether the 
activity is a commercial activity. This standard also applies for 
purposes of determining whether an activity is characterized as a non-
profit activity or governmental function under Sec.  1.892-4T(c)(3) and 
(c)(4). In addition, Sec.  1.892-4(d) of the proposed regulations 
clarifies the rule in the 1988 temporary regulations by providing that 
an activity may be considered a commercial activity even if the 
activity does not constitute a trade or business for purposes of 
section 162 or does not constitute (or would not constitute if 
undertaken in the United States) the conduct of a trade or business in 
the United States for purposes of section 864(b).
    Section 1.892-4T(c) lists certain activities that will not be 
considered commercial activities. One such activity is investments in 
financial instruments, as defined in Sec.  1.892-3T(a)(4), which, if 
held in the execution of governmental financial or monetary policy, are 
not commercial activities for purposes of section 892. Several comments 
have requested that the condition that financial instruments be ``held 
in the execution of governmental financial or monetary policy'' be 
eliminated to more closely conform the treatment of investments in 
financial instruments, including derivatives, with investments in 
physical stocks and securities, which under the 1988 temporary 
regulations generally are not commercial activities regardless of 
whether they are held in the execution of governmental financial or 
monetary policy. Section 1.892-4(e)(1)(i) of the proposed regulations 
modifies the rules in Sec.  1.892-4T(c)(1)(i) by providing that 
investments in financial instruments will not be treated as commercial 
activities for purposes of section 892, irrespective of whether such 
financial instruments are held in the execution of governmental 
financial or monetary policy. In addition, Sec.  1.892-4(e)(1)(ii) of 
the proposed regulations expands the existing exception in Sec.  1.892-
4T(c)(1)(ii) from commercial activity for trading of stocks, 
securities, and commodities to include financial instruments, without 
regard to whether such financial instruments are held in the execution 
of governmental financial or monetary policy. These revisions address 
only the definition of commercial activity for purposes of determining 
whether a government will be considered to derive income from the 
conduct of a commercial activity, or whether an entity will be 
considered to be engaged in commercial activities. They do not address 
whether income from activities

[[Page 68121]]

that are not commercial activities will be exempt from tax under 
section 892. Pursuant to Sec.  1.892-3T(a), only income derived from 
investments in financial instruments held in the execution of 
governmental financial or monetary policy will qualify for exemption 
from tax under section 892.
    Comments have requested clarification as to whether an entity that 
disposes of a United States real property interest (USRPI) as defined 
in section 897(c) will be deemed to be engaged in commercial activities 
solely by reason of this disposition. Section 897(a)(1) requires that a 
nonresident alien or foreign corporation take into account gain or loss 
from the disposition of a USRPI as if the taxpayer were engaged in a 
trade or business within the United States during the taxable year and 
as if such gain or loss were effectively connected with that trade or 
business. The Treasury Department and the IRS believe that an entity 
that only holds passive investments and is not otherwise engaged in 
commercial activities should not be deemed to be engaged in commercial 
activities solely by reason of the operation of section 897(a)(1). 
Accordingly, Sec.  1.892-4(e)(1)(iv) of the proposed regulations 
provides that a disposition, including a deemed disposition under 
section 897(h)(1), of a USRPI, by itself, does not constitute the 
conduct of a commercial activity. However, as provided in Sec.  1.892-
3T(a), the income derived from the disposition of the USRPI described 
in section 897(c)(1)(A)(i) shall in no event qualify for the exemption 
from tax under section 892.
    After the 1988 temporary regulations were published, section 
892(a)(2)(A) was amended by the Technical and Miscellaneous Revenue Act 
of 1988 (TAMRA), Public Law No. 100-647, 102 Stat. 3342 to provide that 
income derived from the disposition of any interest in a controlled 
commercial entity does not qualify for the exemption under section 892. 
The proposed regulations revised Sec.  1.892-5(a) to reflect the 
amendment of section 892 by TAMRA.

