[Federal Register Volume 90, Number 238 (Monday, December 15, 2025)]
[Rules and Regulations]
[Pages 57901-57920]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2025-22776]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 10042]
RIN 1545-BG08
Income of Foreign Governments and of International Organizations
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final and temporary regulations.
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SUMMARY: This document contains final regulations relating to the
taxation of the income of foreign governments from investments in the
United States. In particular, these final regulations provide guidance
for determining when a foreign government is engaged in commercial
activity and when an entity is a controlled commercial entity. The
final regulations will affect foreign governments that derive income
from sources within the United States.
DATES:
Effective date: These regulations are effective on December 15,
2025.
Applicability dates: For dates of applicability, see Sec. Sec.
1.892-3(c), 1.892-4(d), and 1.892-5(e).
FOR FURTHER INFORMATION CONTACT: Jack Zhou at (202) 317-6938 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Authority
This document contains amendments to the Income Tax Regulations (26
CFR part 1) under section 892 of the Internal Revenue Code (Code).
These regulations are issued under the express delegations of authority
under sections 892(c) and 7805(a) of the Code.
Background
On June 27, 1988, the Department of the Treasury (Treasury
Department) and the IRS published in the Federal Register a notice of
proposed rulemaking (53 FR 24100) (1988 proposed regulations) with a
cross-reference to temporary regulations under section 892 (TD 8211, 53
FR 24060) (1988 temporary regulations) to provide guidance concerning
the taxation of income of foreign governments and international
organizations from investments in the United States following changes
made to section 892 of the Code by section 1247 of the Tax Reform Act
of 1986 (1986 Act) (Pub. L. 99-514, 100 Stat. 2085, 2583). After the
1988 temporary regulations and 1988 proposed regulations were
published, section 892(a)(2)(A) was amended by section 1012(t) of the
Technical and Miscellaneous Revenue Act of 1988 (1988 Act or TAMRA)
(Pub. L. 100-647, 102 Stat. 3342, 3527-28) to provide that income
derived from the disposition of any interest in a controlled commercial
entity (CCE) does not qualify for the exemption under section 892.
Section 1019(a) of TAMRA states that, except as otherwise provided, any
amendments made by TAMRA are effective as if included in the provision
of the 1986 Act to which such amendment relates.
On August 1, 2002, the Treasury Department and the IRS published
Sec. 1.892-5(a)(3) in the Federal Register (TD 9012, 67 FR 49864) to
provide that the term ``entity'' for purposes of section 892(a)(2)(B)
(defining ``controlled commercial entity'') includes partnerships (2002
final regulations).
On November 3, 2011, the Treasury Department and the IRS published
in the Federal Register a notice of proposed rulemaking (76 FR 68119)
that would provide additional guidance for determining when a foreign
government is engaged in commercial activity (2011 proposed
regulations). On December 29, 2022, the Treasury Department and the IRS
published in the Federal Register a notice (87 FR 80108) to reopen the
comment period for the 2011 proposed regulations.
Also on December 29, 2022, the Treasury Department and the IRS
published in the Federal Register a notice of proposed rulemaking (87
FR 80097) that would make changes to Sec. 1.892-5T(b)(1) to provide
exceptions to the general rule that a United States real property
holding corporation (USRPHC), as defined in section 897(c)(2), which
may include a foreign corporation, is treated as engaged in commercial
activity and, therefore, is a CCE if the requirements of Sec. 1.892-
5T(a)(1) or (2) are satisfied (2022 proposed regulations).
The Treasury Department and the IRS received comments on the 2011
proposed regulations and the 2022 proposed regulations, all of which
are available at https://www.regulations.gov or upon request. A public
hearing was not requested and none was held. After taking into account
and addressing those comments, this Treasury decision finalizes, with
modifications, the 2022 proposed regulations and the 2011 proposed
regulations. In addition, this Treasury decision finalizes proposed
Sec. 1.892-3(a)(4) of the 1988 proposed regulations in accordance with
the modifications recommended by the comments to the 2011 proposed
regulations, which were reiterated by a comment to the 2022 proposed
regulations. Since reopening the comment period of the 2011 proposed
regulations has not resulted in any new or different comments, Sec.
1.892-3(a)(4) is finalized without reproposing the provision (as
discussed in part II.B.2 of the Summary of Comments and Explanation of
Revisions). Terms used but not defined in this preamble have the
meaning provided in the final regulations.
Summary of Comments and Explanation of Revisions
The final regulations retain the general approach and structure of
the 2011 proposed regulations and the 2022 proposed regulations, with
certain revisions. This section of the preamble discusses the comments
received in response to the 2011 proposed regulations and the 2022
proposed regulations, and explains the revisions reflected in the final
regulations.
I. Overview
Section 892 exempts a foreign government from U.S. income taxation
under subtitle A of the Code on certain qualified income received from
investments in the United States in stocks, bonds, or other domestic
securities, or financial instruments held in the execution of
governmental financial or monetary policy. Section 892(a)(1)(A). This
exemption does not apply to income that is (1) derived from the conduct
of any commercial activity (whether within or outside the United
States), (2) received by a CCE or received (directly or indirectly)
from a CCE, or (3) derived from the disposition
[[Page 57902]]
of any interest in a CCE. Section 892(a)(2)(A).
Section 892 does not define the term ``foreign government.'' The
1988 temporary regulations generally define a foreign government to
consist only of integral parts and controlled entities of a foreign
sovereign, and define an ``integral part'' of a foreign sovereign to
include any body, however designated, that constitutes a governing
authority of a foreign country. See Sec. 1.892-2T(a)(2). The 1988
temporary regulations generally define a ``controlled entity'' of a
foreign sovereign to mean an entity that is separate in form from a
foreign sovereign or otherwise constitutes a separate juridical entity
if it satisfies certain requirements, including that it is wholly owned
and controlled by the foreign sovereign directly or indirectly through
one or more controlled entities. See Sec. 1.892-2T(a)(3). The 1988
temporary regulations provide that a controlled entity does not include
partnerships or any other entity owned and controlled by more than one
foreign sovereign. Thus, a foreign financial organization organized and
wholly owned and controlled by several foreign sovereigns to foster
economic, financial, and technical cooperation between various foreign
nations is not a controlled entity for purposes of section 892. See
Sec. 1.892-2T(a)(3).
Section 892(a)(2)(B) provides that, for purposes of section
892(a)(2)(A), a CCE is any entity engaged in commercial activities
(whether within or outside the United States) and in which a foreign
government holds (directly or indirectly) interests that meet specified
thresholds. The 2002 final regulations provide that the term ``entity''
in section 892(a)(2)(B) means a corporation, a partnership, a trust
(including a pension trust described in Sec. 1.892-2T(c)), and an
estate. See Sec. 1.892-5(a)(3).
Section 892(c) authorizes the Secretary to prescribe such
regulations as may be necessary or appropriate to carry out the
purposes of section 892.
II. Defining Commercial Activities
A. General Rule
The 1988 temporary regulations define commercial activities to
include all activities (whether conducted within or outside the United
States) which are ordinarily conducted by the taxpayer or by other
persons with a view towards the current or future production of income
or gain. See Sec. 1.892-4T(b). Furthermore, those regulations provide
that an activity may be considered commercial activity even if that
activity does not constitute the conduct of a trade or business in the
United States under section 864(b). Id.
The 2011 proposed regulations would continue to define commercial
activities to include all activities (whether conducted within or
outside the United States) which are ordinarily conducted for the
current or future production of income or gain, and provide that only
the nature of the activity, not the purpose or motivation for
conducting it, is determinative of whether the activity is commercial
in character.\1\ See proposed Sec. 1.892-4(d) (which corresponds to
the rule in Sec. 1.892-4T(b)). Moreover, the 2011 proposed regulations
would provide that an activity may be considered commercial activity
even if that 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). Id.
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\1\ The 2011 proposed regulations provided rules in proposed
Sec. 1.892-4(d) and (e) that correspond to the same rules stated in
Sec. 1.892-4T(b) and (c). These final regulations revise the
structure of the provisions of the 2011 proposed regulations to be
consistent with the structure of the 1988 temporary regulations.
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Several comments generally recommended that the final regulations
should not distinguish between commercial activity under section 892
and a trade or business under section 864(b), or should provide that an
activity will not be treated as commercial activity if it would not
constitute a trade or business under section 864(b) if it were carried
on in the United States. The comments recommended that the final
regulations provide additional guidance by making the existing Treasury
regulations under section 864(b) applicable to foreign governments
under section 892.
The Treasury Department and the IRS agree that, subject to express
exceptions, an activity that constitutes a trade or business for
purposes of section 162 or constitutes (or would constitute if
undertaken in the United States) a trade or business in the United
States for purposes of section 864(b) is commercial activity; however,
the best reading of the term ``commercial activities'' as used in
section 892 is that it has a different and broader meaning than ``trade
or business'' under sections 162 and 864. In drafting section 892,
Congress opted for a different term, ``commercial activities,'' instead
of the familiar term ``trade or business.'' The word ``activities''
denotes a standard more easily satisfied than the term ``trade or
business.'' Congress's decision to use a different term should be given
effect.
The final regulations therefore employ a broad definition, and
provide that commercial activities potentially include activities that
may not (or would not, if undertaken in the United States) constitute
the conduct of a trade of business in the United States under section
864(b). Accordingly, the final regulations do not adopt the comments to
limit the definition of commercial activities to activities that are a
trade or business under section 864(b). In addition, the final
regulations clarify that activities that constitute a trade or business
for purposes of section 162 or constitute (or would constitute if
undertaken in the United States) a trade or business in the United
States for purposes of section 864(b) are commercial activities for
purposes of section 892, except as expressly provided otherwise.
Another comment suggested that the position taken in proposed Sec.
1.892-4(d) (that an activity may be considered commercial activity even
if it does not constitute a trade or business) appears contrary to the
rules of proposed Sec. 1.892-4(e)(1)(ii), which would provide that
effecting transactions in securities, commodities, or financial
instruments for a foreign government's own account does not constitute
commercial activity regardless of whether the activity constitutes a
trade or business. The Treasury Department and the IRS do not agree
with this comment, and are of the view that the 2011 proposed
regulations are internally consistent. Proposed Sec. 1.892-4(d) would
define the term commercial activities generally to include activities
beyond those that would constitute a trade or business, while proposed
Sec. 1.892-4(e)(1)(ii) would provide a specific exception to that
general rule for trading activities. The final regulations remove the
reference to trade or business activity to clarify the trading
exception under Sec. 1.892-4(c)(2) (formerly proposed Sec. 1.892-
4(e)(1)(ii)).
B. Investment Exception
Section 892 does not identify specific activities that do or do not
constitute commercial activities. However, the regulations under
section 892 provide that commercial activities do not include
investment activities, cultural events, governmental functions,
purchasing of goods for use of the foreign sovereign, and non-profit
activities. See, for example, Sec. 1.892-4T(c).
The 2011 proposed regulations would provide an exclusive list of
investments that are not treated as commercial
[[Page 57903]]
activities. This list includes 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. See proposed Sec. 1.892-4(e)(1)(i) (which corresponds to Sec.
1.892-4T(c)(1)(i)). The 2011 proposed regulations' investment exception
also would provide that transferring securities under a loan agreement
which meets the requirements of section 1058 is an investment and not
commercial activity, and that 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.
The 2011 proposed regulations also would provide that 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
United States by reason of the application of Sec. 1.864-4(c)(5). See
proposed Sec. 1.892-4(e)(1)(iii) (which corresponds to Sec. 1.892-
4T(c)(1)(iii)).
1. Investment in Loans
The exclusive list of investments that are not treated as
commercial activities under the 2011 proposed regulations includes the
term ``loans.'' See proposed Sec. 1.892-4(e)(1)(i) (which corresponds
to Sec. 1.892-4T(c)(1)(i)). A comment stated that there is uncertainty
as to the circumstances in which loan origination is commercial
activity. The comment recommended that lending (and charging of
associated fees) should not be treated as commercial activity unless an
entity offers to make loans to the general public or makes more than
five loans in a single year.
The recommendation of the comment is not adopted in the final
regulations because the Treasury Department and the IRS do not agree
that making loans to the general public or making a particular minimum
number of loans constitute necessary conditions for loan (or other
debt) acquisitions to be commercial in character, or that a lack of
those characteristics necessarily indicates absence of commercial
activities. The Treasury Department and the IRS are separately
proposing rules in this issue of the Federal Register as to when
acquiring a loan or other debt, including in connection with original
issuance, is treated as an investment for purposes of section 892.
2. Investment and Trading in Financial Instruments
The 1988 temporary regulations provide an exception from commercial
activities for investments in financial instruments held in the
execution of governmental financial or monetary policy. See Sec.
1.892-4T(c)(1). The 2011 proposed regulations would have modified this
exception by providing that investments in financial instruments (as
defined in Sec. 1.892-3T(a)(4)) are not treated as commercial
activities, without regard to whether the financial instruments are
held in the execution of governmental financial or monetary policy. See
proposed Sec. 1.892-4(e)(1)(i) (which corresponds to Sec. 1.892-
4T(c)(1)(i)). The 2011 proposed regulations also would have added
financial instruments (as defined in Sec. 1.892-3T(a)(4)) to the
trading exception under Sec. 1.892-4T(c)(1)(ii), without regard to
whether the financial instruments are held in the execution of
governmental financial or monetary policy. See proposed Sec. 1.892-
4(e)(1)(ii). Section 1.892-3T(a)(4) defines financial instrument to
include any forward, futures, options contract, swap agreement or
similar instrument in a functional or nonfunctional currency (as
defined in section 985(b)) or in precious metals when held by a foreign
government or central bank of issue (as defined in Sec. 1.895-1(b)).
Numerous comments to the 2011 proposed regulations recommended
clarifying that all transactions in financial instruments that are
within the scope of the trading safe harbors under section 864(b),
including derivative transactions within the scope of the 1998 proposed
regulations (63 FR 32164, June 12, 1998) under proposed Sec. 1.864(b)-
1, be treated as within the investment and trading exceptions of
proposed Sec. 1.892-4(e)(1)(i) and (ii) (which correspond to Sec.
