Inbound Investment by Foreign Governments - PowerPoint PPT Presentation

1 / 38
About This Presentation
Title:

Inbound Investment by Foreign Governments

Description:

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN TO BE USED, AND ... Several commentators have criticized this view. See, e.g., Blanchard, 'Rev. Rul. ... – PowerPoint PPT presentation

Number of Views:1389
Avg rating:5.0/5.0
Slides: 39
Provided by: blan81
Category:

less

Transcript and Presenter's Notes

Title: Inbound Investment by Foreign Governments


1
Inbound Investment by Foreign Governments
  • May 8, 2009
  • Investment Management Committee
  • American Bar Association Section of Taxation

2
  • ANY TAX ADVICE IN THIS COMMUNICATION IS NOT
    INTENDED OR WRITTEN TO BE USED, AND CANNOT BE
    USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY
    FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
    MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING,
    MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY
    MATTERS ADDRESSED HEREIN.

3
  • You (and your employees, representatives, or
    agents) may disclose to any and all persons,
    without limitation, the tax treatment or tax
    structure, or both, of any transaction described
    in the associated materials we provide to you,
    including, but not limited to, any tax opinions,
    memoranda, or other tax analyses contained in
    those materials.
  • The information contained herein is of a general
    nature and based on authorities that are subject
    to change. Applicability of the information to
    specific situations should be determined through
    consultation with your tax adviser.

4
Agenda
  • Introduction
  • Exempt entities
  • Exempt income
  • Limits on exemption
  • Controlled commercial entities
  • Commercial activities
  • Attribution and use of blockers
  • Partnerships
  • Withholding issues
  • Closing remarks

5
Who is Exempt?
  • Section 892 exempts two categories of investors
  • An integral part of a foreign government
  • A controlled entity if
  • Owned and controlled 100 by a foreign government
  • Formed in the same country, and
  • Engages in no commercial activities

6
Who is Exempt?A Foreign Government
  • An integral part of a foreign government is
    defined as a person that constitutes a governing
    authority of a foreign country if
  • Its net earnings are credited to its own account
    and
  • No portion of its earnings inures to the benefit
    of any private person
  • Does not include any individual acting in a
    private or personal capacity

7
Who is Exempt?A Controlled Entity
  • A controlled entity is separate in form from the
    foreign government that controls it
  • Like an integral part, its net earnings must not
    inure to a private person, and its assets must
    vest in the foreign sovereign upon dissolution
  • Pension trusts for the sole benefit of the
    governments employees or non-government
    employees who perform governmental or social
    service functions may qualify see PLRs 200216025
    and 200619019
  • Although the regulations refer only to trusts
    the 2002 ruling allowed a Canadian pension board
    formed as a corporation to qualify
  • Governmental pension funds that are not in
    separate entity form might qualify as integral
    parts

8
Sovereign Wealth Funds What are they?
  • Actively managed, government-owned pools of
    capital originating in foreign exchange assets
    (JCS, JCX-49-08)
  • Three of the more important types
  • Commodity funds (e.g., funds sponsored by oil
    producing countries)
  • Non-commodity funds (e.g., funds sponsored by
    Asian countries with large trade surpluses
    China, Korea)
  • Government pension funds
  • Examples include
  • Abu Dhabi Investment Authority
  • Norway Government Pension Fund Global
  • China Investment Corporation

9
Size of SWFs Absolute and Relative
  • Absolute
  • Approximately 2 - 3 trillion
  • Expected to grow to 5 10 15 trillion within
    next decade
  • Relative to other pools of capital
  • Private equity funds 800 billion
  • Hedge funds 1.5 trillion
  • Pension assets 26 trillion
  • Mutual funds 22 trillion
  • Insurance companies 17 trillion
  • All figures, all dollar amounts before crash
  • Source International Financial Services, London
    Estimates are as
  • of 2006, except the 800 billion estimate for
    private equity is as of 2007.

