On November 2, 2011, the US Treasury Department and the Internal Revenue Service issued proposed regulations regarding the exemption from US taxation provided to foreign governments with respect to certain investment income (the “Section 892 exemption”).1 The regulations clarify various questions under the current temporary regulations and generally provide foreign governments with greater certainty as to the effect of “commercial activities” on the availability of the Section 892 exemption. The proposed regulations, which can be relied on by taxpayers currently,2 will likely facilitate foreign government investment in the United States, particularly through investment funds and other partnership arrangements.

Background and Current Law

Derived from the concept of sovereign immunity, Section 892 exempts from US federal income tax certain US investment income received by a foreign government. The current temporary regulations define a foreign government as its integral parts and controlled entities.3 The Section 892 exemption does not apply to income that is (i) derived from the conduct of a commercial activity, (ii) received by or from a “controlled commercial entity” or (iii) derived from the disposition of an interest in a controlled commercial entity.4

While qualifying income of an integral part is thus exempt unless derived from commercial activities, if a controlled entity engages in any commercial activities anywhere, it becomes a controlled commercial entity and none of its income is eligible for the Section 892 exemption.5 This “all or nothing” rule presents a significant potential pitfall for foreign government investors, particularly with respect to investments in partnerships (as the commercial activities of partnerships, other than publicly traded partnerships, are attributed to the partners under the temporary regulations).6

Changes under the Proposed Regulations

The proposed regulations make a number of changes and clarifications in response to comments received from tax practitioners and foreign governments. The proposed regulations generally serve to reduce the likelihood that a foreign government will lose the benefit of the Section 892 exemption with respect to otherwise qualifying income as a result of the commercial activities restriction.

De Minimis Exception to the All or Nothing Rule

The proposed regulations create a de minimis exception to the all or nothing rule. Specifically, controlled entities will not be considered engaged in commercial activities if the activity is “inadvertent.”7 While the income from those inadvertent commercial activities will not be eligible for the Section 892 exemption, the activities will not cause the entity to be considered a controlled commercial entity.8 This rule more closely aligns the treatment of controlled entities with that of integral parts.

Commercial activity is inadvertent where failure to avoid it is reasonable and the activity is cured within 120 days of discovery.9 Whether failure to avoid commercial activity is reasonable is determined in light of all facts and circumstances.10 A safe harbor applies where the entity’s commercial activities (i) make use of 5 percent or less of its assets and (ii) produce 5 percent or less of its gross income.11 In each case, the entity must have in place adequate written policies and operational procedures to monitor its worldwide activities.12

Limited Partner Exception to Partnership Attribution

The proposed regulations also significantly modify the partnership attribution rules by introducing an exception to the attribution of commercial activities in the case of “limited partners.”13 While income derived from the commercial activities of the partnership continues to be attributed to the controlled entity and is ineligible for the Section 892 exemption, the entity is not deemed to be a controlled commercial entity solely on account of those activities.14 To be a “limited partner” for this purpose, the investor must not have rights to participate in the management and conduct of the partnership’s business at any time during the partnership’s taxable year.15

Such impermissible rights 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 the ordinary course of the partnership’s activities, merger or conversion.16 Foreign government investors can be expected to request that their rights with respect to investment funds or other partnerships be structured so as to qualify for this limited partner exception.

Other Changes

The proposed regulations also clarify several issues under the temporary regulations. As to controlled entities, they make clear that the determination of whether an entity is engaged in commercial activity is generally made on an annual basis.17 The proposed regulations also clarify that a controlled entity will not be treated as engaged in commercial activities solely on account of being a partner in a partnership that trades in stocks, bonds, other securities, commodities, or financial instruments for its own account, so long as such trading does not rise to the level of that of a dealer in such products.18

The proposed regulations restate the general rule that activities ordinarily conducted with a profit motive constitute commercial activities but clarify that it is the nature of an activity rather than its purpose that is determinative of whether it is commercial.19 The proposed regulations also repeat the temporary regulations in noting the distinction between an activity being considered commercial in this context and the question of whether it gives rise to a trade or business under Section 162 or a US trade or business under Section 864(b).20 Finally, the proposed regulations clarify that a disposition of a US. real property interest (USRPI), by itself, does not constitute the conduct of a commercial activity, although gain from such disposition does not qualify for the exemption provided by Section 892 unless the USRPI is an interest in a US real property holding corporation.21

Effective Date

Although the proposed regulations are not effective until adopted as final, taxpayers may rely on the proposed regulations until final regulations are issued.22


The changes adopted in the proposed regulations should serve to reduce the likelihood of commercial activities “foot faults” by foreign government investors and facilitate foreign government investment in the United States. Foreign government investors should consider the guidance provided in the proposed regulations in evaluating both their existing and proposed investment structures.

For more information about the proposed regulations, or any other matter raised in this Legal Update, please contact Rafic H. Barrage at +1 202 263 3321, James R. Barry at +1 312 701 7169, Anne Marie Konopack at +1 312 701 8467, Lee Morlock at +1 312 701 8832, or Michael N. Loquercio at +1 312 701 8904.

Learn more about our Tax Transactions & Consulting practice.

  1. 76 Fed. Reg. 68,119 (Nov. 3, 2011). References to “Section” herein refer to sections of the Internal Revenue Code of 1986, as amended (the “Code”).
  2. 76 Fed. Reg. 68,121 (Nov. 3, 2011).
  3. Treas. Reg. § 1.892-2T(a).
  4. Section 892(a)(2)(A).
  5. Section 892(a)(2)(B).
  6. Treas. Reg. § 1.892-5T(c)(3). 
  7. Prop. Reg. § 1.892-5(a)(2)(i).
  8. Id.
  9. Prop. Reg. § 1.892-5(a)(2)(i) and (iii).
  10. Prop. Reg. § 1.892-5(a)(2)(ii)(A).
  11. Prop. Reg. § 1.892-5(a)(2)(ii)(C).
  12. Prop. Reg. § 1.892-5(a)(2)(ii)(B).
  13. Prop. Reg. § 1.892-5(d)(5)(iii)(A).
  14. Id.
  15. Prop. Reg. § 1.892-5(d)(5)(iii)(B).
  16. Id.
  17. Prop. Reg. § 1.892-5(a)(3).
  18. Prop. Reg. § 1.892-5(d)(5)(ii).
  19. Prop. Reg. §1.892-4(d).
  20. Id.
  21. Prop. Reg. § 1.892-4(e)(1)(iv).
  22. 76 Fed. Reg. 68,121 (Nov. 3, 2011).