1.892-4T(c)(1)(i) and (ii)). Certain of these comments asserted that
investing in these financial instruments is no less passive than a
direct investment in stocks or securities and, therefore, the
recommended clarification would be consistent with the purposes of
section 892. Comments also recommended expanding the definition of the
term ``financial instrument'' in Sec. 1.892-3T(a)(4) to include all
types of market standard derivatives. The recommendation was reiterated
by a comment to the 2022 proposed regulations.
The Treasury Department and the IRS generally agree that investing
and trading by a foreign government investor in financial instruments
that are derivatives within the scope of the proposed regulations under
section 864(b) are not commercial activities. See Prop. Reg. Sec.
1.864(b)-1(b)(2), 63 FR 32164, June 12, 1998. Investing and trading in
such financial instruments generally involve only putting capital at
risk and do not involve activity such as structuring the instrument, in
contrast to structuring of bespoke, non-market standard derivatives;
thus, the expected return is generally a return exclusively on capital
rather than on the activities conducted. Accordingly, the final
regulations adopt these comments by revising the definition of the term
``financial instrument'' under Sec. 1.892-3(a)(4) to include financial
instruments that are derivatives, which the final regulations define in
a manner that is substantially similar to the definition in proposed
Sec. 1.864(b)-1(b)(2). As a result, a foreign government may invest
and effect transactions (as a nondealer) for its own account with
respect to these expanded types of financial instruments without being
treated as engaged in commercial activities. See Sec. 1.892-
3(a)(4)(i). If, however, a contract or other financial instrument would
be characterized under general Federal income tax principles as
resulting in beneficial ownership of a reference asset, the
determination of whether the foreign government investor is conducting
commercial activity is made based on ownership of that asset and not
with regard to the financial instrument. Moreover, if a contract or
similar arrangement is not a derivative described in Sec. 1.892-
3(a)(4)(i), and does not otherwise qualify as an investment within the
meaning of Sec. 1.892-4(c)(1), effecting a transaction for one's own
account in that contract or similar arrangement may be commercial
activity unless it is within the scope of an exception to commercial
activities under Sec. Sec. 1.892-4(c) and 1.892-4T(c). The final
regulations also make changes to the structure of Sec. 1.892-3T(a)(4)
by separating the provision into separate paragraphs for ease of
reference. See Sec. 1.892-3(a)(4)(i) and (ii). The final regulations
finalize proposed Sec. 1.892-3(a)(4) of the 1988 proposed regulations
with modifications in accordance with the comments discussed above,
together with the changes described herein, and remove the provision
from the temporary regulations that were published on the same date.
3. Holding of Non-Functional Currency
A comment recommended adding the holding of non-functional currency
in a capacity other than a dealer or financial
[[Page 57904]]
institution to the exclusive list of investments that are not treated
as commercial activities. The Treasury Department and the IRS agree
with this comment because solely holding one's own cash, whether or not
in functional currency, is not an activity ordinarily conducted for the
current or future production of income or gain. Although currency
deposited in a bank may produce income or gain, merely depositing
currency does not rise to the level of commercial activity. Since a
foreign government entity generally would hold currency (whether
functional or non-functional) in a bank deposit, the Treasury
Department and the IRS are revising the rule for holding of bank
deposits to clarify that the exception includes the holding of bank
deposits in any currency. See Sec. 1.892-4(c)(1)(i). The comment also
recommended excluding currency gains from commercial activity income,
but this recommendation is beyond the scope of the final regulations.
Therefore, the final regulations do not adopt this recommendation.
4. Receipt of Certain Fee Income
A comment recommended an exception from commercial activity for the
receipt of certain fee income as a passive investor in a private equity
or private credit fund. The comment noted that foreign governments and
their controlled investment vehicles that invest in private equity or
similar funds may negotiate for the right to share in fees for services
provided to portfolio companies by the sponsor of the fund. The comment
thus recommended that a foreign government investor should not be
treated as conducting commercial activity solely by reason of receiving
a share of the fees for services performed by the sponsor if the
foreign government holds (directly or indirectly) an equity interest in
the underlying fund, subject to certain conditions. The comment also
asserted that a foreign government investor should not be treated as
conducting commercial activity if it receives fees incidental to
providing capital for an investment in debt or equity of an underlying
issuer. The comment contended that the receipt of these types of fees
is not commercial activity because the fees are payable for making,
continuing to make, or having made capital available to the underlying
issuer for an investment otherwise described in Sec. 1.892-4T(c)(1).
The final regulations do not adopt this comment. The Treasury
Department and the IRS are of the view that, for purposes of
determining whether a foreign government is engaged in commercial
activities, the best reading of the term ``commercial activities'' is
that it is concerned with the nature of the activity performed by, or
attributable to, the foreign government. To the extent the commercial
activities of a fund sponsor are attributable to a foreign government
investor in a privately managed fund under Sec. 1.892-5(d)(5)(i)
(attribution from an entity classified as a partnership), or on the
basis of agency, the foreign government investor is considered to
conduct commercial activity unless one or more exceptions under Sec.
1.892-5 (for example, the qualified partnership interest exception
under Sec. 1.892-5(d)(5)(iii)(B)) applies. This analysis applies
without regard to whether the foreign government actually or
constructively receives or otherwise shares in income labelled as a
fee. The final regulations do not treat the receipt of any particular
type of fee as alone determinative of whether a foreign government
conducts commercial activities. This approach is consistent with
Federal tax principles which analyze the substance of a transaction,
rather than its label or form.
5. Partnership Equity Interests
The 2011 proposed regulations would provide, in relevant part, that
investments in other securities (as defined in Sec. 1.892-3T(a)(3)) or
generally effecting transactions in other securities (as defined in
Sec. 1.892-3T(a)(3)) for a foreign government's own account as a
nondealer do not constitute commercial activities. See proposed Sec.
1.892-4(e)(1)(i) and (ii) (which correspond to Sec. 1.892-4T(c)(1)(i)
and (ii)). Section 1.892-3T(a)(3) provides that the term ``other
securities'' does not include partnership interests (with the exception
of publicly traded partnerships within the meaning of section 7704). As
a result of the cross-reference to Sec. 1.892-3T(a)(3) in proposed
Sec. 1.892-4(e)(1)(i) and (ii), comments have requested clarification
as to whether a disposition of a partnership interest would be treated
as commercial activity for purposes of section 892.
The Treasury Department and the IRS have determined that holding or
trading partnership equity interests for one's own account and other
than as a dealer is not by itself commercial activity. Rather, holding
equity interests in a partnership (including holding by an entity
incident to trading partnership equity interests for one's own account
and other than as a dealer) results in commercial activity if the
partnership conducts commercial activity that is attributed to the
holder. If this were not the case, there would be no need for a rule
attributing the commercial activities of a partnership to its partners
or for the exception to that rule for qualified partnership interests
as defined in Sec. 1.892-5(d)(5)(iii)(B). The exclusion of partnership
equity interests from the definition of ``other securities'' for
purposes of the investment and trading exceptions should not be read as
implying that holding or trading such interests for one's own account
and other than as a dealer are commercial activities. Accordingly,
although a partner may be attributed commercial activities conducted by
a partnership, the final regulations provide that the mere act of
holding a partnership equity interest or effecting transactions in a
partnership equity interest (for a foreign government's own account and
other than as a dealer) are not in themselves treated as commercial
activities. See Sec. 1.892-4(c)(1)(i) and (c)(2). Further, pursuant to
section 892(a)(2)(A), a foreign government's distributive share of
partnership income attributable to commercial activities is not exempt
from taxation under section 892. Moreover, pursuant to Sec. 1.892-
3T(a)(2) and (3), gain from the disposition of a partnership equity
interest is not exempt from taxation under section 892 (though,
depending on the partnership's assets and activities, it may be under
the generally applicable Code provisions).
Comments also recommended that any income earned through a
partnership and any gain arising from the disposition of a partnership
interest be exempt under section 892 to the extent such income or gain
would be exempt if realized directly by a foreign government. These
recommendations pertaining to the types of income that are exempt under
Sec. 1.892-3T(a), however, are beyond the scope of the final
regulations. Therefore, the final regulations do not adopt these
recommendations.
6. Banking, Financing, or Similar Business
With respect to the 2011 proposed regulations' provision that
otherwise qualifying investments made by a banking, financing, or
similar business would constitute commercial activities, comments
recommended that the final regulations define banking, financing, or
similar business by reference to Sec. 1.864-4(c)(5)(i) without regard
to the limitation that the activities be undertaken in the United
States.
The Treasury Department and the IRS address this comment by
proposing new rules included in this issue of the Federal Register for
determining the circumstances in which acquisitions of loans (and other
debt) are investments
[[Page 57905]]
or commercial activities for purposes of section 892, and, in doing so,
propose to withdraw Sec. 1.892-4T(c)(1)(iii) (the rule that treats
investments and loans made by a banking, financing, or similar business
as commercial activities). Therefore, the final regulations do not
adopt the comment or finalize proposed Sec. 1.892-4(e)(1)(iii) in the
2011 proposed regulations because it repeats the text of Sec. 1.892-
4T(c)(1)(iii).
III. Controlled Commercial Entities
Consistent with section 892(a)(2)(B), proposed Sec. 1.892-5(a)(1)
would define CCE to mean any entity (including a controlled entity as
defined in Sec. 1.892-2T(a)(3)) that is engaged in commercial
activities (whether conducted within or outside the United States) if
the foreign government 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 holds (directly or
indirectly) any other interest in such entity which provides the
foreign government with effective practical control of such entity. The
2011 proposed regulations would define entity for purposes of section
892 and the regulations thereunder to include a corporation, a
partnership, a trust (including a pension trust described in Sec.
1.892-2T(c)), and an estate. The 2002 final regulations, however,
define entity only for purposes of section 892(a)(2)(B). Consistent
with the 2002 final regulations, the final regulations provide that the
definition of ``entity'' in Sec. 1.892-5(a) is for purposes of section
892(a)(2)(B) only.
Several comments requested further detail on the definition of
effective practical control, including additional examples of
arrangements and rules to illustrate the definition. Other comments
made specific recommendations for what should not be treated as
effective practical control, such as normal creditor interests and
holding solely a minority equity interest (by vote and value) without
more.
The Treasury Department and the IRS generally agree with the
comments that the definition of effective practical control under Sec.
1.892-5T(c)(2) would be made clearer by inclusion of additional details
and examples. The final regulations replace the term ``effective
practical control'' with the term ``effective control'' to be
consistent with section 892(a)(2)(B)(ii). See Sec. 1.892-
5(a)(1)(iii)(B) and (c)(2). No inference is intended that the term
``effective control'' has any meaning different from that of
``effective practical control.'' In a separate notice of proposed
rulemaking published in this issue of the Federal Register, the
Treasury Department and the IRS propose rules for defining effective
control. See proposed Sec. 1.892-5(c)(2).
One comment recommended clarifying that control with respect to
entities held through a partnership be determined based on a foreign
government's indirect interest through the partnership rather than
based on the direct interest held by the partnership. The
recommendation requires modifying Sec. 1.892-5T(c), which is outside
the scope of these final regulations. Therefore, the final regulations
do not adopt this recommendation.
A. U.S. Real Property Holding Corporations and U.S. Real Property
Interests
The 1988 temporary regulations provide that a USRPHC, as defined in
section 897(c)(2), or a foreign corporation that would be a USRPHC if
it were a domestic corporation, is treated as engaged in commercial
activity and, therefore, is a CCE, if a foreign government meets
certain ownership or control thresholds with respect to that USRPHC or
foreign corporation (the USRPHC per se rule). See Sec. 1.892-5T(b)(1).
Proposed Sec. 1.892-4(e)(1)(iv) of the 2011 proposed regulations
would provide that a disposition, including a deemed disposition under
section 897(h)(1), of a U.S. real property interest (as defined in
section 897(c)) (USRPI), by itself, does not constitute the conduct of
commercial activity. However, as provided in Sec. 1.892-3T(a), the
income derived from the disposition of a USRPI described in section
897(c)(1)(A)(i) (generally an interest in real property located in the
United States or the Virgin Islands) shall in no event qualify for the
exemption from tax under section 892.
The 2022 proposed regulations would revise Sec. 1.892-5T(b)(1) by
providing two exclusions from the USRPHC per se rule for: (i) a foreign
corporation that is a qualified holder under Sec. 1.897(l)-1(d)
(referring to qualified foreign pension funds or certain qualified
controlled entities), or (ii) a corporation that is a USRPHC solely by
reason of its direct or indirect ownership interest in one or more
other corporations that are not controlled by the foreign government
(as determined under Sec. 1.892-5T(a)). As a result of the latter
exclusion in the 2022 proposed regulations, a foreign government could
use a domestic holding company for those minority interests without
that holding company being treated as a CCE (the minority interest
exception).\2\ The 2022 proposed regulations would apply to taxable
years ending on or after December 28, 2022, when finalized. The
preamble provided that taxpayers may rely on the 2022 proposed
regulations, including the minority interest exception, until the date
the regulations are published as final regulations in the Federal
Register.
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\2\ The 2022 proposed regulations would also clarify Sec.
1.892-5T(b)(1) by replacing the phrase ``or a foreign corporation
that would be a United States real property holding corporation if
it was a domestic corporation'' with ``which may include a foreign
corporation'' when referencing section 897(c)(2) to define a USRPHC.
See proposed Sec. 1.892-5(b)(1)(i).
