IRS Proposes Regulations Narrowing Section 892 Exemption for Foreign Government Investors

The proposed regulations target two persistent sources of uncertainty under existing Section 892 guidance: (1) when debt acquisitions are “commercial activity”, and (2) when effective control causes an entity to be treated as a “controlled commercial entity” (a “CCE”). Under the proposed regulations, debt acquisitions are presumed to be commercial activity absent limited exceptions, and the effective control standard is significantly broadened. In addition, the proposed regulations clarify that partnerships are not “controlled entities.” If finalized, the rules would apply to taxable years beginning on or after finalization, with limited elective retroactive application available for the treatment of partnerships as not controlled entities. On the same day the proposed regulations were issued, final regulations under Section 892 were also issued that will be addressed in a separate alert.

Key Provisions

1. Debt Acquisitions Treated as Commercial Activity

Under the proposed regulations, a new framework would treat all acquisitions, whether at original issuance or by secondary purchase, of debt as giving rise to a commercial activity and thus outside the scope of the Section 892(a) exemption unless they qualify as an “investment” under one of two safe harbors or a facts-and-circumstances test. Under the safe harbors, an acquisition of debt would qualify as “investment” if it was (1) purchased in a registered offering under the Securities Act of 1933 with unrelated underwriters, or (2) a qualified secondary market purchase of exchange‑traded debt where the acquirer does not buy from the issuer, negotiate terms, or buy from a commonly managed or controlled affiliate (with a limited exception where that affiliate itself acquired the debt as an investment).

Outside the safe harbors, an acquisition would qualify as “investment” only if facts and circumstances show the expected return is exclusively a return on capital (as opposed to a return on activities conducted by the investor). Relevant factors include borrower solicitation, negotiation and structuring roles, non‑interest compensation, instrument form and issuance process, participation size, equity overlays, and distressed‑debt and modification scenarios.

2. Expanded “Effective Control” Standard for CCE Status

The proposed regulations significantly expand the concept of “effective control” for purposes of determining whether an entity is a CCE. Under the proposed regulations, a foreign government may be treated as having effective control through equity interests, debt interests, contractual rights, business relationships, or regulatory authority, if those interests confer control over operational, managerial, board-level, or investor-level decisions of the entity. Notably, effective control may exist even in the absence of any minimum equity ownership threshold.

In addition, the proposed regulations introduce a new deemed‑control rule that treats a foreign government as having effective control of an entity if it is, or controls an entity that is, a managing partner or managing member (or equivalent under local law). Examples address minority interests with special rights, veto powers, significant business relationships, sovereign regulatory authority, and creditor arrangements with broad covenants and consent rights. By contrast, mere consultation rights are expressly stated to be insufficient, standing alone, to establish effective control.

3. Clarification Regarding Partnerships and “Controlled Entities”

The proposed regulations confirm that an entity treated as a partnership for U.S. tax purposes is not a “controlled entity,” including partnerships wholly owned by a single sovereign, and they confirm that entities jointly owned by multiple sovereigns remain excluded.

Implications

The proposed regulations, if finalized, would materially narrow Section 892 by generally treating debt acquisitions as giving rise to a commercial activity unless they fall within a very narrow set of safe harbors or a vague facts and circumstances test, and by meaningfully expanding the concept of “effective control.” In practical terms, the proposals put pressure on Section 892 positions involving private credit, direct lending, and origination‑like activities without a foreign blocker. Because the principal benefit of engaging in loan origination activities without a foreign blocker is typically the availability of a withholding tax exemption on contingent interest, investments structured to rely on that exemption are expected to be among those most significantly affected by the proposed regulations.

In addition, although the proposed regulations are expressly limited to Section 892 and state that no inference should be drawn for purposes of determining whether an activity constitutes a U.S. trade or business under other provisions of the Code, the narrow treatment of loan origination activity reflected in the proposed regulations raises a meaningful risk of spillover in practice. In other words, there is a risk that the analytical posture reflected in the proposed regulations could influence future IRS scrutiny of loan origination and lending activities more broadly. This risk is most relevant for structures that rely on established market views distinguishing passive credit investment from active lending, including CLOs, private credit funds, and similar vehicles that typically operate on the basis of U.S. trade or business opinions. While the proposed regulations do not formally change those standards, their adoption may increase pressure on existing positions where origination-related facts such as borrower solicitation, negotiation of loan terms, or structuring activity are present. Foreign government-related investors investing in U.S. securities, real estate, and other financial instruments, along with asset managers whose investor base includes Section 892-eligible investors, should consult with their tax advisors regarding the impact the proposed regulations, if finalized, may have on their investments and businesses.