Treatment of Partnerships

    Section 1.892-5T(d)(3) provides a general rule that commercial 
activities of a partnership are attributable to its general and limited 
partners (``partnership attribution rule'') and provides a limited 
exception to this rule for partners of publicly traded partnerships 
(PTPs). Several comments have requested that the Treasury Department 
and the IRS modify the partnership attribution rule to provide that the 
activities of a partnership will not be attributed to a foreign 
government partner if that government: (i) Holds a minority interest, 
as a limited partner, in the partnership; and (ii) 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 
comments assert that the partnership attribution 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 United States out of concern that such investments might cause 
those controlled entities to be treated as controlled commercial 
entities.
    In response to these comments, Sec.  1.892-5(d)(5)(iii) of the 
proposed regulations modifies the existing exception to the partnership 
attribution rule for PTP interests by providing a more general 
exception for limited partnership interests. Under this revised 
exception, an entity that is not otherwise engaged in commercial 
activities will not be treated as engaged in commercial activities 
solely because it holds an interest as a limited partner in a limited 
partnership, including a publicly traded partnership that qualifies as 
a limited partnership.
    For this purpose, an interest as a limited partner in a limited 
partnership is defined as an interest in an entity classified as a 
partnership for federal tax purposes if the holder of the interest 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. This definition of an 
interest as a limited partner in a limited partnership applies solely 
for purposes of this exception, and no inference is intended that the 
same definition would apply for any other provision of the Code making 
or requiring a distinction between a general partner and a limited 
partner.
    Although the commercial activity of a limited partnership will not 
cause a controlled entity of a foreign sovereign limited partner 
meeting the requirements of the exception for limited partnerships to 
be engaged in commercial activities, 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. Additionally, in the case of a partnership that is a 
controlled commercial entity, no part of the foreign government 
partner's distributive share of partnership income will qualify for 
exemption from tax under section 892.
    Comments also assert that disparity in tax treatment exists under 
the temporary regulations regarding foreign government trading activity 
described in Sec.  1.892-4T(c)(1)(ii) because trading for a foreign 
government's own account does not constitute a commercial activity but 
no similar rule applies in the case of trading done by a partnership of 
which a foreign government is a partner. The comments note that this 
disparity is not generally present in determining whether an activity 
is a trade or business within the United States under section 864(b). 
See Sec.  1.864-2(c)(2)(i) and (d)(2)(i). In response to these 
comments, Sec.  1.892-5(d)(5)(ii) of the proposed regulations provides 
that an entity that is not otherwise engaged in commercial activities 
will not be considered to be engaged in commercial activities solely 
because it is a member of a partnership that effects transactions in 
stocks, bonds, other securities, commodities, or financial instruments 
for the partnership's own account. However, this exception does not 
apply in the case of a partnership that is a dealer in stocks, bonds, 
other securities, commodities, or financial instruments. For this 
purpose, whether a partnership is a dealer is determined under the 
principles of Sec.  1.864-2(c)(2)(iv)(a).

Proposed Effective/Applicability Date

    These regulations are proposed to apply on the date of publication 
of the Treasury decision adopting these rules as final regulations in 
the Federal Register. For rules applicable to periods prior to the 
publication date, see the corresponding provisions in Sec. Sec.  1.892-
4T and 1.892-5T in the 1988 temporary regulations and in Sec.  1.892-
5(a) as issued under TD 9012 (August 1, 2002).

Reliance on Proposed Regulations

    Taxpayers may rely on the proposed regulations until final 
regulations are issued.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations and because 
the proposed regulations do not impose a collection of information on 
small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) 
does not apply.

[[Page 68122]]

Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking has been submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Requests for Public Hearing

    Before the proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments, that are submitted timely to the 
IRS. The Treasury Department and the IRS request comments on the 
clarity of the proposed regulations and how they can be made easier to 
understand. All comments will be available for public inspection and 
copying. A public hearing will be scheduled if requested in writing by 
any person that timely submits written comments. If a public hearing is 
scheduled, notice of the date, time, and place for the public hearing 
will be published in the Federal Register.