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Comments recommended that the final regulations withdraw the USRPHC
per se rule. They asserted that there is no policy rationale under
section 897 for the USRPHC per se rule in the context of section 892
and that it is merely a ``trap for the unwary'' that causes section 892
investors to devise ways to plan around the rule. One comment asserted
that the 1988 Act's legislative history (discussed below) addressed
only a foreign government's disposition of an investment in a domestic
USRPHC, rather than demonstrating an intent to treat a foreign USRPHC
as a per se CCE. Another comment recommended that the rule should apply
solely to an entity that would be a USRPHC if the reference to USRPI in
section 897(c)(2) were replaced with a cross reference to the
definition of a USRPI in section 897(c)(1)(A)(i). Another comment
recommended replacing the USRPHC per se rule with a rule that treats
the gain or loss on the sale of a controlled USRPHC as if it were
derived from commercial activity, similar to the rule under section
897(a) which treats gain or loss realized from the disposition of a
USRPI as effectively connected with a U.S. trade or business. This
comment explained that this recommendation is better aligned with the
1988 Act's legislative history.
Several comments recommended that the final regulations clarify or
expand the application of the minority interest exception. Two comments
made recommendations that would modify the assets to be taken into
account for the minority interest exception, such as by disregarding
USRPIs that do not collectively exceed ten percent of an entity's
assets after excluding USRPIs that qualify for the minority interest
exception. Other comments recommended other ways of expanding the
minority interest exception, including by taking into account
noncontrolling interests in noncorporate entities and investments in
debt
[[Page 57906]]
instruments or other financial instruments that could be treated as
USRPIs.
The 1988 Act's legislative history includes a statement that ``a
commercial entity is to include any U.S. real property holding
corporation (sec. 897(c)(2)).'' S. Rep. No. 100-445, 306 (1988).
Although the legislative history does not expressly distinguish between
domestic and foreign USRPHCs, the Treasury Department and the IRS have
determined that limiting the USRPHC per se rule to domestic
corporations is appropriate to preserve U.S. taxation of gain on the
sale of shares of a controlled domestic USRPHC, consistent with the
legislative history, while at the same time addressing the concerns of
commenters as to application of the rule to foreign USRPHCs. The
Treasury Department and the IRS also have determined that applying the
USRPHC per se rule only to domestic corporations more directly
addresses the concerns raised by comments that controlled entities,
which are necessarily foreign and otherwise eligible for the section
892 exemption, must continuously monitor their investments to ensure
that they do not become subject to the USRPHC per se rule. Thus, the
final regulations limit the USRPHC per se rule to domestic corporations
and do not deem a foreign corporation to be engaged in commercial
activity solely by reason of its status as a USRPHC. See Sec. 1.892-
5(b)(1)(ii)(A). Due to this change in the USRPHC per se rule in the
final regulations, the proposed exception for foreign corporations that
are qualified holders under Sec. 1.897(l)-1(d) is not necessary and so
is not finalized. Therefore, foreign government investors as defined in
Sec. 1.892-2T(a) and foreign government pension funds that are
qualified holders under Sec. 1.897(l)-1(d) do not need to monitor
their own USRPHC status for purposes of the USRPHC per se rule.
Similarly, the change in the USRPHC per se rule in the final
regulations renders the proposed minority interest exception
unnecessary because, under the final regulations, foreign governments
have the alternative of investing directly or through foreign holding
companies. However, the Treasury Department and the IRS understand that
foreign government investors have relied on the minority interest
exception for taxable years ending on or after December 28, 2022, as
permitted by the preamble to the 2022 proposed regulations, and have
entered into long-term minority interest investments in USRPHCs using
domestic holding companies. If the minority interest exception were not
finalized, the Treasury Department and the IRS understand, these
investors could incur substantial costs to restructure these
investments. Accordingly, the final regulations retain the minority
interest exception (with certain clarifying modifications). See Sec.
1.892-5(b)(1)(ii)(B). The Treasury Department and the IRS are of the
view that adopting the minority interest exception does not present
policy concerns under section 897 in the context of section 892 because
the exception allows foreign government investors to use domestic
holding companies for investments that could otherwise be entered into
directly or by using foreign holding companies and therefore does not
present an opportunity to facilitate the inappropriate avoidance of
section 897.
With respect to the minority interest exception, a comment asserted
that there are two possible interpretations of the phrase ``solely by
reason of its direct or indirect ownership interest in one or more
other corporations'': (1) any ownership interests in noncontrolled
corporations are removed from an entity's balance sheet before
performing the asset test under section 897 to determine whether USRPIs
constitute 50 percent or more of the value of the entity's assets (the
Balance Sheet Method); and (2) noncontrolling interests in USRPHCs are
treated as ``good'' assets for purposes of the asset test under section
897 and thereby are included in the denominator but not the numerator
(the Good Asset Method).
The Treasury Department and the IRS have determined that the
correct interpretation of the minority interest exception in Sec.
1.892-5(b)(1)(ii)(B) requires use of the Balance Sheet Method, and thus
it (and not the Good Asset Method) is the only method permitted to be
used when applying this exception. That is because a corporation
applying the Good Asset Method could satisfy Sec. 1.892-5(b)(1)(ii)(B)
even if it held a controlling interest in a USRPHC or a direct interest
in U.S. real estate. In that case, the corporation would not be a
USRPHC ``solely by reason of its direct or indirect ownership interest
in one or more other corporations that are not controlled by the
foreign government,'' as required for the exception to apply. Thus, the
final regulations provide that the phrase ``solely by reason of its
direct or indirect ownership interest in one or more other corporations
that are not controlled by the foreign government'' means disregarding
any ownership interests, held directly or indirectly, in noncontrolled
corporations determined under Sec. 1.892-5(a)(1), after applying the
asset test under section 897(c)(2) and Sec. 1.897-2. For example, if a
controlled entity (CE) within the meaning of Sec. 1.892-2T(a)(3) does
not own any assets other than 100 percent of the interests in a USRPHC
whose only asset is a minority interest in a real estate investment
trust (REIT), neither the USRPHC directly owned by CE nor CE itself
(which does not hold any other assets) would be treated as a CCE
pursuant to Sec. 1.892-5(b)(1)(ii)(B). The asset test under Sec.
1.897-2(e)(3) provides that CE, which holds a controlling interest in
the USRPHC within the meaning of Sec. 1.897-2(e)(3)(iii) (flush
language), holds a proportionate share of each asset held by the
USRPHC. Thus, because CE holds a controlling interest in the USRPHC,
the USRPHC's minority interest in the REIT is treated as held by CE.
That ownership interest in the REIT, which is a noncontrolled
corporation (within the meaning of Sec. 1.892-5(a)(1)), however, is
disregarded when determining whether the USRPHC and CE are USRPHCs for
purposes of Sec. 1.892-5(b)(1)(ii)(B). Therefore, after having applied
the asset test under Sec. 1.897-2, including the look-through rules of
Sec. 1.897-2(e)(3), and then removing such minority interests from the
balance sheets of the USRPHC and CE, neither the USRPHC nor CE are
USRPHCs and therefore are not CCEs pursuant to Sec. 1.892-
5(b)(1)(ii)(B).
Additionally, the final regulations do not adopt the comments
previously discussed relating to expanding the scope of the minority
interest exception. The Treasury Department and the IRS have determined
that expanding the scope of the minority interest exception may result
in foreign governments holding (through a controlled U.S. corporation)
active rather than passive, noncontrolling investments in U.S. real
property, which would be contrary to the purpose of the CCE rules.
A comment recommended that the parent-to-subsidiary attribution
rule of Sec. 1.892-5T(d)(2)(ii) not apply where the parent corporation
is treated as engaged in commercial activity under Sec. 1.892-5T(b)(1)
because it is a USRPHC. This recommendation is beyond the scope of the
final regulations. Therefore, the final regulations do not adopt this
recommendation.
B. Inadvertent Commercial Activity Exception
The 2011 proposed regulations would treat an entity that conducts
only inadvertent commercial activities in a particular tax year as not
engaged in commercial activities if (1) failure to avoid conducting the
commercial activity is reasonable as described in
[[Page 57907]]
proposed Sec. 1.892-5(a)(2)(ii); (2) the commercial activity is
promptly cured as described in proposed Sec. 1.892-5(a)(2)(iii); and
(3) the record maintenance requirements described in proposed Sec.
1.892-5(a)(2)(iv) are met (the inadvertent commercial activity
exception). However, any income derived from any foreign government's
inadvertent commercial activity, including activity attributed from a
partnership, would not qualify for exemption from tax under section
892. See proposed Sec. 1.892-5(a)(2)(i).
Comments recommended that the final regulations provide for a new
rule permitting a specified percentage of an entity's assets or income
during a tested year to be derived from the conduct of commercial
activities regardless of whether the commercial activities were
inadvertent and regardless of whether the requirements for the
inadvertent commercial activity exception were satisfied. The comment
asserted that section 892 allows for such a de minimis rule.
The final regulations do not adopt these comments. Section
892(a)(2)(B) provides that any entity engaged in commercial activities
is a CCE if either clause (i) or (ii) of section 892(a)(2)(B) is
satisfied. The provision notably does not provide for a quantitative
threshold for determining whether an entity is engaged in commercial
activities. Therefore, the Treasury Department and the IRS have
determined that a quantitative threshold for determining whether an
entity is engaged in commercial activities is inconsistent with section
892. However, the Treasury Department and the IRS have also determined
that the best reading of section 892(a)(2)(B) is that an entity is not
``engaged'' in commercial activities where reasonable precautions were
taken to avoid the commercial activities, but the entity nevertheless
conducted such activities inadvertently. Accordingly, the exception in
Sec. 1.892-5(a)(2) finalizes providing targeted relief in the case of
an entity that inadvertently conducts commercial activity, provided
that the activity is discontinued in a timely manner.
A comment requested that the Treasury Department and the IRS
prescribe procedures to simplify the tax payment and return filing
obligations arising from inadvertent commercial activity. This comment
is beyond the scope of the final regulations and, therefore, it is not
adopted.
1. Whether Failure To Avoid Conducting Commercial Activities Is
Reasonable
Subject to the continuing due diligence requirement under proposed
Sec. 1.892-5(a)(2)(ii)(B) and a safe harbor under proposed Sec.
1.892-5(a)(2)(ii)(C), the 2011 proposed regulations would provide that
whether an entity's failure to avoid engaging in commercial activity is
reasonable is 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 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 2011 proposed
regulations would also provide that for purposes of Sec. 1.892-
5(a)(2)(ii)(A) and (C), where commercial activity conducted by a
partnership is attributed under Sec. 1.892-5(d)(5)(i) to an entity
owning an interest in the partnership, 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 the entity's distributive
share of the partnership's income from the conduct of the commercial
activity is treated as income earned by the entity from the conduct of
commercial activities.
Comments recommended that the final regulations provide that the
continuing due diligence and other requirements to satisfy the
inadvertent commercial activity exception do not apply where an entity
reasonably concludes that it holds an interest as a limited partner in
a limited partnership described in proposed Sec. 1.892-
5(d)(5)(iii)(B). The final regulations do not adopt this comment
because the inadvertent commercial activity exception and qualified
partnership interest exception are provided for different reasons and
apply in different situations. See, for example, Sec. 1.892-
5(a)(2)(ii)(A), which acknowledges the separate exception for qualified
partnership interests by citing to Sec. 1.892-5(d)(5)(i) (attribution
from an entity classified as a partnership that is subject to the
qualified partnership interest exception under Sec. 1.892-
5(d)(5)(iii)). The inadvertent commercial activity exception may be
available when it is not reasonably expected for an entity's investment
to result in the attribution of commercial activities. In contrast, the
qualified partnership interest exception may be available even when an
entity invests in a partnership that it expects will deliberately
conduct activities that may be treated as commercial activities.
Therefore, whether an entity reasonably concludes that it qualifies for
the qualified partnership interest exception is not a factor in
determining whether the inadvertent commercial activity exception is
available for activities conducted by the partnership in which the
entity invests.
Proposed Sec. 1.892-5(a)(2)(ii)(B) provides that 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.
Comments requested additional details and illustrations with
respect to ``adequate written policies and operational procedures.''
One comment recommended a safe harbor in which an entity will be
treated as having adequate written policies and operational procedures
if the entity satisfies certain specified requirements, including that
the entity (1) establish a written policy that prohibits the entity
from engaging in commercial activities both directly and through
investments in entities whose activities could be attributed to it for
purposes of section 892, (2) communicate that written policy and its
operational procedures to employees of the entity and other persons who
have a relationship with the entity, and (3) periodically review a
representative sample of the entity's investments. Another comment
recommended replacing the word ``adequate'' with ``reasonably
suitable'' because an entity that fails the inadvertent commercial
activity exception did not, by definition, have ``adequate'' written
policies and operational procedures.
The final regulations do not adopt the comment requesting a change
to the description of written policies and operational procedures to
``reasonably suitable,'' but instead provide examples of facts and
circumstances that may be used to determine whether a written policy or
operational procedure is considered adequate. See Sec. 1.892-
5(a)(2)(ii)(B). The description of written policies and operational
procedures as being ``adequate'' does not mean that the policies and
procedures, viewed with hindsight, had the effect of completely
preventing commercial activities, but instead means that there is a
reasonable expectation that the policies and procedures will be
adequate for that purpose, considering all facts and circumstances. In
[[Page 57908]]
determining whether written policies and operational procedures are
considered adequate, the final regulations adopt, with modifications,
the factors recommended by the comment but without providing a safe
harbor. See Sec. 1.892-5(a)(2)(ii)(B)(1) through (5).
Another comment recommended adopting a standard of review for
determining reasonableness by taking into account whether commercial
activity is de minimis. The final regulations do not adopt this comment
because, as described above, the Treasury Department and the IRS have
determined that a quantitative threshold for determining whether an
entity is engaged in commercial activity is inconsistent with section
892.
Proposed Sec. 1.892-5(a)(2)(ii)(B) also provides that 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 the written policies and
operational procedures. Comments recommended that the final regulations
include within the scope of this rule the management-level personnel of
an entity that is affiliated with the foreign government investor or
that is responsible for the management of its investments. Comments
similarly recommended that an entity should be able to rely on the
establishment and enforcement of policies and procedures of the
investment manager of (or those of another third-party controlling
investments by) funds or managed accounts in which the entity invests.
