Publications

15 Nov 2011

Proposed regulations would ease sovereign wealth funds' investment in US private funds

International Tax Alert

Thomas S. Dick
Alan Winston Granwell
Gerald Rokoff

The US government has issued Proposed Regulations that would go far in addressing tax concerns of sovereign wealth funds (SWFs) when investing in US-sponsored private equity and real estate funds. 

Many SWFs have been concerned that they risked constituting “controlled commercial entities,” none of whose US-source income would be exempted under the special regime for foreign sovereigns and their controlled entities.  I.R.C. § 892. 

Often, SWFs are formed as entities that are legally separate from the relevant sovereign, and if they conduct any “commercial activity” anywhere in the world they cease to be entitled to the foreign sovereign exemption for certain types of US-source income.  The Proposed Regulations, announced on November 3, would narrow the definition of “commercial activity” and provide a safe harbor whereby commercial activities undertaken by a limited partnership would not be attributed to an SWF limited partner. 

If the Proposed Regulations are finalized in substantially identical form, the extension of benefits of section 892 will be welcomed, particularly by those SWFs that are formed as entities legally separate from their sovereign and are not entitled to the benefits of a bilateral US income tax treaty.

Narrowing the scope of commercial activity

            Disposition of a US Real Property Interest would not constitute commercial activity

The test for commercial activity is one of exclusion: all activities “which are ordinarily conducted . . . with a view towards the current or future production of income or gain” are commercial, unless they have been specifically exempted.  Certain investments, including net leases of real property, are exempted, but it was unclear whether the sale of a US real property interest (a “USRPI”) was a commercial activity.  The Proposed Regulations clarify that disposing of a USRPI, without more, would not constitute conducting a commercial activity.  This would be an important development for real estate funds.  Nevertheless, gain attributable to the disposition of a USRPI, if held directly rather than via a US corporation, would remain excluded from section 892 benefits.

            Investment in financial Instruments would not constitute commercial activity

Second, the exemption for investment in financial instruments would be broadened by removing the proviso that they be “held in the execution of governmental financial or monetary policy.”  Accordingly, an SWF’s investment in “any forward, futures, options contract, swap agreement or similar instrument in a functional or nonfunctional currency . . . or in precious metals” would not be considered engaging in commercial activity.  Income therefrom, however, would continue to qualify for the section 892 exemption only to the extent the instrument is held in the execution of governmental financial or monetary policy.

            De minimis exception

Third, in mitigation of the harsh “all or nothing” rule, whereby a controlled entity of a foreign sovereign loses all the benefits under section 892 if it conducts any amount of commercial activity anywhere in the world, “inadvertent” commercial activity would be forgiven.  “Inadvertent” commercial activity is defined to include the following:

i)          the SWF’s failure to avoid the commercial activity is “reasonable”

ii)         the SWF promptly cures the failure and

iii)         the SWF satisfies record maintenance requirements

The SWF’s failure to avoid commercial activity would be considered reasonable only if, among other requirements, the entity has “adequate written policies and operational procedures in place to monitor the entity’s worldwide activities.”  If these policies and procedures are in place, an SWF would satisfy the “reasonableness” standard under a safe harbor provided its gross assets and income from the commercial activity do not exceed five percent of the assets and income as reflected on the SWF’s financial accounting statement.  Note that, in this case, none of the income derived from inadvertent commercial activity would qualify for exemption from tax under section 892. 

Finally, the determination of controlled commercial entity status would be made on an annual basis and the fact that an entity was a controlled commercial entity in a prior taxable year would not affect its status in a subsequent taxable year.

Safe harbor for partnership investments

Commercial activity undertaken by a partnership is generally attributed to its partners.  To avoid attribution from US private investment funds, SWFs sometimes employ non-controlled “blocker” corporations to hold their investment; i.e., corporations in which a particular SWF does not have a 50 percent or more actual or constructive participation.  If the SWF owns a greater interest, the entity might be a controlled commercial entity, and this would negate any affirmative planning.

SWFs typically invest in hedge funds through an offshore feeder corporation that is established by the sponsor for foreign and US tax-exempt investors.  Private equity and real estate partnership sponsors, however, tend not to provide “above-the-fund” blockers and SWFs then must rely on the sponsor’s formation of a “below-the-fund” blocker corporation or REIT to hold any investment that would be classified as a commercial activity.  This places an SWF (if a controlled entity) in an insecure position because any direct conduct of commercial activity by the fund anywhere would cause the SWF to lose all section 892 benefits with respect to all items of US-source income.

The Proposed Regulations would terminate attribution from a fund in partnership form if the SWF, which otherwise does not engage in commercial activity, is a limited partner-equivalent without any right “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.”  Consent rights on extraordinary events, such as the expulsion of a general partner, would not constitute management and conduct rights.  If this limited partner safe harbor were met with respect to a particular fund, the SWF’s distributive share of fund assets and gross income would not be included in the numerator of the five percent “inadvertent commercial activity” test.  However, the SWF’s distributive share of partnership income attributable to commercial activity would not be eligible for section 892 benefits.

The scope of the limited partner safe harbor seems designed to match the circumstances in which a limited partner avoids liability to third parties under Section 17-303 of the Delaware Revised Uniform Limited Partnership Act.  SWFs interested in joining a fund’s advisory committee should consider carefully whether serving thereon would constitute the “management and conduct” of fund business in a particular case, under the Proposed Regulations.

Effective date

The Proposed Regulations would be effective prospectively from the date of their finalization.

Impact of the Proposed Regulations

The specter of a sovereign’s controlled entity losing all the benefits of section 892 as a result of constituting a controlled commercial entity has resulted in the formation of numerous holding companies in order to ring-fence possible taint.  While such tax planning will not disappear, the Proposed Regulations seek to lower the stakes of a misstep by limiting the scope of commercial activity and providing safe harbors against “inadvertent” commercial activity and attribution from limited partnership investments. 

This approach should be welcomed at a time when the relative participation of SWFs in private investment funds is reported to be growing.  As the Financial Times reported on November 6, 2011, “SWFs, keen on diversifying their asset base, [are] increasingly stepping in for traditional investors, such as pension funds, endowments and insurance groups, which have often less money to invest into the asset class in the wake of the financial crisis.”

Consequences for practice

If finalized as written, the Proposed Regulations can be expected to have at least some of the following consequences in terms of SWF and fund practice:

1.         SWF controlled entities, interested in investing in the United States, will implement written policies and procedures to police against the conduct of inadvertent commercial activity on a global basis.

2.         SWFs interested in the limited partner safe harbor will avoid general partner investments, and give careful consideration before joining a limited partner advisory committee.

3.         Tax disclosure in PPMs will address the sufficiency of the fund’s law of formation and its governing agreement for permitting SWFs to satisfy the limited partner safe harbor.

If you have any questions about the Proposed Regulations, please contact Thomas Dick, Alan Granwell, Jerry Rokoff or your customary tax contact at DLA Piper.