Drafting Information

    The principal author of these regulations is David A. Juster of the 
Office of Associate Chief Counsel (International), within the Office of 
Chief Counsel, IRS. Other personnel from the Treasury Department and 
the IRS participated in developing the regulations.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are proposed to be amended as 
follows:

PART 1--INCOME TAX REGULATIONS

    Paragraph 1. The authority citation for parts 1 and 601 continues 
to read in part as follows:

    Authority:  26 U.S.C. 7805 * * *
    Section 1.892-4 also issued under 26 U.S.C. 892(c). * * *

    Par. 2. Section 1.892-4 is added to read as follows:


Sec.  1.892-4  Commercial activities.

    (a) through (c) [Reserved]. For further guidance, see Sec.  1.892-
4T(a) through (c).
    (d) In general. Except as provided in paragraph (e) of this 
section, all activities (whether conducted within or outside the United 
States) which are ordinarily conducted for the current or future 
production of income or gain are commercial activities. Only the nature 
of the activity, not the purpose or motivation for conducting the 
activity, is determinative of whether the activity is commercial in 
character. An activity may be considered a commercial activity even if 
such activity does not constitute a trade or business for purposes of 
section 162 or does not constitute (or would not constitute if 
undertaken in the United States) the conduct of a trade or business in 
the United States for purposes of section 864(b).
    (e) Activities that are not commercial--(1) Investments--(i) In 
general. Subject to the provisions of paragraphs (e)(1)(ii) and (iii) 
of this section, the following are not commercial activities: 
investments in stocks, bonds, and other securities (as defined in Sec.  
1.892-3T(a)(3)); loans; investments in financial instruments (as 
defined in Sec.  1.892-3T(a)(4)); the holding of net leases on real 
property; the holding of real property which is not producing income 
(other than on its sale or from an investment in net leases on real 
property); and the holding of bank deposits in banks. Transferring 
securities under a loan agreement which meets the requirements of 
section 1058 is an investment for purposes of this paragraph (e)(1)(i). 
An activity will not cease to be an investment solely because of the 
volume of transactions of that activity or because of other unrelated 
activities.
    (ii) Trading. Effecting transactions in stocks, bonds, other 
securities (as defined in Sec.  1.892-3T(a)(3)), commodities, or 
financial instruments (as defined in Sec.  1.892-3T(a)(4)) for a 
foreign government's own account does not constitute a commercial 
activity regardless of whether such activity constitutes a trade or 
business for purposes of section 162 or constitutes (or would 
constitute if undertaken within the United States) the conduct of a 
trade or business in the United States for purposes of section 864(b). 
Such transactions are not commercial activities regardless of whether 
they are effected by the foreign government through its employees or 
through a broker, commission agent, custodian, or other independent 
agent and regardless of whether or not any such employee or agent has 
discretionary authority to make decisions in effecting the 
transactions. Such transactions undertaken as a dealer (as determined 
under the principles of Sec.  1.864-2(c)(2)(iv)(a)), however, 
constitute commercial activity. For purposes of this paragraph 
(e)(1)(ii), the term commodities means commodities of a kind 
customarily dealt in on an organized commodity exchange but only if the 
transaction is of a kind customarily consummated at such place.
    (iii) Banking, financing, etc. Investments (including loans) made 
by a banking, financing, or similar business constitute commercial 
activities, even if the income derived from such investments is not 
considered to be income effectively connected with the active conduct 
of a banking, financing, or similar business in the U.S. by reason of 
the application of Sec.  1.864-4(c)(5).
    (iv) Disposition of a U.S. real property interest. A disposition 
(including a deemed disposition under section 897(h)(1)) of a U.S. real 
property interest (as defined in section 897(c)), by itself, does not 
constitute the conduct of a commercial activity. As described in Sec.  
1.892-3T(a), however, gain derived from a disposition of a U.S. real 
property interest defined in section 897(c)(1)(A)(i) will not qualify 
for exemption from tax under section 892.
    (2) through (5) [Reserved]. For further guidance, see Sec.  1.892-
4T(c)(2) through (c)(5).
    (f) Effective/applicability date. This section applies on the date 
the regulations are published as final regulations in the Federal 
Register. See Sec.  1.892-4T for the rules that apply before the date 
the regulations are published as final regulations in the Federal 
Register.
    Par. 3. Section 1.892-5 is revised to read as follows:


Sec.  1.892-5  Controlled commercial entity.