In response to these comments, the final regulations provide that
either employees of the entity claiming the inadvertent commercial
activity exception or employees of any of its controlling entities
(such control determined within the meaning of Sec. 1.892-5(a)(1)) may
be designated to establish, follow, and enforce the adequate written
policies and operational procedures to appropriately monitor the
worldwide activities of the entity claiming the inadvertent commercial
activity exception. See Sec. 1.892-5(a)(2)(v)(B). Moreover, the final
regulations concentrate on any employees who have these oversight
responsibilities, rather than solely on management-level employees,
because management-level employees are not always the only employees
undertaking efforts with respect to the written policies and
operational procedures. However, regardless of where the responsible
employees are located, the written policies and operational procedures
must be adequate within the meaning of the final regulations. See Sec.
1.892-5(a)(2)(ii)(B). Further, the responsible employees must in all
cases undertake reasonable efforts (meaning exercising ordinary
business care and prudence) in light of all facts and circumstances to
establish, follow, and enforce the written policies and operational
procedures.
Comments also requested with respect to the ``reasonable efforts''
requirement that reasonable reliance on competent tax advisors should
constitute a reasonable effort to avoid conducting commercial activity,
even if the advice is incorrect in hindsight. Other comments
recommended creating a safe harbor under which an entity would be
treated as having undertaken reasonable efforts if it had relied on tax
advice that is a reasoned opinion rendered based on pertinent
information and before the undertaking of the commercial activity.
The Treasury Department and the IRS have determined that an
entity's failure to avoid commercial activity will not be treated as
reasonable solely on the basis of obtaining a tax opinion or legal
advice. Obtaining a tax opinion or legal advice alone does not
supersede the need for employees of the entity claiming the inadvertent
commercial activity exception (or employees of a controlling entity
within the meaning of Sec. 1.892-5(a)(1)) to take reasonable efforts
to establish, follow, and enforce the applicable written policies and
operational procedures to prevent the applicable entity from engaging
in commercial activity. Accordingly, the final regulations do not adopt
this comment with respect to proposed Sec. 1.892-5(a)(2)(ii)(B).
2. Inadvertent Commercial Activity Safe Harbor
The 2011 proposed regulations would provide a safe harbor under
which, if there are adequate written policies and operational
procedures in place, the entity's failure to avoid the conduct of
commercial activity during a taxable year will be considered reasonable
if it satisfies the following two conditions: (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. Proposed Sec. 1.892-
5(a)(2)(ii)(C).
Numerous comments recommended that the final regulations provide
additional information about the meaning of ``prepared for financial
accounting purposes.'' Because foreign government entities are not
publicly traded and are not domestic entities, they are not required to
prepare financial statements under U.S. GAAP. Therefore, comments
recommended that the final regulations provide that financial
statements maintained under IFRS or an entity's local accounting rules
or, if the entity does not prepare separate financial statements, books
and records maintained in the ordinary course of its operations or for
purposes of monitoring its investments will qualify for use under this
safe harbor. A comment observed that many entities that own financial
assets are required to use, or do use, mark-to-market accounting which,
in the case of the income test, may distort an entity's eligibility for
the safe harbor. The same comment also requested guidance regarding
when both the income and assets limits are to be calculated and using
what convention (for example, average of the quarter-end or month-end).
The Treasury Department and the IRS have determined that the safe
harbor must be applied using an applicable financial statement as
defined in section 451(b)(3) and Sec. 1.451-3(a), which may include a
financial statement prepared in U.S. GAAP, IFRS, or another method
required under applicable regulatory accounting rules. The final
regulations provide that if the entity does not prepare financial
statements for financial accounting or regulatory reporting purposes,
the entity may use books of account or records that are adequate and
sufficient to establish the respective amount. The final regulations
also provide that the determination of asset values for purposes of the
safe harbor is made using the average of amounts as of the close of
each quarter of the taxable year and the determination of income is
made as of the end of the taxable year. Whether mark-to-market
accounting is required with respect to financial assets will depend
upon the method used by the applicable financial statement. The
quarterly averaging method is unnecessary for the income portion of the
safe harbor because income (in contrast to assets) is measured over a
period rather than as of specific dates.
A comment recommended that the final regulations increase the safe
harbor thresholds to ten percent (from five percent) to alleviate
challenges with obtaining necessary information about Federal entity
classification status of
[[Page 57909]]
foreign investments. Another comment recommended that only asset values
be used for the safe harbor. The comment also recommended that where an
entity holds an interest as a limited partner under proposed Sec.
1.892-5(d)(5)(iii), the value of that interest be included in the
entity's calculation of its total assets, but not included in the value
of its commercial activity assets.
The Treasury Department and the IRS have determined that an
analysis of both the entity's income and assets and a five percent
threshold are reasonable and appropriate for a safe harbor that relates
to inadvertent commercial activity. The five percent threshold for this
purpose is used to substantiate that the commercial activity is
inadvertent, rather than permitting a de minimis rule that ignores any
evidence of the commercial activity being inadvertent, such as, for
example, having in place adequate written policies and operational
procedures. Therefore, the final regulations do not adopt the comment
to increase the safe harbor thresholds or to limit the safe harbor
measurements to assets only. The Treasury Department and the IRS do
agree with the comment on the treatment of qualified partnership
interests in the safe harbor asset test. The final regulations provide
that the commercial activity asset of a qualified partnership interest
that is described in Sec. 1.892-5(d)(5)(iii) is not included as an
asset used in commercial activity of the tested entity for purposes of
this safe harbor, but the value of the qualified partnership interest
is included in the entity's calculation of its total assets for that
purpose. See Sec. 1.892-5(a)(2)(ii)(A) and (a)(2)(ii)(C)(2).
Furthermore, the final regulations provide that a tested entity's
distributive share of commercial activity income from a qualified
partnership interest that is described in Sec. 1.892-5(d)(5)(iii) is
not included as income earned by the entity from commercial activity
for purposes of this safe harbor, but is included in the entity's gross
income for that purpose and treated as commercial activity income for
all other purposes of section 892. Id.
3. Cure Requirement
The second requirement to qualify for the inadvertent commercial
activity exception is that the commercial activity must be promptly
cured as described in proposed Sec. 1.892-5(a)(2)(iii). A cure is
considered prompt under proposed Sec. 1.892-5(a)(2)(i)(B) if the
entity engaging in inadvertent commercial activity discontinues the
activity within 120 days of discovering it. See proposed Sec. 1.892-
5(a)(2)(iii). The third requirement is that adequate records of each
discovered commercial activity and the remedial action taken to cure
that activity must be maintained. The records must be retained so long
as the contents thereof may become material in the administration of
section 892. See proposed Sec. 1.892-5(a)(2)(iv).
The proposed rule would provide, as an example, that if an entity
holding 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 the discovery of
the commercial activity, the entity discontinues the activity by
divesting itself of its partnership interest (including by transferring
its interest in the partnership to a related entity) or the partnership
itself discontinues its conduct of commercial activity.
Comments recommended that the final regulations provide a period
that is greater than 120 days from the date of discovery for an entity
to cure the inadvertent commercial activity. One comment recommended a
six-month (or 180 days) cure period, and another comment requested that
the cure period be the greater of 120 days or the length of the notice
and exit terms to which the entity is contractually bound under the
relevant governing document of the investment, plus 45 days to initiate
the process of notice and exit. Another comment asserted that a period
longer than 120 days is required because of the time needed to craft a
legal plan effecting the discontinuance of the commercial activity and,
in some cases, to obtain required governmental or third-party
approvals. Yet another comment recommended tolling the curing period
until the commercial activity is discovered by an officer or employee
of the entity who is reasonably expected to be aware of the
significance of the activity.
The Treasury Department and the IRS have determined that a period
greater than 120 days to cure the inadvertent commercial activity is
reasonable and appropriate to accommodate foreign legal and commercial
or contractual considerations. The final regulations extend the cure
period to 180 days from the date of the discovery by the employees who
are responsible for monitoring and reviewing the entity's commercial
activity pursuant to Sec. 1.892-5(a)(2)(ii)(B) (the rule providing
responsible employees undertake reasonable efforts to establish,
follow, and enforce the adequate written policies and operational
procedures). However, the final regulations do not adopt the other
comments because adopting them would provide an entity the ability to
select its own cure period based on contractual terms or by disputing
whether an officer or employee of the entity was reasonably expected to
have been aware of the significance of the activity.
Comments requested that the final regulations provide that an
entity that is engaged in commercial activity solely by attribution
through its interest in a partnership may cure inadvertent commercial
activity by exchanging (including by amending the terms of) its
partnership interest for one that qualifies for the exception under
proposed Sec. 1.892-5(d)(5)(iii) (the qualified partnership interest
exception). The final regulations provide that an entity may, depending
on the facts and circumstances, be able to satisfy the cure requirement
by exchanging its partnership interest for one that is a qualified
partnership interest within the meaning of Sec. 1.892-5(d)(5)(iii) in
the same partnership (including a deemed exchange from an agreed
modification of terms). The final regulations do not adopt the comment
as a bright-line rule because the Treasury Department and the IRS are
concerned about the potential of abuse, such as negotiating for a
partnership interest to be automatically exchanged for a different
interest upon the discovery of commercial activity. Such an automatic
feature also is inconsistent with the principles of satisfying the
inadvertent commercial activity exception, which requires an entity's
active involvement. The final regulations retain the language from
proposed Sec. 1.892-5(a)(2)(iii) that divesture by an entity of its
interest in a partnership may be achieved by transferring its interest
in the partnership to a related entity, such as to a related entity
classified as a corporation for Federal tax purposes, so that
commercial activity is not attributable to an entity that is eligible
for the section 892 exemption.
Finally, a comment recommended that the final regulations use the
term ``promptly'' in Sec. 1.892-5(a)(2) rather than interchangeably
using ``promptly'' and ``timely.'' In the comment's view, the term
``timely'' indicates a deadline imposed by a governmental body. The
final regulations do not adopt this comment, but instead replace the
term ``promptly'' in Sec. 1.892-5(a)(2)(i)(B) with the term
``timely.'' Because Sec. 1.892-5(a)(2)(i)(B) provides that the
commercial activity is promptly cured as described in Sec. 1.892-
5(a)(2)(iii) which in turn describes a ``timely'' cure (relevant to a
particular time period), it is appropriate to revise the general rule
[[Page 57910]]
in Sec. 1.892-5(a)(2)(i)(B) as requiring a ``timely'' cure.
C. Annual CCE Determination
Proposed Sec. 1.892-5(a)(3) would provide that, if an entity
described in proposed Sec. 1.892-5(a)(1)(i) or (ii) (relating to
whether the entity is controlled by a foreign government) engages in
commercial activities at any time during the taxable year, the entity
will be considered a CCE for the entire taxable year. An entity not
otherwise engaged in commercial activities during a taxable year will
not be considered a CCE for a taxable year even if the entity engaged
in commercial activities in a prior taxable year.
A comment recommended that the final regulations expressly provide
that the relevant taxable year for purposes of this rule is the taxable
year of the entity. Another comment requested guidance on whether an
entity's commercial activity carries over to an acquiring entity in an
asset reorganization or a transaction in which the transferee retains
the tax attributes of the transferor under section 381.
The final regulations generally adopt the comment's recommendation
that the annual determination of whether an entity is a CCE under
proposed Sec. 1.892-5(a)(3) be made with respect to the entity's
taxable year, which may be less than a 12-month period if, for example,
the entity's taxable year is terminated as a result of a transaction or
reorganization. See Sec. 1.892-5(a)(3)(i). If the taxable year of a
corporation engaged in commercial activity is terminated as a result of
an acquisition to which section 381(a) applies (except for a complete
liquidation under section 332(a), which acquisition would fall within
the exception to this general rule as described below), the acquiring
corporation generally does not succeed to the commercial activity of
the distributor or transferor corporation for the acquiring
corporation's applicable taxable year, provided that after the
acquisition, the acquiring corporation is not the entity that directly
carries on such commercial activity. See Sec. 1.892-5(a)(3)(ii)(A).
This condition might be met in the case of reorganizations followed by
transfers described in Sec. 1.368-2(k). However, if the corporation
engages in an acquisition to which section 381(a) applies with another
corporation controlled by the same foreign sovereign under Sec. 1.892-
5(a)(1), for example, in a complete liquidation of a subsidiary under
section 332(a), then the distributor or transferor corporation's
commercial activity will cause the acquiring corporation to be treated
as a CCE for the acquiring corporation's taxable year in which the
acquisition occurred. See Sec. 1.892-5(a)(3)(ii)(B).
As a result of adopting the taxable year as the relevant
measurement period for the annual CCE test, it is possible without
further safeguards that activity in one taxable year, considered in
isolation, might not be characterized as commercial, even though it is
part of a course of conduct or transaction spanning two taxable years
which, taken as a whole, is characterized as commercial activity. For
example, consider a controlled entity whose taxable year is the
calendar year and conducts activity in December of year 1 that relates
to a transaction the controlled entity enters into in January of year
2. Without any additional guardrails to the annual CCE test, if the
January transaction in isolation is not considered commercial activity,
and no commercial activities were otherwise performed by the controlled
entity in year 2, the controlled entity would not be treated as a CCE
in year 2, even if the activities in December of year 1 and January of
year 2 constitute commercial activities when considered together. To
address this scenario, the final regulations provide that for purposes
of determining whether an entity is engaged in commercial activities
during its taxable year, that entity's activities during its
immediately preceding taxable year will also be taken into account to
the extent relevant in characterizing the activities in the current
taxable year. See Sec. 1.892-5(a)(3)(i). The Treasury Department and
the IRS concluded that this test should not look past the immediately
preceding year for reasons of administrability, but other doctrines may
still apply to activities that occur across multiple years in form and
only one year in substance when making the commercial activity
determination.
Another comment recommended that an entity that is a CCE under
Sec. 1.892-5T(b)(1) solely because it is a USRPHC should not be
treated as a CCE for its entire taxable year if the entity ceases to be
a USRPHC on any determination date under Sec. 1.897-2(c) or through
operation of the cleansing rule of section 897(c)(1)(B). The Treasury
Department and the IRS have determined that an exception to proposed
Sec. 1.892-5(a)(3) in this limited situation would be inconsistent
with the treatment of other types of entities that do not have the
option to cleanse themselves of CCE status. Moreover, since the 2011
proposed regulations were published, the cleansing rule of section
897(c)(1)(B) generally was eliminated for regulated investment
companies (RICs) and REITs and, therefore, adopting this comment would
have limited effect only for domestic corporations that are not RICs or
REITs. In addition, the final regulations provide that only domestic
corporations are subject to the rule in Sec. 1.892-5(b)(1)(i) that
treats controlled USRPHCs as CCEs. This change to Sec. 1.892-5(b)(1)
narrows the scope of entities that are treated as CCEs, thereby
partially addressing the comment's concerns. Therefore, the final
regulations do not adopt this comment.