10
What is Exempt?
  • Unlike Section 115, the exemption for state and
    local governments from federal tax, Section 892
    extends only to a fairly narrow range of receipts
  • Although the exemption once extended to all US
    source income, today the exemption extends only
    to income from stock and securities, including
    dividends, interest and capital gains

11
What is Exempt?
  • The significance of the Section 892 exemption is
    less than may be supposed
  • Capital gains from stock or securities are
    generally exempt under Section 864(b)
  • But Section 892 extends to gains on the sale of a
    noncontrolling interest in a U.S. real property
    holding corporation, trumping FIRPTA

12
What is Exempt?
  • Interest may be exempt as portfolio interest or
    under a tax treaty
  • But 892 probably extends to contingent interest,
    unlike most treaties
  • And extends to interest received by a 10 or
    greater shareholder (but must be less than 50)
  • And many foreign governments have no treaty with
    the US

13
What is Exempt?
  • Dividends are generally not entitled to zero rate
    of withholding under treaties, so this is a clear
    benefit
  • Exempt dividends include dividends from a
    non-controlled USRPHC or REIT
  • However, IRS has ruled that a Section 897(h)(1)
    distribution from a REIT is not exempt under 892
    Notice 2007-55

14
What is Not Exempt?
  • Anything not described in Section 892, including
    income from a business or commercial activity
  • Gain on disposition of any partnership interest,
    including an interest in a PTP, is not covered
  • A partnership interest is not a security
  • Generally such gain would not be taxed to a
    foreign person regardless of whether 892 applies
  • But this rule causes difficulty in its
    interaction with FIRPTA (more later)
  • Governments view is that gain on the sale of a
    partnership interest is taxable to the extent
    attributable to assets giving rise to effectively
    connected income (or loss). Rev. Rul. 91-32
  • Several commentators have criticized this view.
    See, e.g., Blanchard, Rev. Rul. 91-32
    Extrastatutory Attribution of Partnership
    Activities to Partners

15
Controlled Commercial Entities
  • A controlled commercial entity (CCE) is an
    entity that engages in ANY commercial activity
    anywhere in the world if
  • 50 or more of the entity, by vote or by value,
    is owned, directly or indirectly, by a foreign
    government, or
  • The foreign government has effective practical
    control over such entity
  • How is 50 measured?
  • If foreign sovereign has veto rights, is that
    equivalent to 50 vote?
  • If a third party is introduced to break the tie
    in a 50/50 joint venture, must it be given a
    veto?

16
Controlled Commercial Entities
  • If a controlled entity would be a USRPHC if it
    were domestic, it will be treated as a CCE
    engaged in commercial activity
  • This arbitrary rule forces foreign governments to
    monitor the holdings of their SPVs very carefully
    so as not to trip FIRPTAs 50 threshold
  • A disregarded entity wholly owned by a foreign
    sovereign is a per se corporation fatal if it
    is formed under US law
  • If a sovereign is a partner or member of a
    partnership or LLC in which the other partner has
    no economic interest, this rule may be triggered

17
Deemed USRPHC Rule
Gain on sale of minority interests in USRPHC1,
USRPHC2, and USRPHC3, would generally be exempt
under section 892. But, under a special rule, CE
is treated as a controlled commercial entity and
all gain is taxable.
Foreign Government
CE
10
15
20
USRPHC 1
USRPHC 2
USRPHC 3
A USRPHC or a foreign corporation that would be a
USRPHC were it a domestic corporation shall be
treated as engaged in commercial activity and,
therefore, is a controlled commercial entity if
the foreign government controls the corporation.
Treas. Reg. 1.892-5T(b)(1).
18
How to avoid the deemed USRPHC rule?
  • Avoid USRPHC status
  • A corporation is a USRPHC if
  • USRPI at least 50
  • (i) USRPI, (ii) Foreign Real Property, plus (iii)
    Assets used in trade or business
  • Issues
  • Business assets would likely give rise to a
    commercial activity
  • Investment assets would ordinarily not count in
    the USRPHC fraction
  • Alternative Solutions
  • Acquire commercial activity assets (including
    foreign real estate) through an at least 50
    owned subsidiary - - under FIRPTA attribute
    assets upward (Treas. Reg. 1.897-2(e)(3))
    under 892 no upward attribution from a subsidiary
  • Acquire investment assets that would constitute
    at least 90 of total relevant assets to satisfy
    FIRPTA investment company rule under which such
    assets would be treated as trade or business
    assets. Treas. Reg. 1.897-1(f)(3)(ii)

19
Election to disregard a wholly owned entity is
not possible
A business entity wholly owned by a foreign
government or any other entity described in
1.892-2T (i.e., controlled entity of a foreign
government) is a per se corporation -- even if
not organized under the laws of the foreign
government and so not a controlled entity that
could qualify for exemption. Treas. Reg.
301.7701-2(b)(6). Treaty (or other) jurisdiction
LLC cant elect to be disregarded.
Foreign Government
Treaty or Cayman SPV
20
Controlled Commercial Entities
  • The exemption does not apply, and Section 892 is
    turned off entirely, to ANY income even income
    otherwise described in 892 derived by or
    through a controlled commercial entity
  • This all or nothing rule applies only to
    controlled commercial entities, not to integral
    parts the original theory being (probably) that
    foreign governments that own inherently
    commercial entities should not benefit from 892
    Qantas Airlines case