    (a) In general--(1) General rule and definition of term 
``controlled commercial entity''. Under section 892(a)(2)(A)(ii) and 
(a)(2)(A)(iii), the exemption generally applicable to a foreign 
government (as defined in Sec.  1.892-2T) for income described in Sec.  
1.892-3T does not apply to income received by a controlled commercial 
entity or received (directly or indirectly) from a controlled 
commercial entity, or to income derived from the disposition of any 
interest in a controlled commercial entity. For purposes of section 892 
and the regulations thereunder, the term entity means and includes a 
corporation, a partnership, a trust (including a pension trust 
described in Sec.  1.892-2T(c)), and an estate, and the term controlled 
commercial entity means any entity (including a controlled entity as 
defined in Sec.  1.892-2T(a)(3)) engaged in commercial activities (as 
defined in

[[Page 68123]]

Sec. Sec.  1.892-4 and 1.892-4T) (whether conducted within or outside 
the United States) if the government--
    (i) Holds (directly or indirectly) any interest in such entity 
which (by value or voting power) is 50 percent or more of the total of 
such interests in such entity, or
    (ii) Holds (directly or indirectly) any other interest in such 
entity which provides the foreign government with effective practical 
control of such entity.
    (2) Inadvertent commercial activity--(i) General rule. For purposes 
of determining whether an entity is a controlled commercial entity for 
purposes of section 892(a)(2)(B) and paragraph (a)(1) of this section, 
an entity that conducts only inadvertent commercial activity will not 
be considered to be engaged in commercial activities. However, any 
income derived from such inadvertent commercial activity will not 
qualify for exemption from tax under section 892. Commercial activity 
of an entity will be treated as inadvertent commercial activity only 
if:
    (A) Failure to avoid conducting the commercial activity is 
reasonable as described in paragraph (a)(2)(ii) of this section;
    (B) The commercial activity is promptly cured as described in 
paragraph (a)(2)(iii) of this section; and
    (C) The record maintenance requirements described in paragraph 
(a)(2)(iv) of this section are met.
    (ii) Reasonable failure to avoid commercial activity--(A) In 
general. Subject to paragraphs (a)(2)(ii)(B) and (C) of this section, 
whether an entity's failure to prevent its worldwide activities from 
resulting in commercial activity is reasonable will be determined in 
light of all the facts and circumstances. Due regard will be given to 
the number of commercial activities conducted during the taxable year 
and in prior taxable 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, respectively. For 
purposes of this paragraph (a)(2)(ii)(A) and paragraph (a)(2)(ii)(C) of 
this section, where a commercial activity conducted by a partnership is 
attributed under paragraph (d)(5)(i) of this section to an entity 
owning an interest in the partnership--
    (1) Assets used in the conduct of the commercial activity by the 
partnership are treated as assets used in the conduct of commercial 
activity by the entity in proportion to the entity's interest in the 
partnership; and
    (2) The entity's distributive share of the partnership's income 
from the conduct of the commercial activity shall be treated as income 
earned by the entity from the conduct of commercial activities.
    (B) Continuing due diligence requirement. A failure to avoid 
commercial activity will not be considered reasonable unless there is 
continuing due diligence to prevent the entity from engaging in 
commercial activities within or outside the United States as evidenced 
by having adequate written policies and operational procedures in place 
to monitor the entity's worldwide activities. A failure to avoid 
commercial activity will not be considered reasonable if the 
management-level employees of the entity have not undertaken reasonable 
efforts to establish, follow, and enforce such written policies and 
operational procedures.
    (C) Safe Harbor. Provided that adequate written policies and 
