Category: 3. Business

On December 12, 2025, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released packages of proposed regulations (2025 Proposed Regulations) and final and temporary regulations (Final Regulations) under section 892,¹  which exempts from tax the income of foreign governments from certain U.S. investments. These rules are particularly relevant to sovereign wealth funds and asset managers with which they invest.

Background: Foreign Governments and Section 892

Section 892 generally exempts from U.S. federal income tax the income of foreign governments derived from investments in the United States in stocks, bonds, or other domestic securities, financial instruments held in the execution of governmental financial or monetary policy, and bank deposits. However, the 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, or directly or indirectly from, a controlled commercial entity (CCE) or (3) derived from the disposition of an interest in a CCE. An entity generally is a CCE for these purposes if it is engaged in commercial activities anywhere in the world and the foreign government holds (directly or indirectly) any interest in the entity that constitutes 50% or more (by vote or value) of the total interests in the entity or that provides the foreign government with “effective control” of the entity.

2025 Proposed Regulations

The 2025 Proposed Regulations address primarily two topics: (i) whether the acquisition of debt is considered an investment or a commercial activity and (ii) when a foreign government will be considered to have effective “control” over an entity. The regulations are proposed to apply to taxable years beginning on or after the date final regulations are published.

Acquisition of Certain Debt as “Commercial Activity”

Prior proposed Treasury regulations published on November 3, 2011 (2011 Proposed Regulations) generally treated loans and investments in stocks, bonds, and other securities as not constituting commercial activity for section 892 purposes, but treated investments (including loans) made by a banking, financing, or similar business as commercial activity. The 2025 Proposed Regulations would instead set out a new framework for determining when the acquisition of debt, including at original issuance, qualifies as an investment and not commercial activity for purposes of section 892.

Under the new framework, any acquisition of debt (meaning any obligation treated as debt for U.S. federal tax purposes) is treated as a commercial activity unless the acquisition is treated as an “investment” under (1) a safe harbor for registered offerings, (2) a safe harbor for qualified secondary market acquisitions, or (3) a facts-and-circumstances analysis. This rule applies regardless of whether the activity is considered a trade or business under other provisions of the Code, such as sections 162, 166, or 864(b).

Safe Harbor 1: Securities Act registered offerings

A debt acquisition would be treated as an “investment” (and therefore not commercial) if it involves an acquisition of bonds or other debt securities in an offering registered under the Securities Act of 1933, provided the underwriters are not related to the acquirer under sections 267(b) and 707(b). Treasury and the IRS specifically request input on whether, and under what circumstances, this safe harbor should extend to offerings registered under foreign securities laws that provide a sufficiently similar regulatory framework.

Safe Harbor 2: Qualified secondary market acquisitions

A qualified secondary market acquisition would be treated as an “investment” if:

• the debt is traded on an established securities market;
• the acquirer does not acquire the debt from the issuer and does not participate in negotiating the terms or issuance of the debt; and
• the acquisition is not from a person under common management or control with the acquirer, unless that person acquired the debt as an “investment” within the meaning of these rules.

Facts-and-circumstances test

If neither safe harbor applies, a debt acquisition may still be treated as an investment based on all relevant facts and circumstances. The preamble to the 2025 Proposed Regulations states that facts and circumstances are relevant to the extent they indicate that the entity’s expected return from acquiring the debt is exclusively a return on its capital, rather than including a return on activities it conducts. The 2025 Proposed Regulations set out the following non-exclusive list of factors to be considered, but the preamble notes that the weight given to each relevant factor (and any other factors) may vary from case to case:

1. Whether the acquirer solicited prospective borrowers, or otherwise held itself out as willing to make loans or otherwise acquire debt at or in connection with its original issuance;
2. Whether the acquirer materially participated in negotiating or structuring the terms of the debt;
3. Whether the acquirer is entitled to compensation (whether or not labelled as a fee) that is not treated as interest (including original issue discount) for U.S. federal tax purposes;
4. The form of the debt and the issuance process, including, for example, whether the debt is a bank loan or instead a privately placed debt security pursuant to Regulation S or Rule 144A under the Securities Act;
5. The percentage of the debt issuance acquired by the acquirer relative to the percentages acquired by other purchasers;
6. The percentage of equity in the debt issuer held or to be held by the acquirer;
7. The value of any such equity relative to the amount of the debt acquired; and
8. If debt is deemed to be acquired in a debt-for-debt exchange as a result of a significant modification under § 1.1001-3, whether there was, at the time of acquisition of the original unmodified debt, a reasonable expectation, based on objective evidence, such as a decline in the financial condition or credit rating of the debt issuer between original issuance and the time of the acquisition of the original unmodified debt, that the original unmodified debt would default.

