The Final Regulations finalize, with modifications, regulations that were proposed under section 892 in 2011 and 2022. Concurrently with the Final Regulations, Treasury and the IRS issued newly proposed regulations (the “Proposed Regulations”) which provide new guidance on the treatment of debt acquisitions and the determination of whether an entity is controlled commercial entity ("CCE").
At a high level, the Final Regulations and Proposed Regulations address the following key topics, each of which is discussed in greater detail in the body of this alert:
- The Final Regulations (i) clarify that commercial activity generally does not include investing and trading in derivatives for one’s own account or entering into certain securities loans; (ii) finalize a “qualified partnership interest” exception to commercial activity attribution (previously known as the “limited partner exception”); (iii) eliminate a per se rule that previously had denied section 892 benefits to certain controlled foreign entities whose assets consist predominantly of interests in U.S. real property; and (iv) finalize the inadvertent commercial activity exception first set forth in the 2011 proposed regulations.
- The Proposed Regulations (i) establish a framework for when acquisitions of debt (including at origination) are treated as investments rather than commercial activity; and (ii) provide additional guidance on the “effective practical control” (now termed “effective control”) standard applied in determining when entities are CCEs, which are ineligible for the section 892 exemption.
The Final Regulations are effective on the date of publication in the Federal Register (December 15, 2025). Treasury and the IRS may consider finalization of the Proposed Regulations after receiving comments during a 60-day comment period.
Background: Section 892 and commercial activities
Section 892 generally exempts from U.S. federal income tax certain investment income earned by foreign governments and their integral parts and wholly owned same-country subsidiaries, including income from stocks, bonds, and other securities, and from financial instruments held in the execution of governmental financial or monetary policy. The exemption does not apply to (x) income derived from the conduct of “commercial activity,” (y) income received from or by a CCE or (z) income from the disposition of interests in a CCE.
Under temporary regulations promulgated in 1988, “commercial activity” generally is defined broadly. Subject to certain exceptions, all activities (whether conducted within or outside the United States) that are ordinarily conducted for the current or future production of income or gain are treated as commercial activities. Under the framework set forth in the 1988 temporary regulations, only certain specifically enumerated investment activities, such as investing or trading in stock, securities or commodities for the foreign government’s own account or investing in financial instruments held in the execution of governmental financial or monetary policy, are excluded from treatment as commercial activities.
Although the 2011 proposed regulations under section 892 would have removed the requirement that financial instruments be “held in the execution of governmental financial or monetary policy” in order to not be treated as commercial activity, they appear to define the term “financial instrument” as limited to contracts referencing currency or precious metals, which would exclude many common financial derivatives.
Final regulations
Derivatives and securities lending
The Final Regulations clarify that investing and trading for one’s own account in garden-variety financial derivatives (for example, interest rate, currency, equity, or commodity swaps, or options, forwards or futures referencing commodities, currencies, equity, or debt) generally does not give rise to section 892 commercial activity. The preamble to the Final Regulations explains that “investing and trading in such financial instruments generally involve only putting capital at risk and do not involve activity such as structuring the instrument, in contrast to structuring bespoke, non-market standard derivatives” and that “thus, the expected return is generally a return exclusively on capital rather than the activities conducted.”
This clarification represents welcome guidance, given that as noted above, the 2011 proposed regulations appeared to define “financial instruments” as being limited to contracts that reference currencies or precious metals.2 In addition, the Final Regulations confirm that securities loans described in section 1058(a) are investment and not commercial activity.
Qualified partnership interest exception (f/k/a the “limited partner exception”)
The Final Regulations finalize with modifications the “limited partnership interest exception” included in the 2011 proposed regulations, which provided that an entity is not engaged in commercial activities merely because it holds an interest as a limited partner in a limited partnership, even if such partnership is itself engaged in commercial activity (although the limited partner’s distributive share of partnership income arising out of commercial activity is not eligible for the exemption under section 892).
