Inbound Investment by Foreign Governments

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Inbound Investment by Foreign Governments

• May 8, 2009
• Investment Management Committee
• American Bar Association Section of Taxation

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• ANY TAX ADVICE IN THIS COMMUNICATION IS NOT
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• You (and your employees, representatives, or
  agents) may disclose to any and all persons,
  without limitation, the tax treatment or tax
  structure, or both, of any transaction described
  in the associated materials we provide to you,
  including, but not limited to, any tax opinions,
  memoranda, or other tax analyses contained in
  those materials.
• The information contained herein is of a general
  nature and based on authorities that are subject
  to change. Applicability of the information to
  specific situations should be determined through
  consultation with your tax adviser.

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Agenda

• Introduction
• Exempt entities
• Exempt income
• Limits on exemption
• Controlled commercial entities
• Commercial activities
• Attribution and use of blockers
• Partnerships
• Withholding issues
• Closing remarks

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Who is Exempt?

• Section 892 exempts two categories of investors
• An integral part of a foreign government
• A controlled entity if
• Owned and controlled 100 by a foreign government
• Formed in the same country, and
• Engages in no commercial activities

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Who is Exempt?A Foreign Government

• An integral part of a foreign government is
  defined as a person that constitutes a governing
  authority of a foreign country if
• Its net earnings are credited to its own account
  and
• No portion of its earnings inures to the benefit
  of any private person
• Does not include any individual acting in a
  private or personal capacity

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Who is Exempt?A Controlled Entity

• A controlled entity is separate in form from the
  foreign government that controls it
• Like an integral part, its net earnings must not
  inure to a private person, and its assets must
  vest in the foreign sovereign upon dissolution
• Pension trusts for the sole benefit of the
  governments employees or non-government
  employees who perform governmental or social
  service functions may qualify see PLRs 200216025
  and 200619019
• Although the regulations refer only to trusts
  the 2002 ruling allowed a Canadian pension board
  formed as a corporation to qualify
• Governmental pension funds that are not in
  separate entity form might qualify as integral
  parts

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Sovereign Wealth Funds What are they?

• Actively managed, government-owned pools of
  capital originating in foreign exchange assets
  (JCS, JCX-49-08)
• Three of the more important types
• Commodity funds (e.g., funds sponsored by oil
  producing countries)
• Non-commodity funds (e.g., funds sponsored by
  Asian countries with large trade surpluses
  China, Korea)
• Government pension funds
• Examples include
• Abu Dhabi Investment Authority
• Norway Government Pension Fund Global
• China Investment Corporation

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Size of SWFs Absolute and Relative

• Absolute
• Approximately 2 - 3 trillion
• Expected to grow to 5 10 15 trillion within
  next decade
• Relative to other pools of capital
• Private equity funds 800 billion
• Hedge funds 1.5 trillion
• Pension assets 26 trillion
• Mutual funds 22 trillion
• Insurance companies 17 trillion
• All figures, all dollar amounts before crash
• Source International Financial Services, London
  Estimates are as
• of 2006, except the 800 billion estimate for
  private equity is as of 2007.

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What is Exempt?

• Unlike Section 115, the exemption for state and
  local governments from federal tax, Section 892
  extends only to a fairly narrow range of receipts
• Although the exemption once extended to all US
  source income, today the exemption extends only
  to income from stock and securities, including
  dividends, interest and capital gains

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What is Exempt?

• The significance of the Section 892 exemption is
  less than may be supposed
• Capital gains from stock or securities are
  generally exempt under Section 864(b)
• But Section 892 extends to gains on the sale of a
  noncontrolling interest in a U.S. real property
  holding corporation, trumping FIRPTA

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What is Exempt?

• Interest may be exempt as portfolio interest or
  under a tax treaty
• But 892 probably extends to contingent interest,
  unlike most treaties
• And extends to interest received by a 10 or
  greater shareholder (but must be less than 50)
• And many foreign governments have no treaty with
  the US

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What is Exempt?

• Dividends are generally not entitled to zero rate
  of withholding under treaties, so this is a clear
  benefit
• Exempt dividends include dividends from a
  non-controlled USRPHC or REIT
• However, IRS has ruled that a Section 897(h)(1)
  distribution from a REIT is not exempt under 892
  Notice 2007-55

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What is Not Exempt?