operational procedures are in place to monitor the entity's worldwide 
activities as required in paragraph (a)(2)(ii)(B) of this section, the 
entity's failure to avoid commercial activity during the taxable year 
will be considered reasonable if:
    (1) The value of the assets used in, or held for use in, all 
commercial activity does not exceed five percent of the total value of 
the assets reflected on the entity's balance sheet for the taxable year 
as prepared for financial accounting purposes, and
    (2) The income earned by the entity from commercial activity does 
not exceed five percent of the entity's gross income as reflected on 
its income statement for the taxable year as prepared for financial 
accounting purposes.
    (iii) Cure requirement. A timely cure shall be considered to have 
been made if the entity discontinues the conduct of the commercial 
activity within 120 days of discovering the commercial activity. For 
example, if an entity that holds an interest as a general partner in a 
partnership discovers that the partnership is conducting commercial 
activity, the entity will satisfy the cure requirement if, within 120 
days of discovering the commercial activity, the entity discontinues 
the conduct of the activity by divesting itself of its interest in the 
partnership (including by transferring its interest in the partnership 
to a related entity), or the partnership discontinues its conduct of 
commercial activity.
    (iv) Record maintenance. Adequate records of each discovered 
commercial activity and the remedial action taken to cure that activity 
must be maintained. The records shall be retained so long as the 
contents thereof may become material in the administration of section 
892.
    (3) Annual determination of controlled commercial entity status. If 
an entity described in paragraph (a)(1)(i) or (ii) of this section 
engages in commercial activities at any time during a taxable year, the 
entity will be considered a controlled commercial entity for the entire 
taxable year. An entity not otherwise engaged in commercial activities 
during a taxable year will not be considered a controlled commercial 
entity for a taxable year even if the entity engaged in commercial 
activities in a prior taxable year.
    (b) through (d)(4) [Reserved]. For further guidance, see Sec.  
1.892-5T(b) through (d)(4).
    (5) Partnerships--(i) General rule. Except as provided in paragraph 
(d)(5)(ii) or (d)(5)(iii) of this section, the commercial activities of 
an entity classified as a partnership for federal tax purposes will be 
attributable to its partners for purposes of section 892. For example, 
if an entity described in paragraph (a)(1)(i) or (ii) of this section 
holds an interest as a general partner in a partnership that is engaged 
in commercial activities, the partnership's commercial activities will 
be attributed to that entity for purposes of determining if the entity 
is a controlled commercial entity within the meaning of section 
892(a)(2)(B) and paragraph (a) of this section.
    (ii) Trading activity exception. 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 (whether domestic or foreign) that effects transactions in 
stocks, bonds, other securities (as defined in Sec.  1.892-3T(a)(3)), 
commodities (as defined in Sec.  1.892-4(e)(1)(ii)), or financial 
instruments (as defined in Sec.  1.892-3T(a)(4)) for the partnership's 
own account or solely because an employee of such partnership, or a 
broker, commission agent, custodian, or other agent, pursuant to 
discretionary authority granted by such partnership, effects such 
transactions for the account of the partnership. This exception shall 
not apply to any member in the case of a partnership that is a dealer 
in stocks, bonds, other securities, commodities, or financial 
instruments, as determined under the principles of Sec.  1.864-
2(c)(2)(iv)(a).
    (iii) Limited partner exception--(A) General rule. An entity that 
is not otherwise engaged in commercial activities (including, for 
example, performing services for a partnership as

[[Page 68124]]