D. Commercial Activities of Partnerships
The 1988 temporary regulations generally attribute all commercial
activities of a partnership to its general and limited partners except
for partners of publicly traded partnerships (PTP). See Sec. 1.892-
5T(d)(3). Proposed Sec. 1.892-5(d)(5)(i) of the 2011 proposed
regulations generally would attribute commercial activities of an
entity classified as a partnership for Federal tax purposes to its
partners, subject to two exceptions, for trading activity and for
limited partnership interests. See proposed Sec. 1.892-5(d)(5)(ii) and
(iii). The preamble to the 2011 proposed regulations explained that the
limited partnership interest exception under proposed Sec. 1.892-
5(d)(5)(iii) ``modifies the existing exception to the partnership
attribution rule for PTP interests by providing a more general
exception for limited partnership interests.'' Comments noted that it
may be necessary to amend Sec. 1.892-5T(d)(3) and (4) to coordinate
with the final regulations to the extent they preserve proposed Sec.
1.892-5(d)(5). The final regulations withdraw Sec. 1.892-5T(d)(3) and,
in its place, adopt proposed Sec. 1.892-5(d)(5)(i) with minor
modifications. In addition, the final regulations modify Sec. 1.892-
5T(d)(4) by removing Example 4, which is obsoleted by the final
regulations.
The trading activity exception under proposed Sec. 1.892-
5(d)(5)(ii) would provide 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 (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 proposed 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,
[[Page 57911]]
effects such transactions for the account of the partnership. This
exception does 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). The final regulations adopt proposed Sec. 1.892-
5(d)(5)(ii) with minor modifications.
A comment recommended that transitory ownership of a pass-through
entity not result in attribution of commercial activity from that pass-
through entity. The final regulations do not adopt this comment because
of administrability challenges as to whether a transfer was transitory.
No other comments were received with respect to the attribution of
commercial activities by a partnership under proposed Sec. 1.892-
5(d)(5)(i) or the trading activity exception under proposed Sec.
1.892-5(d)(5)(ii). Instead, comments made recommendations about the
treatment under section 892 of income derived from partnerships or gain
arising from the disposition of a partnership interest.
The 2011 proposed regulations would not alter the treatment of the
income derived by an entity. For example, proposed Sec. 1.892-
5(d)(5)(iii)(A) would provide that, despite an entity that holds an
interest as a limited partner in a limited partnership not being
treated as conducting commercial activities, that entity's distributive
share of partnership income will not be exempt from taxation under
section 892 to the extent that the partnership derives such income from
the conduct of commercial activity. With the exception of Sec. 1.892-
3(a)(4) (regarding the definition of financial instruments), the final
regulations do not address the items of income that are exempt under
section 892. Accordingly, recommendations about the treatment under
section 892 of income derived from partnerships or gain arising from
the disposition of a partnership interest are outside the scope of the
final regulations and are not adopted.
E. Qualified Partnership Interest Exception
The 2011 proposed regulations would provide for a limited
partnership interest exception in which an entity that is not otherwise
engaged in commercial activities (including, for example, performing
services for a partnership as 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. Proposed Sec. 1.892-5(d)(5)(iii)(A). The 2011 proposed
regulations also would provide that 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 commercial activity.
For this purpose, an interest in an entity classified as a
partnership for Federal tax purposes would be treated as an interest as
a limited partner in a limited partnership if the holder 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. See proposed Sec. 1.892-
5(d)(5)(iii)(B). The 2011 proposed regulations would provide that
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. Id.
1. Tax Classification as a Partnership
Comments recommended that the final regulations confirm that Sec.
1.892-5(d)(5)(iii) does not apply solely to limited partnerships under
State or local law. To this end, the comments recommended replacing the
phrase ``interest as a limited partner in a limited partnership'' with
``a passive investment in a partnership or other flow-through entity''
or expressly providing that interests as a limited partner in limited
liability companies and other vehicles not taking the form of State law
partnerships can qualify under Sec. 1.892-5(d)(5)(iii).
The Treasury Department and the IRS are of the view that the 2011
proposed regulations already would provide that a qualifying
partnership interest can include certain interests other than interests
in a State law limited partnership. By providing that ``an interest in
an entity classified as a partnership for Federal tax purposes is
treated as an interest as a limited partner in a limited partnership,''
the 2011 proposed regulations were not confining the scope of the
exception to State law partnerships. Thus, for example, an interest in
a limited liability company that is classified as a partnership for
Federal tax purposes may qualify under proposed Sec. 1.892-
5(d)(5)(iii) if the other requirements are satisfied. To make this
clearer, the final regulations adopt the term ``qualified partnership
interest'' rather than ``interest as a limited partner in a limited
partnership.'' No inference is intended by this change as to the
meaning of the phrase ``limited partner'' in other Code sections or
Treasury regulations.
Because the qualified partnership interest exception applies to
more than only State law partnerships, the Treasury Department and the
IRS determined that the qualified partnership interest exception should
set forth uniform requirements applicable to all relevant juridical
forms to which the qualified partnership interest exception may apply.
Accordingly, the final regulations contain requirements that a holder
of a qualified partnership interest must not (1) have personal
liability for claims against the partnership; or (2) have the right to
enter into contracts or act on behalf of the partnership. These
requirements are generally consistent with the rights of a limited
partner under relevant State law, but apply regardless of the legal
form of the entity or the governing law.
Further, the Treasury Department and the IRS agree with the comment
that the qualified partnership interest exception should be available
only for passive investments in partnerships. To that end, in addition
to the two requirements provided in the previous paragraph, the
qualified partnership interest exception retains the requirement that
the holder of the partnership interest must not have rights to
participate in the management and conduct of the partnership's business
and adopts a requirement that the holder must not control the
partnership within the meaning of Sec. 1.892-5(a)(1). The Treasury
Department and the IRS have determined that these four requirements are
necessary and appropriate guardrails to help ensure that the qualified
partnership interest exception is available only to partnership equity
interest holders with passive participation in the partnership.
Accordingly, the final regulations do not adopt a separate comment
suggesting that a greater than 50 percent economic interest (which
would constitute a controlling interest in an entity under Sec. 1.892-
5(a)(1)(iii)(A)) in a partnership could be a qualified partnership
interest.
[[Page 57912]]
2. Rights To Participate in the Management and Conduct of a
Partnership's Business
With respect to the requirement under the qualified partnership
interest exception that the holder does not have rights to participate
in the management and conduct of the partnership's business, comments
recommended that the final regulations provide greater specificity on
exactly which rights satisfy the definition. For example, a comment
recommended that the final regulations adopt a standard under which
general oversight rights, consultation rights, and veto rights are
treated as consistent with holding an interest as a limited partner
under proposed Sec. 1.892-5(d)(5)(iii)(B) because these rights serve
the purpose of allowing the investor to monitor and protect its
investment and do not convey control over the partnership's day-to-day
operations. Another comment recommended that the final regulations
provide that consent rights customarily granted to a significant
lender, such as approval of a borrowing entity's annual budget, major
transactions and expenses, and other similar items be permitted under
Sec. 1.892-5(d)(5)(iii)(B). Other comments recommended that the final
regulations provide that investor rights typically granted by side
letters, including certain veto rights and consent rights with respect
to key decisions and extraordinary events outside of a partnership's
day-to-day management, are consistent with holding an interest as a
limited partner. Comments also recommended that the final regulations
provide that holding an interest as a limited partner can include
participating on a partnership's investment advisory committee or
holding a minority position on a partnership's governing committee
because these roles are consistent with being a passive investor by
providing investors with consent rights normally afforded to minority
investors for the purpose of monitoring and protecting their
investments.
These comments generally suggested that participation in the
management and conduct of a partnership's business refers to
participation in the day-to-day management or operation of the
partnership's business and does not include participation in activities
relating to monitoring and protecting the partnership interest holder's
capital investment. The Treasury Department and the IRS agree, and the
final regulations clarify that rights to participate in the management
and conduct of a partnership's business mean rights to participate in
the day-to-day management or operation of the partnership's business.
The final regulations also provide that rights to participate in
monitoring or protecting the partnership interest holder's capital
investment in the partnership do not constitute rights to participate
in the management and conduct of the partnership's business, to the
extent such rights are not rights to participate in the day-to-day
management or operation of the partnership's business and do not result
in effective control under Sec. 1.892-5(a)(1)(iii)(B).
Due to the highly fact-intensive nature of determining whether
rights to participate in the management and conduct of a partnership's
business exist, the final regulations do not provide an exclusive list
of rights that would (or would not) be consistent with participating in
the management and conduct of a partnership's business. Instead, the
Treasury Department and the IRS have determined that this analysis
should be based on a holistic review taking into account all the facts
and circumstances. The final regulations do specify, however, that
participation in the management and conduct of a partnership's business
includes the right to participate in ordinary-course personnel and
compensation decisions, and the right to take active roles in
formulating the business strategy for the partnership. The final
regulations also specify that rights to monitor or protect capital
investment in the partnership may include oversight or supervisory
rights in the case of major strategic decisions, such as admission or
expulsion of a partner, amendment of the partnership agreement, or
dissolution of the partnership, unusual and non-ordinary course
deviations from previously determined investment parameters, extending
the term of the partnership's governing agreement, merger or conversion
of the partnership, or disposition of all or substantially all of the
partnership's property outside of the ordinary course of the
partnership's activities. Facts and circumstances pertaining to the
analysis of participation in the management and conduct of a
partnership's business may be identified by reference to, for example,
the conduct of the relevant parties, the law of the jurisdiction in
which the partnership is organized, the governing documents of the
partnership, contractual agreements such as side letters, shareholders'
agreements, and the partnership's agreements with creditors. See Sec.
1.892-5(d)(5)(iii)(B).
Comments also recommended that the final regulations eliminate the
rule that the law of the jurisdiction in which a partnership is
organized determines whether a partner has rights to participate in the
management and conduct of the partnership's business. These comments
asserted that making this determination under this standard would be
complex and burdensome. These comments, therefore, also recommended
that an investor be permitted to rely on the advice of local counsel
when determining whether the investor has rights exceeding those
permitted under proposed Sec. 1.892-5(d)(5)(iii)(B).
The final regulations do not adopt these comments because the
Treasury Department and the IRS have determined that the relevant law
of the jurisdiction in which the partnership is organized often sets
forth certain default rights where rights are not expressly provided by
the entity's governing documents, and that those default rights are
relevant to a facts and circumstances analysis.
No inference is intended as to the meaning of the phrase
``participate in the management and conduct of the partnership's
business'' or similar phrases and standards in other Code sections and
Treasury regulations.
3. Qualified Partnership Interest Safe Harbors
A comment recommended that the final regulations provide certainty
to investors by incorporating one or more of three proposed safe
harbors for determining whether the investor holds an interest as a
limited partner in a limited partnership. The first safe harbor would
be available to investors who have obtained legal opinions stating that
the investors are, in fact, and, at law, limited partners with limited
liability. The second safe harbor recommended by the comment would
cover interests in widely held investment partnerships with more than
ten unrelated partners. The third recommended safe harbor would cover
investors who hold less than a prescribed percentage of interests in a
partnership. The comment recommended taking into account all investors
both in the main investment vehicle and any related parallel or
alternative investment vehicles for purposes of determining whether an
investor qualifies for the widely held or the de minimis safe harbors.
The final regulations adopt a safe harbor for a holder who at all
times during the partnership's taxable year (1) has no personal
liability for claims against the partnership; (2) has no right to enter
into contracts or act on behalf of the partnership; (3) is not a
managing member or managing partner, and does
[[Page 57913]]
not hold an equivalent role under applicable law; and (4) does not
directly or indirectly (under the principles of Sec. 1.892-
5(d)(5)(iii)(B)(2)(iii)) own more than five percent of either the
partnership's capital interests or the partnership's profits interests.
See Sec. 1.892-5(d)(5)(iii)(C). The Treasury Department and the IRS
have determined that this safe harbor would ease the compliance burden
for those investors who fall within its scope. The first two
requirements typically would be met by a holder treated as a limited
partner under State law. As to the last two requirements, an investor
with no more than five percent of a partnership's capital or profits
interests and who is neither a managing member (in the case of an
entity organized as a limited liability company) nor a managing partner
(in the case of an entity organized as a partnership) is unlikely to
control the partnership under Sec. 1.892-5(a)(1) or have any rights to
participate in the management and conduct of a partnership's business
and thus can be treated as a passive investor. Although a foreign
government investor, for example, that satisfies the requirements of
the safe harbor is not attributed the partnership's commercial
activities, the investor's distributive share of the partnership's
income from the conduct of commercial activity is not exempt from
taxation under section 892. See Sec. 1.892-5(d)(5)(iii)(A).
4. Holding Multiple Interests in a Partnership or in Tiered
Partnerships
Finally, comments made requests and recommendations regarding tiers
of partnerships and attribution of the qualified partnership interest
exception among classes of partnership interests. Comments recommended
that the final regulations provide rules for the operation of the
qualified partnership interest exception in tiered partnership
structures. These comments asserted that an investor should not be
deemed to participate in the management and conduct of a lower-tier
partnership's business if that investor holds an interest in an upper-
tier partnership that does not engage in any commercial activity and
does not afford the investor any rights to participate in the
management and conduct of the lower-tier partnership's business. In
other words, these comments requested that the final regulations apply
a ``bottom-up'' approach in determining whether the requirements for
the qualified partnership interest exception are met.
Another comment requested that the final regulations provide
guidance on whether the rights of one class of partnership interest
could be attributed to another class of partnership interest when
determining whether an investor, who holds multiple classes of
partnership interests, satisfies the exception under proposed Sec.