The Final Regulations generally finalize the foregoing exception, re-naming it as the “qualified partnership interest exception” and articulating four requirements designed to ensure that the qualified partnership interest exception is available only to partnership equity interest holders with passive participation in the partnership (a “qualified partnership interest”). For these purposes, a “qualified partnership interest” is defined as a partnership interest if the holder of such interest (i) has limited liability within the meaning of Treasury regulations section 301.7701-3(b)(2)(ii); (ii) does not possess the legal authority to bind or to act on behalf of the partnership; (iii) does not control the partnership (i.e., own 50% or more of the vote or value of the partnership or holds interests that amount to “effective control”, as discussed in more detail below); and (iv) does not have rights to participate in the management and conduct of the partnership’s business at any time during the partnership’s taxable year.
For these purposes, rights to participate in the management and conduct of a partnership’s business mean rights to participate in the day-to-day management or operation of the partnership’s business, including the right to participate in ordinary-course personnel and compensation decisions and the right to take active roles in formulating the business strategy for the partnership. By contrast, rights to participate in monitoring or protecting the partnership interest holder’s capital investment in the partnership do not constitute rights to participate in the management and conduct of the partnership’s business.
Such non-management rights may include oversight or supervisory rights in the case of major strategic decisions, such as admission or expulsion of a partner, amendment of the partnership agreement, or dissolution of the partnership, unusual and non-ordinary course deviations from previously determined investment parameters, extending the term of the partnership’s governing agreement, merger or conversion of the partnership, or disposition of all or substantially all of the partnership’s property outside of the ordinary course of the partnership’s activities.
Generally, the determination of whether a partnership interest is a qualified partnership interest depends on consideration of all relevant facts and circumstances. Helpfully, however, the Final Regulations provide a safe harbor for a holder of partnership interests that, at all times during the partnership’s taxable year, (i) has no personal liability for claims against the partnership; (ii) has no right to enter into contracts or act on behalf of the partnership; (iii) is not a managing member or managing partner, and does not hold an equivalent role under applicable law; and (iv) does not directly or indirectly own more than 5% of either the partnership’s capital interests or the partnership’s profits interests (which generally would include carried interest).
As under the 2011 proposed regulations, the Final Regulations provide that even in the case of a qualified partnership interest, the partner’s distributive share of partnership income that is derived from the conduct of commercial activity is not exempt from tax under section 892.
Elimination of per se rule for foreign U.S. real property holding corporations
As noted above, section 892 does not exempt income from or derived by a CCE. The 1988 temporary regulations provided that any U.S. real property holding corporation (a "USRPHC") as defined in section 897(c)(2) (very generally, any domestic corporation the value of whose business assets and interests in real property is attributable at least 50% to interests in U.S. real property at any time during a five-year lookback period), or a foreign corporation that would be a USRPHC if it were a domestic corporation, is automatically treated as engaged in commercial activity (the “USRPHC Per Se Rule”). The 2022 proposed regulations created exclusions from the USRPHC Per Se Rule for certain qualified foreign pension funds and certain qualified controlled entities, as well as for a corporation that is a USRPHC solely by reason of its direct or indirect ownership interest in one or more corporations that are not controlled by the foreign government (e.g., interests in a REIT). The Final Regulations eliminate the USRPHC Per Se Rule altogether as applied to foreign corporations and limit the USRPHC Per Se Rule solely to domestic USRPHCs as defined in section 897(c)(2).
The Final Regulations also retain and clarify the minority‑interest exception for interests in domestic corporations that are USRPHCs solely because of their direct or indirect minority interests in one or more noncontrolled corporations. The Final Regulations adopt a balance sheet method as the only method permitted to be used when applying this exception. Under the balance sheet method, any ownership interests in noncontrolled corporations are removed from an entity’s balance sheet before determining whether interests in U.S. real property constitute 50% or more of the value of the entity’s non-excluded assets.
Lastly, the Final Regulations clarify that the disposition of an interest in U.S. real property does not by itself give rise to commercial activities.