described in section 707(a) or section 707(c)) will not be deemed to be 
engaged in commercial activities solely because it holds an interest as 
a limited partner in a limited partnership. Nevertheless, pursuant to 
sections 875, 882, and 892(a)(2)(A)(i), a foreign government member's 
distributive share of partnership income will not be exempt from 
taxation under section 892 to the extent that the partnership derived 
such income from the conduct of a commercial activity. For example, 
where a controlled entity described in Sec.  1.892-2T(a)(3) that is not 
otherwise engaged in commercial activities holds an interest as a 
limited partner in a limited partnership that is a dealer in stocks, 
bonds, other securities, commodities, or financial instruments in the 
United States, although the controlled entity partner will not be 
deemed to be engaged in commercial activities solely because of its 
interest in the limited partnership, its distributive share of 
partnership income derived from the partnership's activity as a dealer 
will not be exempt from tax under section 892 because it was derived 
from the conduct of a commercial activity.
    (B) Interest as a limited partner in a limited partnership. Solely 
for purposes of paragraph (d)(5)(iii) of this section, an interest in 
an entity classified as a partnership for federal tax purposes shall be 
treated as an interest as a limited partner in a limited partnership if 
the holder of such interest 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. 
Rights to participate in the management and conduct of a partnership's 
business do not include consent rights in the case of extraordinary 
events such as admission or expulsion of a general or limited partner, 
amendment of the partnership agreement, dissolution of the partnership, 
disposition of all or substantially all of the partnership's property 
outside of the ordinary course of the partnership's activities, merger, 
or conversion.
    (iv) Illustration. The following example illustrates the 
application of this paragraph (d)(5):

    Example 1. K, a controlled entity of a foreign sovereign, has 
investments in various stocks and bonds of United States 
corporations and in a 20% interest in Opco, a limited liability 
company that is classified as a partnership for federal tax 
purposes. Under the governing agreement of Opco, K has the authority 
to participate in the management and conduct of Opco's business. 
Opco has investments in various stocks and bonds of United States 
corporations and also owns and manages an office building in New 
York. Because K has authority to participate in the management and 
conduct of Opco's business, its interest in Opco is not a limited 
partner interest. Therefore, K will be deemed to be engaged in 
commercial activities because of attribution of Opco's commercial 
activity, even if K does not actually make management decisions with 
regard to Opco's commercial activity, the operation of the office 
building. Accordingly, K is a controlled commercial entity, and all 
of its income, including its distributive share of partnership 
income from its interest in Opco and its income from the stocks and 
bonds it owns directly, will not be exempt from tax under section 
892.
    Example 2. The facts are the same as in Example 1, except that 
Opco has hired a real estate management firm to lease offices and 
manage the office building. Notwithstanding the fact that an 
independent contractor is performing the activities, Opco will still 
be deemed to be engaged in commercial activities. Accordingly, K is 
a controlled commercial entity, and all of its income, including its 
distributive share of partnership income from its interest in Opco 
and its income from the stocks and bonds it owns directly, will not 
be exempt from tax under section 892.
    Example 3. The facts are the same as in Example 1, except that K 
is a member that has no right to participate in the management and 
conduct of Opco's business. Assume further that K is not otherwise 
engaged in commercial activities. Under paragraph (d)(5)(iii) of 
this section, Opco's commercial activities will not be attributed to 
K. Accordingly, K will not be a controlled commercial entity, and 
its income derived from the stocks and bonds it owns directly and 
the portion of its distributive share of partnership income from its 
interest in Opco that is derived from stocks and bonds will be 
exempt from tax under section 892. The portion of K's distributive 
share of partnership income from its interest in Opco that is 
derived from the operation of the office building will not be exempt 
from tax under section 892 and Sec.  1.892-3T(a)(1).

    (e) Effective/applicability date. This section applies on the date 
these regulations are published as final regulations in the Federal 
Register. See Sec.  1.892-5(a) as issued under TD 9012 (August 1, 2002) 
for rules that apply on or after January 14, 2002, and before the date 
these regulations are published as final regulations in the Federal 
Register. See Sec.  1.892-5T(a) for rules that apply before January 14, 
2002, and Sec.  1.892-5T(b) through (d) for rules that apply before the 
date these regulations are published as final regulations in the 
Federal Register.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 4. The authority for part 602 continues to read as follows:

    Authority:  26 U.S.C. 7805.

    Par. 5. In Sec.  602.101, paragraph (b) is amended by adding an 
entry to the table in numerical order to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       Control No.
------------------------------------------------------------------------
 
                                * * * * *
1.892-5.................................................       1545-1053
 
                                * * * * *
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 Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2011-28531 Filed 11-2-11; 8:45 am]
BILLING CODE 4830-01-P