1.892-5(d)(5)(iii). The comment asserted that the qualified partnership
interest exception should apply in situations where an investor, in
addition to holding its interest as a limited partner in a limited
partnership, also holds an interest as a limited partner in the general
partner of the same limited partnership.
The final regulations adopt with modifications the comment that the
qualified partnership interest exception applies from the bottom up. An
upper-tier partnership that holds a qualified partnership interest in a
lower-tier partnership is not attributed the lower-tier partnership's
commercial activities. If, however, the upper-tier partnership's
interest in a lower-tier partnership is not a qualified partnership
interest, the lower-tier partnership's commercial activity will be
attributed to the upper-tier partnership and could, in turn, be further
attributed to a foreign government investor holding an interest in the
upper-tier partnership unless the investor holds a qualified
partnership interest in the upper-tier partnership. See Sec. 1.892-
5(d)(5)(iii)(D).
The rules in Sec. 1.892-5(d)(5)(iii)(D) applicable to tiered
partnerships may provide relief in certain circumstances if, in
addition to holding directly a qualified partnership interest in a
lower-tier partnership, the foreign government investor holds a
qualified partnership interest in the entity that is a general partner
of the lower-tier partnership and does not have rights to participate
in the management and conduct of the general partner's business in
managing the lower-tier partnership.
With respect to holding multiple classes of interests in the same
partnership, the final regulations provide that all interests held in a
partnership by an investor are evaluated in their totality to determine
whether the investor has rights to participate in the management and
conduct of that partnership's business. See Sec. 1.892-
5(d)(5)(iii)(B)(2)(i). Thus, the final regulations do not adopt the
approach that the qualified partnership interest exception ignores
other interests held by an investor in the same partnership.
The final regulations also provide that where a foreign sovereign
holds directly or indirectly multiple interests in a partnership
through one or more integral parts or controlled entities as defined in
Sec. 1.892-2T, or controlled subsidiaries under Sec. 1.892-5(a)(1),
all of these entities' interests in the partnership are aggregated for
purposes of the qualified partnership interest exception. To the extent
any one entity's interest or all of the interests aggregated together
fails to satisfy the qualified partnership interest exception, then
none of the entities would qualify for the qualified partnership
interest exception. See Sec. 1.892-5(d)(5)(iii)(B)(2)(iii).
F. Other Comments and Revisions
In addition to the comments and revisions described in parts II and
III of this Summary of Comments and Explanation of Revisions, the final
regulations include several drafting changes. The final regulations
revise the structure of the provisions of the 2011 proposed regulations
to be consistent with the structure of the 1988 temporary regulations.
In doing so, the final regulations change the placement of rules under
Sec. 1.892-4(c).
There were numerous comments that were outside the scope of the
final regulations and, therefore, are not adopted by the final
regulations. Several comments recommended that Sec. 301.7701-2(b)(6)
(treating a business entity wholly owned by a foreign government as a
per se corporation) be modified so that a business entity that is
wholly owned by a foreign government is not precluded from electing to
be disregarded as an entity separate from its owner. Another comment
requested guidance on whether incentive compensation arrangements for
investment advisors, brokers, or employees would cause an entity to
fail the requirement under Sec. 1.892-2T(a)(3)(iii) (requiring that
net earnings of the entity be credited to its own account or to other
accounts of the foreign sovereign, with no portion of the entity's
income inuring to the benefit of any private person) to be a controlled
entity. The comment also requested guidance on whether an entity
established under a statute with a separate legal personality can be an
``integral part'' of a foreign sovereign under Sec. 1.892-2T(a).
Finally, a comment recommended modifying Sec. 1.882-5(a)(6) to remove
the limitation on a foreign government's ability to deduct its
allocable interest expense. The final regulations do not adopt these
comments because they are outside the scope of the final regulations.
However, the final regulations modify Sec. 1.882-5(a)(6) to update the
cross-reference to Sec. 1.892-5.
IV. Applicability Dates
The 2011 proposed regulations were proposed to apply on the date
the final regulations are published in the Federal
[[Page 57914]]
Register. See proposed Sec. Sec. 1.892-4(f) and 1.892-5(e). The
preamble to the 2011 proposed regulations provided that taxpayers may
rely on the 2011 proposed regulations until final regulations are
issued. The 2022 proposed regulations were proposed to apply to taxable
years ending on or after December 28, 2022. See proposed Sec. 1.892-
5(b)(1)(iii). The preamble to the 2022 proposed regulations provided
that taxpayers may rely on the 2022 proposed regulations until the date
of publication of the final regulations in the Federal Register. The
rules under Sec. Sec. 1.892-4T and 1.892-5T are effective for taxable
years beginning after June 30, 1986, until, and only to the extent
that, they are replaced by these final regulations.
The Treasury Department and the IRS have determined that the
applicability date of the 2025 final regulations should be consistent
with the 2011 proposed regulations and generally apply to taxable years
beginning on or after the date the regulations become finalized in the
Federal Register. A comment recommended that when the 2011 proposed
regulations are finalized, taxpayers be permitted to apply the
provisions of the final regulations to all open taxable years. The
Treasury Department and the IRS agree that taxpayers should be
permitted to apply the rules of the 2025 final regulations, once
finalized, to their open taxable years subject to consistency
requirements. Accordingly, except in the case of Sec. 1.892-3(a)(6)
and the second sentence of Sec. 1.892-5(a)(1) (rules finalized in
prior regulations), the final regulations provide that a taxpayer may
choose to apply the 2025 final regulations to a taxable year beginning
before December 15, 2025 (finalization date) if the period of
limitations on assessment of the taxable year is open under section
6501 and the taxpayer and entities that are related (within the meaning
of section 267(b) or section 707(b)) to the taxpayer consistently apply
the rules of 2025 final regulations in their entirety to the taxable
year and all succeeding taxable years beginning before the finalization
date.
Another comment recommended that taxpayers who have structured
investments in reliance on the 2011 proposed regulations be given a
transition period to undertake any necessary restructuring if the final
regulations are different from the 2011 proposed regulations. The final
regulations do not adopt this comment. The Treasury Department and the
IRS have determined that the provisions of the final regulations are
consistent with the 2011 proposed regulations and the differences do
not require a transition period. A separate notice of proposed
rulemaking is published in this issue of the Federal Register which
contains proposed changes and modifications that are materially
different from the 2011 proposed regulations.
Special Analyses
I. Regulatory Planning and Review--Economic Analysis
These final regulations are not subject to review under section
6(b) of Executive Order 12866 pursuant to the Memorandum of Agreement
(July 4, 2025) between the Treasury Department and the Office of
Management and Budget (OMB) regarding review of tax regulations.
II. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (44 U.S.C. 3501-3520) (PRA)
generally requires that a Federal agency obtain the approval of the OMB
before collecting information from the public, whether such collection
of information is mandatory, voluntary, or required to obtain or retain
a benefit. An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless the
collection of information displays a valid control number.
The collection of information in these final regulations contains
recordkeeping requirements. The recordkeeping requirements are
necessary for the IRS to validate if certain entities have met the
regulatory requirements and are entitled to the inadvertent commercial
activity exception under section 892. No public comments received by
the IRS were directed at the recordkeeping requirements. The
recordkeeping requirements in Sec. 1.892-5(a)(2)(ii)(B) and Sec.
1.892-5(a)(2)(iv) are approved by OMB under Control Number 1545-2239.
III. Regulatory Flexibility Act
Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it
is hereby certified that this rulemaking will not have a significant
economic impact on a substantial number of small entities within the
meaning of section 601(6) of the Regulatory Flexibility Act. This
certification is based on the fact that the final regulations affect
foreign governments, including their controlled entities, with income
from sources within the United States. Accordingly, the entities
affected by the final regulations are not considered small entities,
and a regulatory flexibility analysis under the Regulatory Flexibility
Act is not required.
IV. Section 7805(f)
Pursuant to section 7805(f) of the Code, the notice of proposed
rulemaking that preceded these final regulations was submitted to the
Chief Counsel for the Office of Advocacy of the Small Business
Administration for comment on its impact on small business. No comments
on that notice of proposed rulemaking were received from the Chief
Counsel for the Office of Advocacy of the Small Business
Administration.
V. Unfunded Mandates Reform Act
Section 202 of the Unfunded Mandates Reform Act of 1995 requires
that agencies assess anticipated costs and benefits and take certain
other actions before issuing a final rule that includes any Federal
mandate that may result in expenditures in any one year by a State,
local, or Tribal government, in the aggregate, or by the private
sector, of $100 million in 1995 dollars, updated annually for
inflation. These final regulations do not include any Federal mandate
that may result in expenditures by State, local, or Tribal governments,
or by the private sector in excess of that threshold.
VI. Executive Order 13132: Federalism
Executive Order 13132 (entitled ``Federalism'') prohibits an agency
from publishing any rule that has federalism implications if the rule
either imposes substantial, direct compliance costs on State and local
governments, and is not required by statute, or preempts State law,
unless the agency meets the consultation and funding requirements of
section 6 of the Executive order. These final regulations do not have
federalism implications and do not impose substantial direct compliance
costs on State and local governments or preempt State law within the
meaning of the Executive order.
Statement of Availability of IRS Documents
IRS guidance cited in this preamble is published in the Internal
Revenue Bulletin and is available from the Superintendent of Documents,
U.S. Government Publishing Office, Washington, DC 20402, or by visiting
the IRS website at https://www.irs.gov.
Drafting Information
The principal authors of the final regulations are Jack Zhou of the
Office of Associate Chief Counsel (International), and Joel Deuth,
formerly of the Office of Associate Chief Counsel (International).
However, other personnel from the Treasury
[[Page 57915]]
Department and the IRS participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, the Treasury Department and the IRS amend 26 CFR part
1 as follows:
PART 1--INCOME TAXES
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Paragraph 1. The authority citation for part 1 is amended by adding
entries for Sec. Sec. 1.892-3 and 1.892-4 in numerical order to read
in part as follows:
Authority : 26 U.S.C. 7805 * * *
* * * * *
Section 1.892-3 also issued under 26 U.S.C. 892(c).
* * * * *
Section 1.892-4 also issued under 26 U.S.C. 892(c).
* * * * *
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Par. 2. Section 1.882-5 is amended by revising paragraph (a)(6) to read
as follows:
Sec. 1.882-5 Determination of interest deduction.
(a) * * *
(6) Special rule for foreign governments. The amount of interest
expense of a foreign government, as defined in Sec. 1.892-2T(a), that
is allocable to ECI is the total amount of interest paid or accrued
within the taxable year by the United States trade or business on U.S.
booked liabilities (as defined in paragraph (d)(2) of this section).
Interest expense of a foreign government, however, is not allocable to
ECI to the extent that it is incurred with respect to U.S. booked
liabilities that exceed 80 percent of the total value of U.S. assets
for the taxable year (determined under paragraph (b) of this section).
This paragraph (a)(6) does not apply to controlled commercial entities
within the meaning of Sec. 1.892-5.
* * * * *
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Par. 3. Section 1.892-3 is revised to read as follows:
Sec. 1.892-3 Income of foreign governments.
(a) Types of income exempt--(1) In general. For further guidance,
see Sec. 1.892-3T(a)(1).
(2) Income from investments. For further guidance, see Sec. 1.892-
3T(a)(2).
(3) Securities. For further guidance, see Sec. 1.892-3T(a)(3).
(4) Financial instrument--(i) Definition. For purposes of this
paragraph (a), the term financial instrument includes:
(A) Any interest rate, currency, equity, or commodity (as the term
is used in section 864(b)(2)(B) and Sec. 1.864-2(d)) notional
principal contract (as the term is used in section 475(c)(2)); or
(B) Any evidence of an interest in options, forward or futures
contracts, and any other similar contracts, the value of which, or any
payment or other transfer with respect to which, is (directly or
indirectly) determined by reference to one or more of the following:
(1) Commodity (as the term is used in section 864(b)(2)(B) and
Sec. 1.864-2(d));
(2) Currency;
(3) Share of stock;
(4) Partnership or beneficial ownership interest in a widely held
or publicly traded partnership or trust;
(5) Note, bond, debenture, or other evidence of indebtedness; or
(6) Notional principal contract described in paragraph (a)(4)(i)(A)
of this section.
(ii) Special rule. For purposes of paragraph (a)(4)(i) of this
section, nonfunctional currency or gold is a financial instrument when
physically held by a foreign central bank of issue (as defined in Sec.
1.895-1(b)).
(5) Execution of financial or monetary policy. For further
guidance, see Sec. 1.892-3T(a)(5).
(6) Dividend equivalents. Income from investments in stocks
includes the payment of a dividend equivalent described in section
871(m) and the regulations in this part under section 871(m).
(b) Illustrations. For further guidance, see Sec. 1.892-3T(b).
(c) Applicability dates. (1) Paragraph (a)(4) of this section
applies to taxable years beginning on or after December 15, 2025. See
Sec. 1.892-3T(a)(4), as contained in 26 CFR in part 1 in effect on
April 1, 2025, for the rules that apply to taxable years beginning
before December 15, 2025. A taxpayer may choose to apply paragraph
(a)(4) of this section to a taxable year beginning before December 15,
2025, if the period of limitations on assessment of the taxable year is
open under section 6501 and the taxpayer and entities that are related
(within the meaning of section 267(b) or section 707(b)) to the
taxpayer apply this rule and Sec. Sec. 1.892-4 and 1.892-5 in their
entirety to the taxable year and all succeeding taxable years beginning
before December 15, 2025.
(2) Paragraph (a)(6) of this section applies to payments made on or
after December 5, 2013.
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Par. 4. Section 1.892-3T is amended by revising paragraph (a)(4) to
read as follows:
Sec. 1.892-3T Income of foreign governments (temporary regulations).
(a) * * *
(4) Financial instrument. For further guidance, see Sec. 1.892-
3(a)(4).
* * * * *
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Par. 5. Section 1.892-4 is added to read as follows:
Sec. 1.892-4 Commercial activities.
