Sovereign wealth funds should consider the effect of these rules on their existing and future US investments. They should also revisit opportunities they may have passed up earlier to determine whether these changes might improve the investments' prospects.
'Hot dog stand' trap eliminated
The US proposals, issued in September 2011, provide a welcome exception for inadvertent commercial activities of a controlled entity. Under existing rules, income from any commercial activity anywhere in the world conducted by a controlled entity would cause it to become a 'controlled commercial entity' (CCE), disqualifying the income of (and from) the entity from the sovereign exemption. To use a common example, even operating a single hot dog stand outside of the US would be enough to put the fund offside.
This 'all or nothing' rule created significant traps for the unwary and often required inefficient tax planning or discouraged US investment altogether. The proposed regulations contain an inadvertency exception that allows a controlled entity that has gone offside to cleanse its operations or avoid CCE classification altogether.
The proposed regulations also contain a related safe harbor to avoid CCE status for inadvertent commercial activity. Under the safe harbor, CCE status can be avoided if the controlled entity passes two tests:
- Asset test – The value of the assets used in or held for use in commercial activities may not exceed 5 percent of the total value of the entity's assets for the tax year.
- Income test – Income earned from commercial activities may not exceed 5 percent of the entity's gross income (as shown on the income statement) for the tax year. To use the safe harbor exception, the fund would need to have written policies and procedures in place to monitor the entity's worldwide activities.
CCE status determined annually
The pre-existing guidance, introduced in 1988, did not set any testing period for determining the status of controlled entities. This lack of clarity created a spectrum of possibilities. Under one interpretation, even a single commercial activity would cause a controlled entity to remain a CCE forever.
Under the proposed regulations, the CCE determination is made annually. The proposals clarify that a controlled entity will not be deemed a CCE for the current tax year simply because it engaged in commercial activities in an earlier year.
New commercial activity exceptions for partnerships
Under the temporary regulations, commercial activities of a limited partnership were attributable to its general and limited partners (except for certain interests in publicly traded partnerships). For sovereign wealth funds, this commercial activity attribution rule discouraged investment in the US because any ownership interest in a flow-through entity could render a controlled entity a CCE, even if the commercial activity is conducted several tiers below the sovereign wealth fund investment.
The proposed regulations create two new exceptions. Under the first exception, a controlled entity will not be a CCE solely because it owns an interest in a partnership that trades in stocks, bonds, other securities, commodities, or financial instruments for the partnership's own account. Generally, this exception is intended to put partnerships on par with controlled entities in their ability to effect transactions for their own account.
The second exception states that a limited partnership's commercial activities will not be attributed to a controlled entity that owns only a limited partner interest in the partnership. Briefly put, a limited partner's interest is an interest that affords no rights to participate in managing or conducting the partnership's business. This exception is expected to be helpful for sovereign wealth funds whose investments are subject to legal or practical restrictions.
Proposals welcome, but pitfalls remain
These proposals offer sovereign wealth funds opportunities to enter new investments or to make existing investments in a more straightforward, tax-efficient fashion. Despite their benefits, however, the existing and proposed rules are complex and detailed in their scope and application, and some significant pitfalls and traps remain. For example, even though the commercial activity requirements have been eased, certain indirect real property investments can still create a CCE determination.
Sovereign wealth funds with US investments should examine their investments – past, current and future – to determine the impact of these proposals on their decisions and investment structures.
Background – US tax treatment of foreign governments' income
US tax law exempts from US federal income tax certain income earned by a 'foreign government' and by certain qualifying entities controlled by a foreign government that are organized in the sovereign's jurisdiction. A controlled entity of a sovereign does not qualify for this relief if it engages in any 'commercial activity', even if the only commercial activity is outside of the US. Thus, a sovereign fund that is a 'controlled entity' under these rules is only eligible for relief if the entity is not engaged in any commercial activity as determined for purposes of these rules. Note that US tax law generally does not provide other forms of US federal tax relief unless the sovereign is eligible for US tax treaty relief.
The US treats a foreign government as a corporate resident of its country for tax purposes. Thus, in the absence of the sovereign exemption or a favorable tax treaty, a sovereign wealth fund generally is subject to income tax on its investment income from US sources (i.e. 'fixed or determinable annual or period income' or FDAP, which includes items such as dividends and interest) and on US business income (i.e. 'effectively connected income' or ECI).
The tax exemption for foreign governments specifically applies to US-source FDAP income that is not treated as business income and does not extend to US business income. Thus, the exemption generally applies to dividends, as well as to non-business interest, rents and royalties. Capital gains, for example, from sales of US company shares, generally are exempt from tax under US domestic law (in other words, the exemption does not depend on the non-US persons status as a sovereign). Note that this general exemption from US tax on share gain does not apply to gain from a sale of shares of a US company that qualifies as a US real property holding corporation. However, a foreign government may enjoy relief from US tax in such cases if its ownership of the US real property holding corporation falls below certain control thresholds.
This sovereign exemption is particularly important for Middle Eastern sovereign wealth funds because no Gulf Cooperation Council countries have entered into income tax treaties with the US.
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