Sovereign and special has been saved
Sovereign and special
ME PoV Spring 2021 issue
U.S. tax exemptions for Sovereign Wealth Funds
The purpose of Sovereign Wealth Funds (SWF) is to invest excess cash resulting from a trade surplus in the hope of generating higher returns for governments. As investment arms of any sovereign nation responsible for managing and investing the nation’s wealth in domestic and international markets, SWFs play a vital role in the generation of wealth, employment, value creation and the overall sustainability of a global economy.
Sovereign Wealth Funds are often portrayed in news outlets as making mega deals in various continents, backing major multinational companies and private equity funds in the world. According to the Sovereign Wealth Fund Institute (SWFI), the Government Pension Fund of Norway, China Investment Corporation and Abu Dhabi Investment Authority are the top three listed SWFs in the world with total combined assets in excess of US$2 trillion dollars1.
Why is Section 892 important for SWFs based in the Middle East?
According to SWFI, four of the top ten SWFs in the world are based in the Middle East. As part of a diversification strategy away from oil and gas, SWFs are broadening their investments in various sectors such as technology, real estate, private equity, and hedge funds. As far as investment commitment by geographies are concerned, the United States is considered as a preferred location when it comes to investments from SWFs. Foreign direct investment from SWFs in the United States can be considered as a major source of cash flow for the U.S. economy. So to encourage a smooth and continual flow of cash, the U.S. internal revenue code includes a special rule, under Section 892, that proffers upon the foreign government or its integral parts, a tax exemption on investments made in the United States. With certain caveats.
Some of the investments covered by Section 892 are interests, dividends and gains arising from stocks, bonds, securities, and bank deposits. As a general rule, foreign persons are generally subject to a 30 percent U.S. withholding tax on U.S.-sourced dividends unless there is a treaty benefit. Section 892 may exempt SWFs from this type of withholding tax. Similarly, if any foreign person owns more than a 10 percent vote or value in any corporation, interest income from such source would be subject to 30 percent withholding tax unless there is a treaty benefit which would reduce the rate. There is a special provision in the U.S. tax law, known as portfolio interest exception, which stipulates that as long as a foreign investor owns less than a 10 percent vote or value in the borrower, the foreign investor is not subject to withholding tax on the interest income. However, Section 892 exempts a foreign government from the 30 percent withholding tax on all interest from non-controlled borrowers that does not otherwise satisfy the portfolio interest exception.
Even in the case that a SWF of a particular nation does not have a bilateral tax treaty with the U.S. government, earnings from certain non-commercially motivated investments (primarily debt and equity investments) are still tax exempt under Section 892. For example, Middle Eastern countries such as the UAE, Qatar, and Bahrain do not have a tax treaty with the United States. If a foreign investor from these nations were to lend a greater stake than 10 percent in a U.S. company, their interest income would be subject to a 30 percent withholding tax. However, SWFs are exempt from these rules, and that is one of the benefits they are granted.
Not all investments by SWFs can be tax-free
Although Section 892 is a special mechanism by which SWFs get tax-free treatment in the United States, there are certain caveats. Any income derived by SWFs from the conduct of a commercial activity (with the exception of trading or investment), income received directly or indirectly from a “commercially controlled entity” and any gain derived from the disposition of any interest in a “commercially controlled entity” does not get exemption under Section 892.
A “commercially controlled entity” can be defined as any separate entity (corporation or partnership) engaged in the commercial activity in any part of the world in which the foreign government holds directly or indirectly greater than a 50 percent vote or value or any interest that would mean an effective control of such entity. Any income generated in the United States by such a commercially controlled entity loses Section 892 exemption for the foreign government or SWF and is subject to regular income tax. For example, should a foreign government, which does not have a tax treaty with United States, directly own a 60 percent stake in a U.S. corporation engaged in trade or business, and its share of dividend income is US$100, it is not exempt under Section 892 and is subject to the full 30 percent withholding tax, unless reduced by treaty benefits. Similarly, let’s say that the same, above-mentioned foreign government also separately owns less than a 50 percent stake or value of a stock of a U.S. multinational company, its share of income derived from the company is not taxable under Section 892—based on the consideration that a foreign government is not engaging in commercial activity due to investment exceptions (i.e. where less than a 50 percent investment in stocks, bonds and loans are not considered as a commercial activity).
All or nothing rule
It is key to distinguish between a “commercial controlled entity” and “controlled entity”. While SWFs are typically a controlled entity of a foreign government, not all investments made by SWFs are necessarily through a commercial controlled entity. As explained above, if a foreign government engages in a commercial activity, only that income is tainted from Section 892 exemption but not from other investments, where foreign government in not involved in commercial activity. However, under an all or nothing rule, if a “controlled entity” (i.e. SWF) engages in any commercial activity and earns only US$1 income from the specific activity, there is a risk that it may entirely lose the benefit of Section 892 exemption, not only on that US$1 income but on its entire portfolio (even income from other non-commercial activity) because that SWF is now considered as a “controlled commercial entity” of a foreign government. This can be a huge challenge and trap for unwary foreign governments and SWFs as they start making investments in the United States without proper tax planning and due diligence.
Commercial Controlled Entities exceptions
According to the proposed regulations from the Internal Revenue Service (IRS), there are certain circumstances where being considered as commercial controlled entities can be avoided, allowing entities to benefit from Section 892 exemption. There is a new de minimis exception rule for inadvertent commercial activity by controlled entities of foreign governments which should provide a safe harbor for controlled entities to make investments as long as certain criteria are met. Even if all requirements of the de minimis exception are met, all income derived from the inadvertent commercial activity will be subject to U.S. tax but may not taint income from non-commercial activity. The determination of whether a controlled entity is a commercial controlled entity must be made on an annual basis. Similarly, under the proposed regulations, an entity will not be treated as engaged in commercial activity merely because it holds a limited partner in a limited partnership provided certain conditions are met.
As SWFs in the Middle East continue to grow in number and size, it is fair to say that there is a lot of foreign direct investment appetite in the United States, and Section 892 is one of the key U.S. tax provisions available to foreign governments and SWFs. This is especially important for Middle-East based SWFs as some of these nations still do not have a tax treaty with the United States. However, any time SWFs are inadvertently engaged or are even perceived to be engaged in commercial activities, there is a risk that tax exemption under Section 892 will not apply. Therefore, anytime an investment is made in the United States, it is important for the tax department of SWFs to have a thorough and careful due diligence/planning process and properly review investment documents.
by Holly Byrnes, Partner and Abi Man Joshi, Director, Tax, Deloitte Middle East