(a) Purpose. The exemption generally applicable to a foreign
government (as defined in Sec. 1.892-2T) for income described in
Sec. Sec. 1.892-3T and 1.892-3 does not apply to income derived from
the conduct of commercial activity (whether within or outside the
United States), income received by a controlled commercial entity or
received (directly or indirectly) from a controlled commercial entity,
or income derived from the disposition of any interest in a controlled
commercial entity. This section provides rules for determining whether
income is derived from the conduct of commercial activity. The rules in
this section also apply in determining under Sec. Sec. 1.892-5T and
1.892-5 whether an entity is a controlled commercial entity.
(b) In general. Except as provided in paragraph (c) of this
section, all activities (whether conducted within or outside the United
States) that 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. For purposes of this paragraph (b), activities that
constitute a trade or business for purposes of section 162 or
constitute (or would constitute if undertaken in the United States) a
trade or business in the United States for purposes of section 864(b)
are commercial activities except as otherwise provided in paragraph (c)
of this section.
(c) Activities that are not commercial--(1) Investments--(i) In
general. Subject to the provisions of this paragraph (c), 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. 1.892-3(a)(4)); the holding
of partnership equity interests; 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 deposits in any currency in banks.
Transferring securities under a loan agreement which meets the
requirements of section 1058 is an
[[Page 57916]]
investment for purposes of this paragraph (c)(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) [Reserved]
(iii) Banking, financing, etc. For further guidance, see Sec.
1.892-4T(c)(1)(iii).
(2) Trading. Effecting transactions in stocks, bonds, other
securities (as defined in Sec. 1.892-3T(a)(3)), partnership equity
interests, commodities, or financial instruments (as defined in Sec.
1.892-3(a)(4)) for a foreign government's own account does not
constitute commercial activity. 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 (c)(2), 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.
(3) 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 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.
(4) Cultural events. For further guidance, see Sec. 1.892-
4T(c)(2).
(5) Non-profit activities. For further guidance, see Sec. 1.892-
4T(c)(3).
(6) Governmental functions. For further guidance, see Sec. 1.892-
4T(c)(4).
(7) Purchasing. For further guidance, see Sec. 1.892-4T(c)(5).
(d) Applicability date. Except as otherwise provided in this
paragraph (d), this section applies to taxable years beginning on or
after December 15, 2025. See Sec. 1.892-4T, as contained in 26 CFR in
part 1 in effect on April 1, 2025, for the rules that apply to taxable
years beginning before December 15, 2025. A taxpayer may choose to
apply this section to a taxable year beginning before December 15,
2025, if the period of limitations on assessment of the taxable year is
open under section 6501 and the taxpayer and entities that are related
(within the meaning of section 267(b) or section 707(b)) to the
taxpayer apply this section and Sec. Sec. 1.892-3(a)(4) and 1.892-5 in
their entirety to the taxable year and all succeeding taxable years
beginning before December 15, 2025.
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Par. 6. Section 1.892-4T is amended by revising paragraphs (a), (b),
and (c)(1)(i) and (ii) to read as follows:
Sec. 1.892-4T Commercial activities (temporary regulations).
(a) Purpose. For further guidance, see Sec. 1.892-4(a).
(b) In general. For further guidance, see Sec. 1.892-4(b).
(c) * * *
(1) * * *
(i) In general. For further guidance, see Sec. 1.892-4(c)(1)(i).
(ii) Trading. For further guidance, see Sec. 1.892-4(c)(2).
* * * * *
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Par. 7. 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 the term
controlled commercial entity. (i) Under section 892(a)(2)(A)(ii) and
(iii), the exemption generally applicable to a foreign government (as
defined in Sec. 1.892-2T) for income described in Sec. Sec. 1.892-3T
and 1.892-3 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.
(ii) For purposes of section 892(a)(2)(B) and this section, the
term entity includes a corporation, a partnership, a trust (including a
pension trust described in Sec. 1.892-2T(c)), and an estate.
(iii) 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 Sec. Sec. 1.892-4T and
1.892-4) (whether conducted within or outside the United States) if the
foreign government--
(A) 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
(B) Holds (directly or indirectly) any other interest in such
entity which provides the foreign government with effective control of
such entity.
(2) Inadvertent commercial activity--(i) General rule. For purposes
of section 892(a)(2)(B) and paragraph (a)(1) of this section, a tested
entity that conducts, including by attribution, only inadvertent
commercial activity will not be considered to be engaged in commercial
activities. However, any income derived from any foreign government's
inadvertent commercial activity (including activity attributed from a
partnership) will not qualify for exemption from tax under section 892.
Commercial activity of a tested 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 timely 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 a tested entity's failure to prevent its worldwide activities
from resulting in commercial activity is reasonable will be determined
based on all the facts and circumstances. Due regard will be given to
the number of commercial activities conducted during the taxable year
and the activities in the immediately preceding taxable year to the
extent relevant in characterizing the activities in the current taxable
year, as well as the amount of income earned from, and assets used in,
the conduct of the commercial activities in relationship to the tested
entity's total income and assets. For purposes of this paragraph
(a)(2)(ii)(A) and paragraph (a)(2)(ii)(C) of this section, where
commercial activity conducted by a partnership is attributed under
paragraph (d)(5)(i) of this section to a tested 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 tested entity's interest in
the partnership; and
(2) The tested entity's distributive share of the partnership's
income from the conduct of the commercial activity is treated as income
earned by the tested 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
[[Page 57917]]
tested entity from engaging in commercial activities within or outside
the United States as evidenced by having adequate written policies and
operational procedures, within the meaning of this paragraph
(a)(2)(ii)(B), in place to monitor the tested entity's worldwide
activities. A failure to avoid commercial activity will not be
considered reasonable if responsible employees have not undertaken
reasonable efforts, based on all facts and circumstances, to establish,
follow, and enforce such written policies and operational procedures
with respect to the tested entity. For purposes of this paragraph
(a)(2)(ii)(B), all facts and circumstances are considered in the
determination of whether written policies and operational procedures
are considered adequate, including whether the written policies and
operational procedures:
(1) Prohibit the tested entity from engaging in commercial
activities both directly and through investments in entities whose
commercial activities would be attributed to the tested entity within
the meaning of this section;
(2) Are communicated in writing to all persons who exercise
discretionary authority, acting alone or as part of a decisional body,
to cause the tested entity to undertake an investment;
(3) Require an advance determination, by receipt of an opinion of
counsel or otherwise, as to whether an investment is commercial
activity;
(4) Include an annual internal or external audit or review of
direct investments and investments in entities whose commercial
activities would be attributed to the tested entity within the meaning
of this section; and
(5) Require the result of periodic tests to be reviewed and
certified by responsible employees who have authority and obligation to
cause the curing of any commercial activity disclosed in such
procedures.
(C) Safe Harbor--(1) In general. Provided that adequate written
policies and operational procedures are in place to monitor the tested
entity's worldwide activities as required in paragraph (a)(2)(ii)(B) of
this section, the tested entity's failure to avoid commercial activity
during the taxable year will be considered reasonable if:
(i) 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 tested entity's balance sheet for the
taxable year, determined using the average of the value of the assets
as of the close of each quarter of the taxable year, as prepared for an
applicable financial statement as defined in section 451(b)(3) and
Sec. 1.451-3(a), or, if the tested entity is not required to prepare a
balance sheet for an applicable financial statement, as reflected in
the books of account or records that are adequate and sufficient to
establish the amount; and
(ii) The income earned by the tested entity from commercial
activity does not exceed five percent of the tested entity's gross
income as reflected on its income statement for the taxable year, as
prepared for an applicable financial statement as defined in section
451(b)(3) and Sec. 1.451-3(a), or, if the tested entity is not
required to prepare an income statement for an applicable financial
statement, as reflected in the books of account or records that are
adequate and sufficient to establish the amount.
(2) Calculation of total assets and income. For purposes of
paragraph (a)(2)(ii)(C)(1) of this section, the amount of total assets
includes the value of the tested entity's qualified partnership
interests under paragraph (d)(5)(iii) of this section, and the amount
of total gross income includes the tested entity's distributive share
of income, including income derived from commercial activity, from
partnerships in which the tested entity holds a qualified partnership
interest under paragraph (d)(5)(iii) of this section.
(iii) Cure requirement. A timely cure is considered to have been
made if the tested entity discontinues the conduct of the commercial
activity within 180 days of the date of discovery of the commercial
activity by responsible employees who are responsible for monitoring
and reviewing the tested entity's commercial activity pursuant to
paragraph (a)(2)(ii)(B) of this section. For example, if a responsible
employee discovers that the partnership in which the tested entity
holds an interest as a partner is conducting commercial activity, the
entity will satisfy the cure requirement if, within 180 days of that
person discovering the commercial activity, the tested 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. The tested entity may, depending on
the facts and circumstances, be able to satisfy the cure requirement
if, within 180 days of a responsible employee discovering the
commercial activity, the tested entity exchanges its interest in the
partnership for one that is a qualified partnership interest, within
the meaning of paragraph (d)(5)(iii) of this section, of the same
partnership (including a deemed exchange from an agreed modification of
terms).
(iv) Record maintenance. Adequate records of each discovered
commercial activity and the remedial action taken to cure that activity
must be maintained. The records must be retained so long as the
contents thereof may become material in the administration of section
892.
(v) Definitions. The following definitions apply for purposes of
this paragraph (a)(2).
(A) Tested entity. A tested entity means an entity that is engaged,
including by attribution under paragraph (d)(5)(i) of this section, in
commercial activity without regard to paragraph (a)(2)(i) of this
section.
(B) Responsible employees. Responsible employees may include
employees of a tested entity or employees of an entity that controls
(within the meaning of paragraph (a)(1) of this section) the tested
entity.
(C) Reasonable efforts. The term reasonable efforts means
exercising ordinary business care and prudence.
(3) Annual determination of controlled commercial entity status--
(i) In general. If an entity described in paragraph (a)(1) of this
section engages in commercial activities at any time during its taxable
year, the entity will be considered a controlled commercial entity for
its entire taxable year. An entity that is not engaged in commercial
activities during its taxable year will not be considered a controlled
commercial entity for its taxable year. For purposes of determining
whether an entity is engaged in commercial activities during its
taxable year, that entity's activities during its immediately preceding
taxable year will also be taken into account to the extent relevant in
characterizing the activities in the current taxable year.
(ii) Certain corporate acquisitions--(A) In general. For purposes
of paragraph (a)(3)(i) of this section, if the assets of a corporation
that is engaged in commercial activity in a taxable year are acquired
by another corporation in an acquisition described in section 381(a),
then, except as provided in paragraph (a)(3)(ii)(B) of this section,
the acquiring corporation will not be treated as conducting commercial
activity for the taxable year in which the acquisition occurs solely by
reason of acquiring and holding the distributor or transferor
corporation's assets, provided that the taxable year of the distributor
or transferor corporation ends under section 381(b), and after the
acquisition, the acquiring corporation is not the entity that directly
continues the distributor or transferor corporation's
[[Page 57918]]
commercial activity. If the taxable year of the distributor or
transferor corporation does not end as a result of such acquisition,
the acquiring corporation will be treated as conducting commercial
activity for the taxable year in which the acquisition occurs.
(B) Exception. If the acquisition described in paragraph
(a)(3)(ii)(A) of this section to which section 381(a) applies is
between corporations that are controlled by the same foreign sovereign
within the meaning of paragraph (a)(1) of this section, the acquiring
corporation will be treated as conducting commercial activity for the
taxable year of the acquiring corporation in which such acquisition
occurs regardless of whether the taxable year of the distributor or
transferor corporation ends as described in section 381(b) or whether
the acquiring corporation directly continues the distributor or
transferor corporation's commercial activity.
(b) Entities treated as engaged in commercial activity--(1) United
States real property holding corporations--(i) General rule. Except as
provided in paragraph (b)(1)(ii) of this section, a corporation that is
a United States real property holding corporation as defined in section
897(c)(2), is treated as engaged in commercial activity and, therefore,
is a controlled commercial entity if the requirements of paragraph
(a)(1)(iii)(A) or (B) of this section are satisfied.
(ii) Exceptions. Paragraph (b)(1)(i) of this section does not apply
to the following--
(A) Corporations that are foreign; or
(B) A corporation that is a United States real property holding
corporation, as defined in section 897(c)(2), solely by reason of its
direct or indirect ownership interest in one or more other corporations
that are not controlled by the foreign government (as determined under
paragraph (a)(1) of this section). For this purpose, the phrase solely
by reason of its direct or indirect ownership interest in one or more
other corporations that are not controlled by the foreign government
(as determined under paragraph (a)(1) of this section) means
disregarding any ownership interests, held directly or indirectly, in
noncontrolled corporations (as determined under paragraph (a)(1) of
this section), after applying the asset test under section 897(c)(2)
and Sec. 1.897-2.
(2) Central banks. For further guidance, see Sec. 1.892-5T(b)(2).
(3) Pension trusts. For further guidance, see Sec. 1.892-5T(b)(3).
(c) Control--(1) Attribution. For further guidance, see Sec.
1.892-5T(c)(1).
(2) Effective control. For further guidance, see Sec. 1.892-
5T(c)(2).
(d) Related controlled entities--(1) Brother/sister entities. For
further guidance, see Sec. 1.892-5T(d)(1).
(2) Parent/subsidiary entities. For further guidance, see Sec.
1.892-5T(d)(2).
(3) [Reserved]
(4) Illustrations. For further guidance, see Sec. 1.892-5T(d)(4).
(5) Partnerships--(i) General rule. Except as provided in
paragraphs (d)(5)(ii) and (iii) of this section, the commercial
activities of an entity classified as a partnership for Federal tax
purposes are attributable to its partners for purposes of section 892.
For example, if an entity described in paragraph (a)(1)(iii)(A) or (B)
of this section holds an interest as a general or limited partner in a
partnership that is engaged in commercial activities, except as
provided in paragraphs (d)(5)(ii) and (iii) of this section, the
partnership's commercial activities are 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)(1) 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)),
partnership equity interests, commodities (as defined in Sec. 1.892-
4(c)(2)), or financial instruments (as defined in Sec. 1.892-3(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
paragraph (d)(5)(ii) does not apply to any member in the case of a
partnership that is a dealer in stocks, bonds, other securities,
partnership equity interests, commodities, or financial instruments, as
determined under the principles of Sec. 1.864-2(c)(2)(iv)(a).
