Section 892 rules address how foreign governments qualify for US tax exemption

Section 892(a) exempts from U.S. federal income tax certain types of income received by foreign governments, including their CEs, from investments in the United States. The exemption generally covers income from stocks, bonds, other domestic securities, financial instruments held in the execution of governmental financial or monetary policy, and interest on deposits in U.S. banks.

However, the exemption does not apply to any of the following types of income:

• Derived from the conduct of any commercial activity either within or outside the United States
  
  
• Received by a CCE or received directly or indirectly from a CCE
  
  
• Derived from the disposition of any interest in a CCE

Under section 892, a foreign government investment exempt from tax includes only the integral parts of a foreign sovereign and CEs of the foreign government.

Definition of a CE: A CE is defined as an entity that is wholly owned and controlled by a foreign sovereign, either directly or indirectly through one or more controlled entities, and whose net earnings do not inure to the benefit of any private person but only to its own account or to other accounts of the foreign sovereign.

Commercial activities

The final regulations provide a broader definition of "commercial activities" to include any activity ordinarily conducted for the current or future production of income or gain, regardless of whether it constitutes a trade or business under section 864(b).

In the preamble to the final regulations, the IRS and the Treasury Department clarified that an activity’s commercial character is determined by the nature of the activity itself, not by the purpose or motivation for undertaking it.

The final regulations clarify that activities qualifying as a trade or business under sections 162 or 864(b) are commercial activities for section 892 purposes, unless an express exception applies.

The investment exception to commercial activities

Although section 892 itself does not specify which activities constitute commercial activities, the regulations provide important exclusions. In general, commercial activities do not include investment activities, governmental functions, cultural events, purchases of goods for sovereign use, or nonprofit activities.

With respect to loans, separate proposed guidance addresses when loan origination and acquisition constitute investment activity. See the section below covering the proposed regulations.

The final regulations expand the investment and trading exceptions for financial instruments. Whereas earlier rules limited the exception to instruments held in furtherance of governmental monetary policy, the final regulations permit foreign governments to invest and trade, as nondealers and for their own account, in a broad range of market-standard derivatives without engaging in commercial activities. 

This expansion aligns section 892 rules with trading safe harbors under section 864(b). However, the preamble provides that if a contract or other financial instrument would be characterized under general federal income tax principles as resulting in beneficial ownership of a reference asset, the determination of whether the foreign government investor is conducting commercial activity is made based on ownership of that asset and not with regard to the financial instrument.

The final regulations also clarify that holding bank deposits in any currency, including nonfunctional currency, is not a commercial activity, as merely holding cash is not an income-producing activity.

Partnership equity interests

The final regulations also clarify the treatment of partnership equity interests. Merely holding or trading a partnership interest for a foreign government’s own account—unless as a dealer—is not, by itself, commercial activity.

However, the final regulations retain the rules that commercial activities conducted by a partnership are attributed to its partners. As a result, income or gain from those activities is not exempt under section 892 unless the partner meets the QPI requirements.

QPI exception and safe harbor

Although a partner in a partnership is deemed to be engaged in the activities of the partnership, the final regulations under section 892 clarify that holding a QPI does not cause the foreign government or CE to be treated as engaged in commercial activities.

As a result, these partners remain eligible for section 892 exemption on income from noncommercial activities. However, the QPI holders are still subject to tax on their share of the partnership’s commercial income.

The QPI exception applies only to holders of partnership equity interests who participate passively in the partnership. To qualify as a QPI, a holder of a partnership interest can not:

• Have limited personal liability for claims against the partnership
  
  
• Have authority to enter contracts or act on behalf of the partnership
  
  
• Control the partnership within the meaning of §1.892–5(a)(1)
  
  
• Have rights to participate in the day-to-day management or operation of the partnership

The final regulations also provide a QPI safe harbor. Under this safe harbor, an interest is automatically treated as a QPI without requiring a facts-and-circumstances analysis of management rights and limited liability, provided the partner meets all of the following criteria:

• Is an entity with limited liability (within the meaning of regulation 301.7701-3(b))
  
  
• Does not have the authority to bind or act on behalf of the partnership, is not the partnership’s managing partner, managing member, or equivalent
  
  
• Does not own directly or indirectly more than 5% of either the partnership’s capital interests or partnership’s profits interest

Controlled commercial entities (CCEs) defined

Amounts received by a CCE are not exempt from tax under section 892, including income received directly or indirectly from a CCE, or income from disposing of an interest in a CCE. The regulations provide that an entity is considered a CCE if it is engaged in commercial activities and if one of the following two conditions involving a non-U.S. government applies:

• Owns at least 50% of the entity (by value or voting power)
  
  
• Has effective control over the entity (See effective control definition in the proposed regulations section).
   