Illustrative examples in the 2025 Proposed Regulations

The 2025 Proposed Regulations include examples that provide insight into how Treasury and the IRS expect the facts-and-circumstances test to apply to a controlled entity of a foreign government. The examples address:

• Isolated loan origination. A controlled entity’s offering, structuring, negotiation, and extension of a single loan in a year was commercial activity.
• Shareholder loans. A $50 million loan to a company was not commercial activity where the controlled entity owned 80% of the company’s equity (valued at $100 million).
• Private placements and Treasury auctions. Purchases of privately placed debt securities offered by placement agents under Regulation S and U.S. Treasury securities at auction were investments, not commercial activity, where the controlled entity did not materially participate in structuring/negotiation, the controlled entity purchased less than one third by principal amount of each debt offering, and at least one other unrelated purchaser purchased a larger percentage of each debt offering.
• Debt workouts of existing investments
  • The acquisition of a restructured debt via a significant modification of an existing debt was not a commercial activity where the controlled entity had acquired the existing debt in a secondary market acquisition that qualified as an investment, there were no objective indications of an impending default when the existing debt was acquired, and the controlled entity did not participate in the creditors’ committee that negotiated the restructuring.
  • Alternatively, under the same facts as above except that the controlled entity was a member of the creditors’ committee, the acquisition of the restructured debt was a commercial activity.

“Effective Control” for CCE status

The 2025 Proposed Regulations generally would provide that a foreign government has effective control over an entity where it has any “interest” that, directly or indirectly and separately or in combination with other interests, results in control over the entity’s operational decisions, managerial decisions, board-level decisions, or investor-level decisions. Mere consultation rights would not alone give rise to effective control. The “interests” considered include any debt or equity interests, voting rights, director appointment rights, veto rights, contractual rights or arrangements with the entity or its other interest holders, business relationships with the entity or its other interest holders, regulatory authority, and any other interest in or relationship with the entity that may provide influence over the foregoing decisions. All of the facts and circumstances related to the interests would be considered in determining effective control. In all events, however, a foreign government would be considered to have effective control of an entity if it is, or controls an entity that is, the managing partner or managing member of the entity (or holds an equivalent role under local law).

The 2025 Proposed Regulations include several examples illustrating when a foreign government’s interests in an entity do or do not create effective control.

• Examples of situations where there was effective control of an entity:
  • The foreign government was entitled to appoint one of the entity’s three directors, but that one director alone could appoint or dismiss the manager of the entity, who was responsible for managing the entity’s operations.
  • Same facts as above, except the director instead had veto rights over dividends, material capital expenditure, new equity issuances, and the operating budget.
  • The foreign government was entitled to appoint one of the entity’s three directors but also had significant business dealings with an unrelated investor who also appointed one director, and the other investor, as a matter of course, causes its appointed director to always vote in the same manner as the foreign government’s director.
  • The entity’s business was primarily the extracting and marketing of a mineral in the foreign government’s country, and the foreign government owns all rights to and regulates the extraction of that mineral.
  • The foreign government was a creditor of the entity under a credit agreement that restricted the entity’s types of investments, asset dispositions, levels of future borrowing, and dividend distributions, as well as providing veto rights over dividends, stock repurchases, additional borrowing, capital expenditure, the annual operating budget, and redemptions of subordinated debt.
• Examples of situations that did not constitute effective control:
  • The foreign government has only a minority stake and no special rights/arrangements.
  • The foreign government and entity agree to investment guidelines that govern the types of investments the entity could make but provide no voting, operational, managerial, or other rights.
  • The foreign government was entitled to participate in an investment committee with consultation rights regarding acquisitions and dispositions of property but no right to make decisions or execute transactions.