• Anything not described in Section 892, including
  income from a business or commercial activity
• Gain on disposition of any partnership interest,
  including an interest in a PTP, is not covered
• A partnership interest is not a security
• Generally such gain would not be taxed to a
  foreign person regardless of whether 892 applies
• But this rule causes difficulty in its
  interaction with FIRPTA (more later)
• Governments view is that gain on the sale of a
  partnership interest is taxable to the extent
  attributable to assets giving rise to effectively
  connected income (or loss). Rev. Rul. 91-32
• Several commentators have criticized this view.
  See, e.g., Blanchard, Rev. Rul. 91-32
  Extrastatutory Attribution of Partnership
  Activities to Partners

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Controlled Commercial Entities

• A controlled commercial entity (CCE) is an
  entity that engages in ANY commercial activity
  anywhere in the world if
• 50 or more of the entity, by vote or by value,
  is owned, directly or indirectly, by a foreign
  government, or
• The foreign government has effective practical
  control over such entity
• How is 50 measured?
• If foreign sovereign has veto rights, is that
  equivalent to 50 vote?
• If a third party is introduced to break the tie
  in a 50/50 joint venture, must it be given a
  veto?

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Controlled Commercial Entities

• If a controlled entity would be a USRPHC if it
  were domestic, it will be treated as a CCE
  engaged in commercial activity
• This arbitrary rule forces foreign governments to
  monitor the holdings of their SPVs very carefully
  so as not to trip FIRPTAs 50 threshold
• A disregarded entity wholly owned by a foreign
  sovereign is a per se corporation fatal if it
  is formed under US law
• If a sovereign is a partner or member of a
  partnership or LLC in which the other partner has
  no economic interest, this rule may be triggered

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Deemed USRPHC Rule
Gain on sale of minority interests in USRPHC1,
USRPHC2, and USRPHC3, would generally be exempt
under section 892. But, under a special rule, CE
is treated as a controlled commercial entity and
all gain is taxable.
Foreign Government
CE
10
15
20
USRPHC 1
USRPHC 2
USRPHC 3
A USRPHC or a foreign corporation that would be a
USRPHC were it a domestic corporation shall be
treated as engaged in commercial activity and,
therefore, is a controlled commercial entity if
the foreign government controls the corporation.
Treas. Reg. 1.892-5T(b)(1).
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How to avoid the deemed USRPHC rule?

• Avoid USRPHC status
• A corporation is a USRPHC if
• USRPI at least 50
• (i) USRPI, (ii) Foreign Real Property, plus (iii)
  Assets used in trade or business
• Issues
• Business assets would likely give rise to a
  commercial activity
• Investment assets would ordinarily not count in
  the USRPHC fraction
• Alternative Solutions
• Acquire commercial activity assets (including
  foreign real estate) through an at least 50
  owned subsidiary - - under FIRPTA attribute
  assets upward (Treas. Reg. 1.897-2(e)(3))
  under 892 no upward attribution from a subsidiary
• Acquire investment assets that would constitute
  at least 90 of total relevant assets to satisfy
  FIRPTA investment company rule under which such
  assets would be treated as trade or business
  assets. Treas. Reg. 1.897-1(f)(3)(ii)

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Election to disregard a wholly owned entity is
not possible
A business entity wholly owned by a foreign
government or any other entity described in
1.892-2T (i.e., controlled entity of a foreign
government) is a per se corporation -- even if
not organized under the laws of the foreign
government and so not a controlled entity that
could qualify for exemption. Treas. Reg.
301.7701-2(b)(6). Treaty (or other) jurisdiction
LLC cant elect to be disregarded.
Foreign Government
Treaty or Cayman SPV
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Controlled Commercial Entities

• The exemption does not apply, and Section 892 is
  turned off entirely, to ANY income even income
  otherwise described in 892 derived by or
  through a controlled commercial entity
• This all or nothing rule applies only to
  controlled commercial entities, not to integral
  parts the original theory being (probably) that
  foreign governments that own inherently
  commercial entities should not benefit from 892
  Qantas Airlines case

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Controlled Commercial Entities