21
Controlled Commercial Entities
  • What is a commercial activity? Under Treas. Reg.
    1.892-4T(b),
  • Except as otherwise provided, includes all
    activities (whether conducted within or outside
    the United States) which are ordinarily conducted
    by the taxpayer or by other persons with a view
    towards the current or future production of
    income or gain.
  • An activity may be considered a commercial
    activity even if it does not constitute the
    conduct of a trade or business under Section
    864(b).
  • Nevertheless, commercial activity is probably
    fairly co-extensive with conduct of a trade or
    business under Section 864
  • Note that the scope of the exemption is NOT
    co-extensive with the scope of the definition of
    commercial activity
  • An activity throwing off dividends or interest
    can be a commercial activity (such as activities
    undertaken as a dealer or investments made by a
    banking, financing or other similar business),
    and
  • Income from a noncommercial activity may not be
    covered by Section 892 (e.g., trade show receipts)

22
Special CCE Rule for Government Pension Trust
  • A government pension trust that earns only income
    that would not be UBTI if it were a qualified
    trust under 401(a) is not treated as a CCE.
    However, for purposes of taxation, only income
    that is exempt and not from a commercial activity
    without regard to this special rule is exempt.
    Treas. Reg. 1.892-5T(b)(3)

Foreign Government Pension Trust
Shopping center Independent agent leases and
manages
US stocks and bonds
Investment in shopping center NOT treated as UBTI
  • A Foreign Government Pension trust is not a CCE
    so income from stocks and bonds is exempt. But
    income from the shopping center is not covered by
    Section 892
  • If not a pension trust, but another type of
    controlled entity, no income exempt as it would
    be a CCE assuming that shopping center activity
    is commercial

23
Controlled Commercial Entities
  • As interpreted by the IRS, all of this means that
    a CCE that engages to any extent in any
    commercial activity anywhere in the world cannot
    qualify to any extent for the Section 892
    exemption
  • When it applies, taints all other income of the
    CCE (except as discussed on previous slide in
    respect of pension trusts)
  • Moreover, any income, such as a dividend, derived
    by a foreign sovereign from or through a CCE is
    excluded from Section 892 a tracking rule
    applies
  • The all or nothing rule forces foreign
    sovereigns to act directly, without using
    controlled entities, or to limit their percentage
    interest to less than 50

24
Difference in Treatment of Integral Part CCE
Foreign Government
Foreign Government
KHD Stand
10 billion US stocks and bonds
Controlled Entity
Income on stocks and bonds exempt under 892
Kazakhstan hot dog stand (KHD) 10 billion
US stocks and bonds Income on stocks
and bonds NOT exempt
25
Controlled Commercial Entities
  • The regulations contain rules for attributing
    commercial activity among affiliated entities
  • A subsidiary is deemed to have commercial
    activities if its parent does this is to
    prevent commercial entities from hiving off
    noncommercial activities into subsidiaries
  • A subsidiarys commercial activity is not
    attributed to its parent or to its sisters
    (although the parents dividends from that
    subsidiary will not qualify for exemption)

26
Controlled Commercial Entities
  • Note that an entity will be treated as engaged in
    a commercial activity if it is a partner of a
    partnership (other than a PTP) that is so engaged
  • This rule should be changed
  • No revenue impact the only effect of the rule is
    to taint unrelated investments that a CCE partner
    may have
  • While the rule made some sense when section 892
    covered all US source income, today a sovereign
    investor in a partnership that carries on a
    commercial activity would never be entitled to
    exemption on any partnership ECI

27
Use of Blockers
  • CCEs cannot use blockers to earn exempt income,
    because neither a non-controlled blocker nor a
    controlled blocker will be entitled to the 892
    exemption (i.e., no income of a CCE is exempt)
  • A blocker can, however, cut off commercial
    activity such that the controlled entitys other
    income remains untainted
  • A non-controlled blocker can also be used to
    achieve exemption of FIRPTA gain

28
Basic Blocker Structure
Foreign Government
Parent CE
BadCo
GoodCo
Partnership
Stocks and Bonds
Operating Business
Operating Business
29
Use of Blockers
  • If a partnership uses below-the-fund blockers,
    there will still be the potential for its
    commercial activity to be attributed to a CCE
    partner, even if the CCE has no share of the
    income from such activity
  • This problem can be avoided by setting up a
    parallel partnership to invest in the blocker