Treasury and the IRS request comments on how to treat situations where minority investors have rights shared with others (e.g., supermajority or consent structures) and whether such rights should (or should not) result in effective control or 50% voting power.

Practical Implications

Private credit investments – commercial activity. Foreign government investors should review current structures and practices for acquisitions of debt instruments in entities that are intended not to be engaged in commercial activity to confirm whether the safe harbors described above are met or whether the debt acquisitions are properly viewed as investments under the facts and circumstances analysis.

Minority positions in entities engaged in commercial activity. Foreign government investors should review any non-passive rights they hold (e.g., board appointment provisions, veto rights, consent rights, creditor rights) in entities generating income that is expected to be exempt from tax under section 892.

Final Regulations

The Final Regulations finalize, with certain revisions, proposed Treasury regulations, published on November 3, 2011 (2011 Proposed Regulations) and on December 29, 2022 (2022 Proposed Regulations) that address (i) when a foreign government is engaged in “commercial activities” and (ii) when an entity is a CCE of a foreign government. Generally, the Final Regulations apply to taxable years beginning on or after December 15, 2025. However, taxpayers may elect to apply the Final Regulations to earlier open taxable years, provided they and their related parties consistently apply the final rules in their entirety to that year and all succeeding pre-finalization years.

Commercial Activities

Definition of commercial activities

Under the Final Regulations, the term “commercial activities” retains the historically broad definition: any activity ordinarily conducted for the current or future production of income or gain, and is expressly broader than the “trade or business” standards under section 162 or section 864(b). In particular: (i) every activity that constitutes a trade or business for purposes of section 162 or a trade or business in the United States for purposes of section 864(b) is a commercial activity, unless specifically excepted (e.g., through exceptions for investments and trading); (ii) non–trade-or-business activities may still be commercial depending on their nature; and (iii) the Final Regulations reject any argument that investment purpose or governmental policy motivation can shield an activity from being treated as commercial.

Financial instruments

The Final Regulations retain the concept that investing and trading in “financial instruments” for one’s own account as a non-dealer falls within the investment and trading exceptions and thus does not constitute commercial activity. Further, they expand the definition of “financial instrument” to broadly include any interest rate, currency, equity, or commodity notional principal contract and any evidence of an interest in options/forwards/futures and similar contracts the value of which is determined by reference to one or more of any such notional principal contract, stock, debt, publicly traded partnership interest, commodity or currency. Accordingly, it is now clear that investments in such derivatives do not present the risk of commercial activity. However, the preamble confirms that if a financial instrument is treated as beneficial ownership of a reference asset under general U.S. federal income tax principles, the determination of whether a transaction in the financial instrument constitutes commercial activity is based on the reference asset, not the financial instrument.

Certain fee income

Treasury and the IRS rejected a request to include an exception from commercial activity for the receipt of certain fee income as a passive investor in a private equity or private credit fund (e.g., fees for services performed by the sponsor or fees incidental to the providing of capital). Treasury and the IRS asserted that the determination of whether the receipt of such fees give rise to commercial activities is based on the substance of a transaction, rather than its label or form.

Controlled Commercial Entities

U.S. real property holding corporations and U.S. real property interests

Temporary regulations issued in 1988 have long provided that a corporation, domestic or foreign, that is a United States real property holding corporation (USRPHC) is per se treated as engaged in commercial activity and thus not entitled to benefits under section 892. This rule required controlled entities of foreign governments to continuously monitor and carefully structure their direct and indirect investments in U.S. real estate to ensure they would not lose their entitlement to section 892 benefits.

The Final Regulations limit this rule to domestic corporations that are USRPHCs. Accordingly, foreign governments will no longer have the burden of monitoring and structuring to avoid their non-U.S. controlled entities becoming USRPHCs. The Final Regulations also finalize with clarifications a rule introduced in the 2022 Proposed Regulations that treats a corporation as not a USRPHC for these purposes if it is a USRPHC solely by reason of its direct or indirect ownership interests in noncontrolled USRPHCs.