• What is a commercial activity? Under Treas. Reg.
  1.892-4T(b),
• Except as otherwise provided, includes 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.
• An activity may be considered a commercial
  activity even if it does not constitute the
  conduct of a trade or business under Section
  864(b).
• Nevertheless, commercial activity is probably
  fairly co-extensive with conduct of a trade or
  business under Section 864
• Note that the scope of the exemption is NOT
  co-extensive with the scope of the definition of
  commercial activity
• An activity throwing off dividends or interest
  can be a commercial activity (such as activities
  undertaken as a dealer or investments made by a
  banking, financing or other similar business),
  and
• Income from a noncommercial activity may not be
  covered by Section 892 (e.g., trade show receipts)

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Special CCE Rule for Government Pension Trust

• A government pension trust that earns only income
  that would not be UBTI if it were a qualified
  trust under 401(a) is not treated as a CCE.
  However, for purposes of taxation, only income
  that is exempt and not from a commercial activity
  without regard to this special rule is exempt.
  Treas. Reg. 1.892-5T(b)(3)

Foreign Government Pension Trust
Shopping center Independent agent leases and
manages
US stocks and bonds
Investment in shopping center NOT treated as UBTI

• A Foreign Government Pension trust is not a CCE
  so income from stocks and bonds is exempt. But
  income from the shopping center is not covered by
  Section 892
• If not a pension trust, but another type of
  controlled entity, no income exempt as it would
  be a CCE assuming that shopping center activity
  is commercial

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Controlled Commercial Entities

• As interpreted by the IRS, all of this means that
  a CCE that engages to any extent in any
  commercial activity anywhere in the world cannot
  qualify to any extent for the Section 892
  exemption
• When it applies, taints all other income of the
  CCE (except as discussed on previous slide in
  respect of pension trusts)
• Moreover, any income, such as a dividend, derived
  by a foreign sovereign from or through a CCE is
  excluded from Section 892 a tracking rule
  applies
• The all or nothing rule forces foreign
  sovereigns to act directly, without using
  controlled entities, or to limit their percentage
  interest to less than 50

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Difference in Treatment of Integral Part CCE
Foreign Government
Foreign Government
KHD Stand
10 billion US stocks and bonds
Controlled Entity
Income on stocks and bonds exempt under 892
Kazakhstan hot dog stand (KHD) 10 billion
US stocks and bonds Income on stocks
and bonds NOT exempt
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Controlled Commercial Entities

• The regulations contain rules for attributing
  commercial activity among affiliated entities
• A subsidiary is deemed to have commercial
  activities if its parent does this is to
  prevent commercial entities from hiving off
  noncommercial activities into subsidiaries
• A subsidiarys commercial activity is not
  attributed to its parent or to its sisters
  (although the parents dividends from that
  subsidiary will not qualify for exemption)

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Controlled Commercial Entities

• Note that an entity will be treated as engaged in
  a commercial activity if it is a partner of a
  partnership (other than a PTP) that is so engaged
• This rule should be changed
• No revenue impact the only effect of the rule is
  to taint unrelated investments that a CCE partner
  may have
• While the rule made some sense when section 892
  covered all US source income, today a sovereign
  investor in a partnership that carries on a
  commercial activity would never be entitled to
  exemption on any partnership ECI

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Use of Blockers

• CCEs cannot use blockers to earn exempt income,
  because neither a non-controlled blocker nor a
  controlled blocker will be entitled to the 892
  exemption (i.e., no income of a CCE is exempt)
• A blocker can, however, cut off commercial
  activity such that the controlled entitys other
  income remains untainted
• A non-controlled blocker can also be used to
  achieve exemption of FIRPTA gain

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Basic Blocker Structure
Foreign Government
Parent CE
BadCo
GoodCo
Partnership
Stocks and Bonds
Operating Business
Operating Business
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Use of Blockers

• If a partnership uses below-the-fund blockers,
  there will still be the potential for its
  commercial activity to be attributed to a CCE
  partner, even if the CCE has no share of the
  income from such activity
• This problem can be avoided by setting up a
  parallel partnership to invest in the blocker

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Parallel Fund with Blocker
Foreign LP
892 Entity
Taxable LPs
GP
Parallel Fund
Fund
Blocker
Corps
LLC
Operating Business
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Partnerships