30
Parallel Fund with Blocker
Foreign LP
892 Entity
Taxable LPs
GP
Parallel Fund
Fund
Blocker
Corps
LLC
Operating Business
31
Partnerships
  • Generally, a partnership is an aggregate, so if
    partnership has good or bad income, it flows
    through as such
  • But as noted above, a partnership interest is not
    a security and so the sale thereof is not
    covered by Section 892
  • Treas. Reg. 1.892-3T(a)(2) states Gain on the
    disposition of an interest in a partnership or a
    trust is not exempt from taxation under section
    892.
  • But that is not the same as saying that such gain
    is subject to tax if the partnership is not
    engaged in a US trade or business, normally there
    is no tax on the sale of a partnership interest
    under the Code
  • A publicly traded partnership (PTP) is treated
    like a publicly-traded corporation for purposes
    of determining gain on the sale of the PTP
    interest (not for gain on the PTPs sale of
    property). Treas. Reg. 1.897-1(c)(2)(iv)
  • For PTP interests not greater than 5, there is
    no FIRPTA tax
  • For PTP interests greater than 5, there is a
    FIRPTA tax only if the PTP would be a USRPHC were
    it a corporation

32
Partnerships (cont. 2)
  • If a foreign government partner sells an interest
    in a partnership that owns non-controlled
    USRPHCs, and section 897(g) applies such that the
    sale would normally be subject to withholding
    tax, the section 892 exemption should be
    available.
  • Section 892(a)(1)(A) exempts from tax income from
    stock investments
  • Under Treas. Reg. 1.892-3T(a)(2), income from
    stock includes gain from its disposition
  • Treas. Reg. 1.892-3T(b), example 1, paragraph
    (ix) makes clear that the exemption applies to
    gain from the disposition of a non-controlling
    interest in a USRPHC
  • Treas. Reg. 1.892-5T, example 4(c),
    illustrates that the 892 exemption generally
    applies on a look-through basis to income from
    stocks and bonds owned by a partnership. PLR
    9643031 confirms this aggregate approach to the
    892 exemption
  • But, how to prove availability of exemption to
    buyers satisfaction?
  • Seller can seek an IRS issued withholding
    certificate under Treas. Reg. 1.1445-3, but
    takes 90 days

33
Partnerships (cont. 3)
  • Is a partnerships gain on the sale of a
    non-controlled USRPHC qualifying capital gain
    under section 892 to a foreign government
    partner?
  • Could assert that gain is not ECTI under Treas.
    Reg. 1.1446-2(b)(2)(iii), such that withholding
    does not apply under Treas. Reg.
    1.1446-1(c)(2)(ii)(G)
  • Example where an 892 eligible entity remains
    subject to withholding under section 1446
    Integral part of foreign government realizing
    exempt and clearly non-exempt income
  • These problems also could be solved by forcing
    the partnership to distribute USRPHC stock in
    kind for direct sale by foreign government, but
    does that approach make sense?

34
Withholding Issues
  • Section 1441 withholding on dividends and
    interest is avoided by filing Form W-8EXP
  • Regular FIRPTA withholding under Section 1445
    (not where investment is made through a
    partnership) is avoided in one of two ways under
    Treas. Reg. 1.1445-10T
  • By delivery of a non-recognition statement
    claiming the 892 exemption or
  • By obtaining a Treas. Reg. 1.1445-3 withholding
    certificate

35
Closing Remarks
36
Presenter Contact Details
  • Michael A. DiFronzoDeputy Associate Chief
    Counsel (International - Technical)Office of
    Chief Counsel, Internal Revenue Service
  • Kimberly S. BlanchardWeil, Gotshal Manges
    LLPdirect dial (212) 310-8799direct fax
     (212) 833-3192kim.blanchard_at_weil.com

37
Presenter Contact Details
  • Deanna Flores, Principal
  • KPMG LLP direct dial  (619) 525-3340
    direct fax   (619) 923-3491
  • djflores_at_kpmg.com
  • Alvin D. Knott, Principal
  • KPMG LLP
  • direct dial (303) 295-5557
  • direct fax (212) 409-8965
  • adknott_at_kpmg.com

38
Bibliography Further Reading
  • New York State Bar Association Tax Section,
    Report on the Tax Exemption for Foreign
    Sovereigns Under Section 892 of the Internal
    Revenue Code, June, 2008
  • Joint Committee on Taxation Report (JCX-49-08),
    Economic and U.S. Income Tax Issues Raised by
    Sovereign Wealth Fund Investment in the United
    States, June 17, 2008
Write a Comment
User Comments (0)
About PowerShow.com