Relaxed IRS rules could rouse foreign investment

US tax authorities have significantly reduced the risk of sovereign wealth funds losing their tax-exempt status should certain trading restrictions be breached.

Ahead of a slew of new regulations designed to encourage investors to pare back private equity commitments, the US Internal Revenue Service has adopted new proposals that will have the opposite effect. 

The US tax office will no longer strip foreign governments of their tax-exempt status should one of their private equity fund investments engage in any “commercial activity”. Unusually, the IRS said the proposals could immediately be relied upon even though final rules have not yet been issued.

Section 892 of the tax code provides foreign governments a tax exemption from passive investment income, such as bonds and stocks. Not allowed are tax-exempt investments in commercial activity, so as not to provide foreign investors an advantage over domestic taxpayers.

These rules will likely help some foreign governments scared of that risk to be more willing to commit to private equity

Peter Furci

 “The rule was quite draconian because if a sovereign wealth fund generated even just one US dollar of income from a commercial activity, its entire US portfolio of stocks and bonds could be subject to tax,” said Debevoise & Plimpton tax partner Peter Furci.

Accordingly, some foreign governments would avoid private equity funds, which if investing in a portfolio company structured as a pass-through commercial entity, could jeopardize their tax-exempt status.

GPs could mitigate that risk by creating side-agreements to avoid flow-through companies or by creating separate holding structures for foreign investors, but “even so, some big sovereign wealth funds were still concerned about risking a multi-billion US portfolio for a relatively small private equity investment”, said Furci.

The proposals clarify that investments not covered by the Section 892 exemption would be taxed without subjecting a foreign investors’ entire portfolio to US tax. “These rules will likely help to make some foreign governments scared of that risk more willing to commit to private equity,” said Furci.