Annual CCE determination

The Final Regulations generally adopt rules from the 2011 Proposed Regulations providing that an entity controlled by a foreign government is a CCE if it engages in commercial activity at any time during its taxable year. However, to prevent abuse where a commercial transaction is split across years, the Final Regulations require that activities in the immediately preceding taxable year be considered to the extent relevant in characterizing the current year’s activities.

In addition, for corporate transactions where the tax attributes of assets carry over from a transferring corporation to an acquiring corporation under section 381, the acquiring corporation is not generally treated as engaging in the transferor’s commercial activity in the acquisition year, provided that the transferor’s taxable year ends and the acquiring corporation does not directly continue the commercial activity. However, if the acquisition is between commonly controlled entities (e.g., a section 332 liquidation within the same foreign sovereign’s group), the acquirer is treated as engaged in commercial activity for its taxable year of the acquisition.

The Final Regulations do not address whether an entity that is 50% or more owned by a foreign government for only part of a taxable year is treated as a CCE for the entire taxable year.

Inadvertent commercial activity

The Final Regulations adopt and refine with minor revisions the inadvertent commercial activity exception in the 2011 Proposed Regulations pursuant to which a controlled entity is not treated as engaged in commercial activity if: (1) the failure to avoid the activity is reasonable; (2) the activity is promptly cured (within 180 days as opposed to 120 days under the 2011 Proposed Regulations); and (3) certain recordkeeping requirements are satisfied. Income from the inadvertent activity itself remains taxable.

The Final Regulations also adopt a safe harbor pursuant to which a failure to avoid commercial activities will be deemed reasonable if an entity’s assets and income from inadvertent commercial activity are less than 5% of the total assets and income of the entity (per applicable financial statements or adequate books), and written policies and procedures are in place to monitor the entity’s worldwide activities.

Qualified partnership interest exception

The 2011 Proposed Regulations included a “limited partner” exception that prevented the commercial activity of an entity treated as a partnership for U.S. federal tax purposes from being attributed to its limited partners. The Final Regulations rename, reformulate, and finalize the limited partner exception as the “qualified partnership interest” (QPI) exception.

A partner holding a QPI is not treated as engaging in commercial activity solely due to the partnership’s activities, but its distributive share of commercial activity income remains taxable.

In order to be treated as a QPI, the holder of the interest must not:

1. have personal liability for claims against the partnership;
2. have the right to enter into contracts or act on behalf of the partnership;
3. “control” the partnership (must only hold minority interest in the partnership and not have “effective control”); and
4. have no rights to participate in the management and conduct of the partnership’s business, defined as rights to participate in day-to-day management or operations. The Final Regulations distinguish permissible monitoring/protection rights (e.g., on extraordinary events, deviations from investment parameters, admission/expulsion of partners, partnership agreement amendments, extensions of term, mergers, non-ordinary-course sale of substantially all assets) from impermissible day-to-day operational control.

The Final Regulations also add a safe harbor for de minimis QPIs. A partner is automatically treated as holding a QPI if it:

1. has no personal liability for claims against the partnership;
2. does not have the right to enter into contracts or act on behalf of the partnership;
3. is not a managing member/partner (or equivalent); and
4. owns less than 5% of capital and less than 5% of profits.

The Final Regulations further clarify the application of the QPI exception to tiered partnerships. An upper-tier partnership that holds a QPI 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 QPI, 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 QPI in the upper-tier partnership.

The Final Regulations also provide rules for the aggregation of multiple interests. All interests held in a partnership by or through integral parts or controlled entities of the same foreign sovereign are aggregated for purposes of applying the QPI exception. If the aggregated interest fails to meet the QPI requirements, none of the interests qualify.

Practical Implications

Real estate investments. Foreign government investors no longer need to monitor the real estate holdings of their foreign controlled entities to ensure that they are not treated as USRPHCs and thus CCEs.

Investing in partnerships. Foreign government investors may consider whether their current and future investments qualify for the QPI exception, and in particular, the new safe harbor for de minimis QPIs, in order to protect their controlled entities from being treated as CCEs.

¹ All “section” references herein are to the Internal Revenue Code of 1986 (the Code).