U.S. real property holding corporations (USRPHC)

A USRPHC, as defined in section 897(c)(2), is generally treated as engaged in commercial activity and thus as a CCE if the foreign government meets the ownership or control thresholds. This is known as the "USRPHC per se rule."

The final regulations narrow the USRPHC per se rule so that it applies only to domestic corporations that are USRPHCs. For domestic corporations, the per se rule still applies, but the regulations retain a minority interest exception for foreign government.

Under section 1.892-5(b)(1)(ii)(B), a minority interest exception allows a foreign government investor to avoid losing the section 892 tax exemption solely because its holding company is classified as a USRPHC due to noncontrolling, minority interests in other such corporations.

Inadvertent commercial activity exception

Relief is available for entities that unintentionally engage in commercial activity, provided the activity is corrected within 180 days of discovery, the failure was reasonable, and appropriate records are maintained.

A safe harbor applies when assets or income from the inadvertent activity do not exceed 5% of the entity’s total, and written policies and procedures exist to prevent and monitor worldwide commercial activities.

Note that income from inadvertent commercial activities, including partnership attributed income is not exempt under section 892.

Annual CCE determination

The final regulations require that whether an entity is a CCE must be determined on an annual, taxable-year basis. An entity that engages in commercial activities at any time during a taxable year is treated as a CCE for the entire year. If the entity does not engage in any commercial activities during the taxable year, it is not treated as a CCE for that year.

In making this determination, the entity’s activities during its immediately preceding taxable year must also be considered to the extent they are relevant in characterizing the entity’s activities in the current year.

If a corporation engaged in commercial activities is acquired in a transaction described in section 381(a), the acquiring corporation is generally not treated as conducting commercial activities in the year of acquisition solely because it acquires and holds the target’s assets.

This relief applies only if the target corporation’s taxable year ends as a result of the acquisition and the acquiring corporation does not directly continue the commercial activities.

If the acquisition occurs between corporations controlled by the same foreign sovereign, for example, in a complete liquidation of a subsidiary under section 332(a), the acquiring corporation is treated as conducting commercial activities for the taxable year in which the acquisition occurs, regardless of whether the transferor’s taxable year ends or whether the acquiring corporation directly continues the commercial activities.

Effective dates

The final regulations apply to tax years beginning on or after Dec. 15, 2025. Taxpayers may elect to apply them to any prior year for which the statute of limitations remains open.

The proposed regulations clarify three key areas:

• Exclusion of partnerships from the definition of a CE
  
  
• Debt acquisition as commercial activity
  
  
• Definition of “effective control”

Exclusion of partnerships from the definition of a CE

Partnerships are explicitly excluded from the definition of a CE for U.S. tax purposes, even if they are wholly owned by a single foreign government.  

Debt acquisition as commercial activity

Debt acquisitions are generally considered commercial activity unless they meet specific exceptions. They are not treated as commercial activity if they fall within safe harbors, such as registered offerings, qualified secondary market acquisitions, or if they qualify as an investment based on all the relevant facts and circumstances.

The facts-and-circumstances test looks at factors such as whether the acquirer helped structure the debt, received any non-interest compensation, the form and process of the debt issuance, and whether the acquirer holds equity in the issuer.

Definition of “effective control”

“Effective control” is defined as having the ability to influence or direct an entity’s key decisions, at the operational, managerial, board-level, or investor-level, based on all relevant facts and circumstances. This control can arise from equity or debt ownership, contractual rights, business relationships, or other arrangements, whether individually or combined.

Effective dates

The proposed regulations will apply to tax years beginning on or after their finalization date. A foreign government may elect early application for taxable years of its wholly owned entities (direct or indirect) beginning before finalization, provided the following two criteria are met:

• The statute of limitations for the entity remains open
  
  
• The rules are applied consistently and in full for that year and all subsequent years beginning before finalization

• Attribution of commercial activities: The regulations reinforce the rule that commercial activities of partnerships are attributed to partners unless the QPI exception applies. Foreign government investors may benefit from ensuring that their interests in partnerships are considered a QPI.
  
  
• Debt investments: Under the proposed regulations, the broader definition of commercial activity means that certain activities previously thought to be passive investments may now be considered commercial. The new framework for debt investments may require foreign government investors to reassess their direct lending and private credit strategies to ensure continued eligibility for section 892 exemption.
  
  
• Inadvertent commercial activity: The safe harbor provides some relief for inadvertent commercial activity, but strict compliance with the requirements is necessary. This includes the foreign government investments have appropriate policies and procedures to monitor commercial status and methods to cure any inadvertent commercial activity.