(iii) Qualified partnership interest exception--(A) General rule.
An entity that is not otherwise engaged in commercial activities
(including, for example, performing services for a partnership as
described in section 707(a) or section 707(c)) will not be deemed to be
engaged in commercial activities solely because it holds a qualified
partnership interest in a partnership, notwithstanding that the entity
may be considered as being engaged in a trade or business within the
United States under section 875(1). Nevertheless, pursuant to section
892(a)(2)(A)(i), a foreign government member's distributive share of
partnership income will be treated as from commercial activity, and
thus will not be exempt from taxation under section 892 to the extent
that the partnership derived such income from the conduct of 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 a qualified partnership interest in a partnership that is a
dealer in stocks, bonds, other securities, partnership equity
interests, 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
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 commercial
activity.
(B) Qualified partnership interest--(1) In general. Solely for
purposes of paragraph (d)(5)(iii) of this section, an interest
classified as equity in an entity classified as a partnership for
Federal tax purposes is treated as a qualified partnership interest if
the holder of such interest has limited liability within the meaning of
Sec. 301.7701-3(b)(2)(ii) of this chapter, does not possess the legal
authority to bind or to act on behalf of the partnership, does not
control the partnership within the meaning of paragraph (a)(1) of this
section, and 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.
(2) Rights to participate in the management and conduct of a
partnership's business--(i) In general. Rights to participate in the
management and conduct of a partnership's business mean rights to
participate in the day-to-day management or operation of the
partnership's business, including, for example, the right to
participate in ordinary-course personnel and compensation decisions, or
take active roles in formulating the partnership's business strategy or
in respect of the partnership's acquisition or disposition of a
specific investment. The existence of these rights is determined based
on all facts and circumstances. In addition to the conduct of relevant
parties, such determination shall consider the totality of all rights
arising from all direct or indirect interests of the holder of the
[[Page 57919]]
partnership, including rights provided under the law of the
jurisdiction in which the partnership is organized, the partnership's
governing documents, contractual agreements such as side letters,
shareholders' agreements, and agreements with creditors of the
partnership.
(ii) Rights to participate in the monitoring or protection of a
partner's capital investment. Rights to participate in the management
and conduct of a partnership's business generally do not include
participation rights with respect to monitoring or protecting the
partner's capital investment in the partnership, but only if such
rights do not include rights to participate in the day-to-day
management or operation of the partnership's business and do not result
in effective control under paragraph (a)(1)(iii)(B) of this section.
These rights may, subject to the limitations of the previous sentence,
include oversight and supervision rights in the case of major strategic
decisions such as: admission or expulsion of a partner; hiring or
firing key strategic personnel; amendment of the partnership agreement;
dissolution, merger, or conversion of the partnership; unusual and non-
ordinary course deviations from previously determined investment
parameters; extending the term of the partnership's governing
agreement; and disposition of all or substantially all of the
partnership's property outside of the ordinary course of the
partnership's activities.
(iii) Holding more than one interest in a partnership. If a foreign
sovereign holds directly or indirectly interests in a partnership
through one or more integral parts or controlled entities (within the
meaning of Sec. 1.892-2T) or entities controlled by such foreign
sovereign under paragraph (a)(1) of this section, then such interests
are aggregated for purposes of this paragraph (d)(5)(iii)(B)(2). For
example, if a controlled entity (within the meaning of Sec. 1.892-2T)
of a foreign sovereign or an entity controlled by the foreign sovereign
under paragraph (a)(1) of this section holds a partnership interest
that is not a qualified partnership interest, then any other equity
interest held in the same partnership by any other controlled entities
of the foreign sovereign is also not treated as a qualified partnership
interest. Furthermore, if a foreign sovereign directly or indirectly
holds more than one interest in a partnership through one or more
integral parts or controlled entities (within the meaning of Sec.
1.892-2T) or entities controlled by such foreign sovereign under
paragraph (a)(1) of this section and those partnership interests in the
aggregate result in a disqualification from qualified partnership
interest, then each such interest in the partnership is not treated as
a qualified partnership interest.
(C) Safe harbor for de minimis interests. For purposes of this
paragraph (d)(5)(iii), a holder of an interest classified as equity in
an entity classified as a partnership for Federal tax purposes is
treated as holding a qualified partnership interest (within the meaning
of paragraph (d)(5)(iii)(B) of this section) if the holder at all times
during the partnership's taxable year:
(1) Has limited liability within the meaning of Sec. 301.7701-
3(b)(2)(ii) of this chapter;
(2) Does not possess the legal authority to bind or to act on
behalf of the partnership;
(3) Is not the partnership's managing partner, managing member, or
an equivalent role under applicable law; and
(4) Does not own, directly or indirectly (under the principles of
paragraph (d)(5)(iii)(B)(2)(iii) of this section), more than five
percent of either the partnership's capital interests or the
partnership's profits interests.
(D) Tiered partnerships. The rules of this paragraph (d)(5)(iii)
apply in cases where a partnership (lower-tier partnership) that
conducts commercial activity has a partner that is a partnership
(upper-tier partnership). If an upper-tier partnership holds no
interest in the lower-tier partnership other than a qualified
partnership interest, within the meaning of paragraph (d)(5)(iii)(B) or
(C) of this section, the lower-tier partnership's commercial activity
is not attributed to the upper-tier partnership. Nevertheless, the
upper-tier partnership's distributive share of the lower-tier
partnership's income that is derived from the conduct of commercial
activity will not be exempt from tax under section 892.
(iv) Illustration. The following examples illustrate the
application of this paragraph (d)(5):
(A) Example 1--(1) Facts. K is a controlled entity of a foreign
sovereign under Sec. 1.892-2T(a)(3). K holds a 20 percent equity
interest in Opco, a domestic limited liability company that is
classified as a partnership for Federal tax purposes. Opco owns and
manages an office building that produces income from rental and
advertising activities that constitute commercial activity under Sec.
1.892-4. Under the governing agreement and the applicable law of Opco,
K is not liable for the debts of or claims against Opco by reason of
being a member, does not possess the legal authority to bind or act on
behalf of Opco, and does not control Opco within the meaning of
paragraph (a)(1) of this section. K is not the managing member of, and
does not hold an equivalent role under applicable law in, Opco.
Pursuant to a side letter between K and Opco, K, however, has rights to
review and advise on Opco's material business contracts and business
expenses.
(2) Analysis. Opco's commercial activity is attributable to K under
paragraph (d)(5)(i) of this section unless K's interest in Opco is a
qualified partnership interest. K's interest in Opco does not satisfy
the safe harbor under paragraph (d)(5)(iii)(C) of this section because
K holds a 20 percent equity interest in Opco. Under all facts and
circumstances as provided in paragraph (d)(5)(iii)(B) of this section,
K's rights to review and advise on Opco's material business contracts
and business expenses constitutes the right to participate in the day-
to-day management and operation of Opco's business. As a result, K's
interest in Opco is not a qualified partnership interest. Therefore,
Opco's commercial activity is attributable to K under paragraph
(d)(5)(i) of this section, and K will be treated as a controlled
commercial entity.
(B) Example 2--(1) Facts. The facts are the same as in paragraph
(c)(5)(iv)(A) of this section (Example 1), except that K does not have
rights to review and advise on Opco's material business contracts and
business expenses. Instead, K is a member of Opco's member committee
that only has the ability to make non-binding recommendations, but not
decisions in respect of investor-level strategic matters such as
dissolution of the partnership, deviations from previously determined
investment parameters, and extending the term of the partnership's
governing agreement. The extent of K's membership and participation in
Opco's member committee does not result in control over Opco within the
meaning of paragraph (a)(1) of this section. K does not otherwise have
control over Opco within the meaning of paragraph (a)(1) of this
section.
(2) Analysis. Although K is on Opco's member committee, the
committee only has the ability to make non-binding recommendations but
not decisions of an investor-level nature in respect of strategic
matters, and not in respect of Opco's day-to-day operations. As a
result, Opco's commercial activities will not be attributable to K
pursuant to paragraph (d)(5)(iii)(A) of this section. Accordingly, if K
is not treated as engaged in any other activities that are commercial
activities, K will not be a
[[Page 57920]]
controlled commercial entity. The portion of K's distributive share of
income from Opco, however, that is derived from commercial activity
will not be exempt from tax under section 892.
(e) Applicability date. Except as otherwise provided in this
paragraph (e), this section applies to taxable years beginning on or
after December 15, 2025. See Sec. Sec. 1.892-5 and 1.892-5T, as
contained in 26 CFR in part 1 in effect on April 1, 2025, for the rules
that apply to taxable years beginning before December 15, 2025. A
taxpayer may choose to apply this section to a taxable year beginning
before December 15, 2025, if the period of limitations on assessment of
the taxable year is open under section 6501 and the taxpayer and
entities that are related (within the meaning of section 267(b) or
section 707(b)) to the taxpayer apply this section and Sec. Sec.
1.892-3(a)(4) and 1.892-4 in their entirety to the taxable year and all
succeeding taxable years beginning before December 15, 2025. The rule
in paragraph (a)(1)(ii) of this section applies on or after January 14,
2002.
0
Par. 8. Section 1.892-5T is amended by:
0
a. Revising paragraph (a), the heading of paragraph (b), and paragraph
(b)(1);
0
b. Removing and reserving paragraph (d)(3); and
0
c. Revising paragraph (d)(4).
The revisions read as follows:
Sec. 1.892-5T Controlled commercial entity (temporary regulations).
(a) In general. For further guidance, see Sec. 1.892-5(a).
(b) Entities treated as engaged in commercial activity--(1) U.S.
real property holding corporations. For further guidance, see Sec.
1.892-5(b)(1).
* * * * *
(d) * * *
(4) Illustrations. The principles of this section may be
illustrated by the following examples.
(i) Example 1. (A) The Ministry of Industry and Development is an
integral part of a foreign sovereign under Sec. 1.892-2T(a)(2). The
Ministry is engaged in commercial activity within the United States. In
addition, the Ministry receives income from various publicly traded
stocks and bonds, soybean futures contracts and net leases on U.S. real
property. Since the Ministry is an integral part, and not a controlled
entity, of a foreign sovereign, it is not a controlled commercial
entity within the meaning of paragraph (a) of this section. Therefore,
income described in Sec. 1.892-3T is ineligible for exemption under
section 892 only to the extent derived from the conduct of commercial
activities. Accordingly, the Ministry's income from the stocks and
bonds is exempt from U.S. tax.
(B) The facts are the same as in paragraph (d)(4)(i)(A) of this
section, except that the Ministry also owns 75 percent of the stock of
R, a U.S. holding company that owns all the stock of S, a U.S.
operating company engaged in commercial activity. Ministry's dividend
income from R is income received indirectly from a controlled
commercial entity. The Ministry's income from the stocks and bonds,
with the exception of dividend income from R, is exempt from U.S. tax.
(C) The facts are the same as in paragraph (d)(4)(i)(A) of this
section, except that the Ministry is a controlled entity of a foreign
sovereign. Since the Ministry is a controlled entity and is engaged in
commercial activity, it is a controlled commercial entity within the
meaning of paragraph (a) of this section, and none of its income is
eligible for exemption.
(ii) Example 2. (A) Z, a controlled entity of a foreign sovereign,
has established a pension trust under the laws of the sovereign as part
of a pension plan for the benefit of its employees and former
employees. The pension trust (T), which meets the requirements of Sec.
1.892-2T(c), has investments in the U.S. in various stocks, bonds,
annuity contracts, and a shopping center which is leased and managed by
an independent real estate management firm. T also makes securities
loans in transactions that qualify under section 1058. T's investment
in the shopping center is not considered an unrelated trade or business
within the meaning of section 513(b). Accordingly, T will not be
treated as engaged in commercial activities. Since T is not a
controlled commercial entity, its investment income described in Sec.
1.892-3T, with the exception of income received from the operations of
the shopping center, is exempt from taxation under section 892.
(B) The facts are the same as paragraph (d)(4)(ii)(A) of this
section, except that T has an interest in a limited partnership (that
is not a qualified partnership interest within the meaning of Sec.
1.892-5(d)(5)(iii)) which owns the shopping center. The shopping center
is leased and managed by the partnership rather than by an independent
management firm. Managing a shopping center, directly or indirectly
through a partnership of which a trust is a member, would be considered
an unrelated trade or business within the meaning of section 513(b)
giving rise to unrelated business taxable income. Since the commercial
activities of a partnership are attributable to its partners, T will be
treated as engaged in commercial activity and thus will be considered a
controlled commercial entity. Accordingly, none of T's income will be
exempt from taxation under section 892.
(C) The facts are the same as paragraph (d)(4)(ii)(A) of this
section, except that Z is a controlled commercial entity. The result is
the same as in paragraph (d)(4)(ii)(A) of this section.
(iii) Example 3. (A) The Department of Interior, an integral part
of foreign sovereign FC, wholly owns corporations G and H. G, in turn,
wholly owns S. G, H and S are each controlled entities. G, which is not
engaged in commercial activity anywhere in the world, receives interest
income from deposits in banks in the United States. Both H and S do not
have any investments in the U.S. but are both engaged in commercial
activities. However, only S is engaged in commercial activities within
the United States. Because neither the commercial activities of H nor
the commercial activities of S are attributable to the Department of
Interior or G, G's interest income is exempt from taxation under
section 892.
(B) The facts are the same as paragraph (d)(4)(iii)(A) of this
section, except that G rather than S is engaged in commercial
activities and S rather than G receives the interest income from the
United States. Since the commercial activities of G are attributable to
S, S's interest income is not exempt from taxation.
Frank J. Bisignano,
Chief Executive Officer.
Approved: October 30, 2025
Kenneth J. Kies,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2025-22776 Filed 12-12-25; 8:45 am]
BILLING CODE 4831-GV-P