Inadvertent commercial activity
The Final Regulations finalize proposed regulations in 2011 that provided that an entity that inadvertently engages in commercial activities will be treated as not engaged in commercial activities if (i) failure to avoid conducting the commercial activity is reasonable, (ii) the commercial activity ceases and is “cured” promptly and (iii) record maintenance requirements are satisfied.3 This preserves section 892 eligibility for other qualifying income, but income from the inadvertent commercial activity (including amounts attributed through a partnership) remains taxable.
Proposed regulations
Debt acquisitions: investment versus commercial activity
The Proposed Regulations would establish a framework for determining when the acquisition of debt (including the acquisition of loans at origination) is an investment rather than a commercial activity.
The new framework includes two safe harbors exempting acquisitions of (i) debt securities acquired from unrelated underwriters in an offering registered under the Securities Act of 1933, as amended, and (ii) acquisitions of debt traded on an established securities market provided the acquirer is not purchasing from the issuer or participating in negotiation of the terms or issuance of the debt.
For all acquisitions of debt that do not fall within one or both of the safe harbors, the Proposed Regulations provide that the determination of whether the debt is acquired for investment (as opposed to constituting commercial activity) must be made on the basis of all of the facts and circumstances and provides a non-exclusive multi‑factor test. The test generally focuses on whether expected returns are a return on capital versus a return on loan origination activities (e.g., whether the taxpayer solicited borrowers, participated in structuring the debt, negotiated loan terms, and shares in services-flavored fees, as well as the portion of loan acquired by the taxpayer relative to other unrelated holders) and also generally appears to carve out loans made as a shareholder to a subsidiary or affiliate as well as deemed debt issuances arising as a consequence of a debt modification if the debt was not distressed at the time it was acquired by the taxpayer. As a corollary, the Proposed Regulations would remove the portion of the 1988 temporary regulations providing that loans made by a “banking, financing, or similar” business constitute commercial activities, thereby channeling the commercial-activities analysis of loans and debt acquisitions through the new framework.
Key takeaways for sovereign investors arising from this framework are as follows:
- Private credit and direct debt investments: Certain types of direct debt investments, such as investments in middle-market corporate loans, generally may not satisfy the safe harbors for registered or traded debt. However, the multi‑factor test used to determine whether a loan (or interest therein) is acquired for investment generally includes certain analytical factors practitioners historically have applied to conclude that acquisitions of debt should not give rise to section 892 commercial activities or a U.S. lending trade or business under section 864 (albeit without any apparent requirement for the relevant activities to be “considerable, continuous and regular” as required for a trade or business).
- No safe harbor for annual “silver bullet” or “five‑or‑fewer” originations: The Final Regulations decline to adopt a commenter’s request for a “five‑or‑fewer originations” safe harbor that would treat sporadic lending as not being commercial activity. In addition, the Proposed Regulations include an example (Example 1: Isolated debt financing as commercial activity) determining that a controlled entity of a foreign government is engaged in commercial activity solely because it solicited, structured, negotiated and funded a loan to an unrelated foreign borrower. However, the Final Regulations emphasize that the section 892 commercial‑activity determination is distinct from, and generally broader than, the separate U.S. trade or business and effectively connected income analysis under section 864. Indeed, Example 1 explicitly limits its reach to the commercial activity context, observing that it reaches its determination “regardless of whether [the taxpayer] is treated as engaged in a trade or business for purposes of section 162, section 166 or section 864(b).”
- Shareholder loans: The multi-factor test includes a factor allowing taxpayers to take into account whether (and to what extent) the taxpayer owns equity of the borrower in determining whether a loan to the borrower constitutes commercial activities. The Proposed Regulations also include an example applying this factor to conclude that a loan by a foreign corporation to its 80%-owned subsidiary does not give rise to commercial activity (Example 2: Debt financing as investment when combined with certain equity investments).