• Generally, a partnership is an aggregate, so if
  partnership has good or bad income, it flows
  through as such
• But as noted above, a partnership interest is not
  a security and so the sale thereof is not
  covered by Section 892
• Treas. Reg. 1.892-3T(a)(2) states Gain on the
  disposition of an interest in a partnership or a
  trust is not exempt from taxation under section
  892.
• But that is not the same as saying that such gain
  is subject to tax if the partnership is not
  engaged in a US trade or business, normally there
  is no tax on the sale of a partnership interest
  under the Code
• A publicly traded partnership (PTP) is treated
  like a publicly-traded corporation for purposes
  of determining gain on the sale of the PTP
  interest (not for gain on the PTPs sale of
  property). Treas. Reg. 1.897-1(c)(2)(iv)
• For PTP interests not greater than 5, there is
  no FIRPTA tax
• For PTP interests greater than 5, there is a
  FIRPTA tax only if the PTP would be a USRPHC were
  it a corporation

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Partnerships (cont. 2)

• If a foreign government partner sells an interest
  in a partnership that owns non-controlled
  USRPHCs, and section 897(g) applies such that the
  sale would normally be subject to withholding
  tax, the section 892 exemption should be
  available.
• Section 892(a)(1)(A) exempts from tax income from
  stock investments
• Under Treas. Reg. 1.892-3T(a)(2), income from
  stock includes gain from its disposition
• Treas. Reg. 1.892-3T(b), example 1, paragraph
  (ix) makes clear that the exemption applies to
  gain from the disposition of a non-controlling
  interest in a USRPHC
• Treas. Reg. 1.892-5T, example 4(c),
  illustrates that the 892 exemption generally
  applies on a look-through basis to income from
  stocks and bonds owned by a partnership. PLR
  9643031 confirms this aggregate approach to the
  892 exemption
• But, how to prove availability of exemption to
  buyers satisfaction?
• Seller can seek an IRS issued withholding
  certificate under Treas. Reg. 1.1445-3, but
  takes 90 days

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Partnerships (cont. 3)

• Is a partnerships gain on the sale of a
  non-controlled USRPHC qualifying capital gain
  under section 892 to a foreign government
  partner?
• Could assert that gain is not ECTI under Treas.
  Reg. 1.1446-2(b)(2)(iii), such that withholding
  does not apply under Treas. Reg.
  1.1446-1(c)(2)(ii)(G)
• Example where an 892 eligible entity remains
  subject to withholding under section 1446
  Integral part of foreign government realizing
  exempt and clearly non-exempt income
• These problems also could be solved by forcing
  the partnership to distribute USRPHC stock in
  kind for direct sale by foreign government, but
  does that approach make sense?

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Withholding Issues

• Section 1441 withholding on dividends and
  interest is avoided by filing Form W-8EXP
• Regular FIRPTA withholding under Section 1445
  (not where investment is made through a
  partnership) is avoided in one of two ways under
  Treas. Reg. 1.1445-10T
• By delivery of a non-recognition statement
  claiming the 892 exemption or
• By obtaining a Treas. Reg. 1.1445-3 withholding
  certificate

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Closing Remarks
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Presenter Contact Details

• Michael A. DiFronzoDeputy Associate Chief
  Counsel (International - Technical)Office of
  Chief Counsel, Internal Revenue Service
• Kimberly S. BlanchardWeil, Gotshal Manges
  LLPdirect dial [phone]direct fax
   [phone]kim.blanchard_at_weil.com

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Presenter Contact Details

• Deanna Flores, Principal
• KPMG LLP direct dial  [phone]
  direct fax   [phone]
• djflores_at_kpmg.com
• Alvin D. Knott, Principal
• KPMG LLP
• direct dial [phone]
• direct fax [phone]
• adknott_at_kpmg.com

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Bibliography Further Reading

• New York State Bar Association Tax Section,
  Report on the Tax Exemption for Foreign
  Sovereigns Under Section 892 of the Internal
  Revenue Code, June, 2008
• Joint Committee on Taxation Report (JCX-49-08),
  Economic and U.S. Income Tax Issues Raised by
  Sovereign Wealth Fund Investment in the United
  States, June 17, 2008