- Debt modifications: The multi-factor test includes a factor allowing taxpayers to take into account, in the context of a debt issuance arising out of a significant modification of a debt instrument as defined in Treasury regulations 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. The Proposed Regulations also include an example applying this factor to conclude that a foreign corporation that acquired non-distressed debt on the secondary market and that subsequently is deemed to receive newly issued debt in a workout that constitutes a significant modification within the meaning of Treasury regulations 1.1001-3 is not thereby engaged in commercial activities, in a case where the foreign corporation did not participate in the creditors’ committee and was not involved in any aspect of negotiating the debt workout with the borrower (Example 4: Debt modification as investment). However, a second example with similar facts, except that the foreign corporation was a member of the creditors’ committee, which materially participated in negotiating and structuring the terms of the modified debt, appears to conclude that the foreign corporation engaged in commercial activity (Example 5: Debt restructuring as commercial activity).
“Effective control” test
For purposes of evaluating whether an entity is a CCE, the 1988 temporary regulations include both a quantitative and a qualitative test for control. Under the quantitative test, control includes a 50% or greater interest by vote or by value. Under the qualitative test, a less-than-50%-owned entity may still qualify as controlled if the foreign government holds an equity interest or other interest in the entity which provides it with “effective practical control” of the entity. The 1988 temporary regulations provide that that “[e]ffective practical control may be achieved through a minority interest which is sufficiently large to achieve effective control, or through creditor, contractual, or regulatory relationships which, together with ownership interests held by the foreign government, achieve effective control.”
The Final Regulations replace the term “effective practical control” with the term “effective control,” although the preamble to the Final Regulations states no inference is intended that the term “effective control” has any meaning different from that of “effective practical control.”
The Proposed Regulations contain new rules and examples intended to clarify what constitutes “effective control.” Specifically, the Proposed Regulations provide that effective control may be achieved by any interest or interests in the entity that directly or indirectly result in control over the operational, managerial, board-level, or investor-level decisions of the entity, but helpfully clarify that mere consultation rights with respect to operational, managerial, board-level, or investor-level decisions of an entity (such as extending the term of the entity’s investment period, change in control of the entity, or liquidation of the entity) do not alone give rise to effective control.
For this purpose, “interests” may include equity interests, voting power in the entity, debt interests, contractual rights in or arrangements with the entity or with holders of equity or other interests in the entity, certain business relationships with the entity or with other interest holders in the entity, regulatory authority over the entity, or any other arrangement or relationship that provides influence over the entity’s operational, managerial, board-level, or investor-level decisions. Thus, all of the foreign government’s authority, interests, relationships, powers, rights and arrangements would be taken into account in determining whether the foreign government has effective control, considering all relevant facts and circumstances.
The Proposed Regulations also would provide that a foreign government is deemed to have effective control of an entity if the foreign government (i) is, or has “effective control” over, a managing partner or managing member of such entity or (ii) holds or controls an entity that holds an equivalent role with respect to such entity under local law applicable to the entity.
As noted above, the Proposed Regulations are subject to a comment period and potentially additional changes, and will not become effective unless and until final regulations are published in the Federal Register.
Footnotes
1. Unless otherwise indicated, all “section” references contained herein are to sections of the Code.
2. It is not entirely clear whether this limitation in the 2011 proposed regulations was intentional, as the preamble to the 2011 proposed regulations and contemporaneous comment letters suggest an intent to cover a broader universe of derivatives, and as 2013 final regulations under section 871(m) specifically included dividend equivalent amounts on equity derivatives as a category of exempt income under section 892 (which makes little sense if entering into equity derivatives per se qualifies as commercial activity).
3. Reasonableness turns on facts and circumstances and may be satisfied under a safe harbor if, with adequate policies and procedures in place, average quarterly assets used in commercial activity and gross income from such activity each do not exceed 5% of the total value of the entity’s assets and total gross income (respectively) for the year. Any inadvertent commercial activity must be discontinued within 180 days of discovery by responsible employees, and the entity must retain records of the activity and the cure.
