On December 15, 2025, the Treasury and IRS published final and temporary regulations (TD 10042) and proposed regulations (REG-101952-24) under section 892 of the Internal Revenue Code (Code) that will affect how foreign governments structure their investments in US debt and evaluate control of a commercial entity. The proposed regulations (Proposed Regulations) create a rebuttable presumption that all debt acquisitions are to be treated as commercial activities and address when a foreign government has “effective control” of a commercial entity. The final and temporary regulations (Final Regulations) finalize proposed regulations from 2011 and 2022 with modifications.
Foreign governments should review their existing debt portfolios and fund structures in light of both the Final Regulations and the Proposed Regulations. If the Proposed Regulations are finalized in their current form, restructuring may be necessary to avoid US income tax on investments not previously considered taxable. Moreover, foreign governments will need to undertake documentation and diligence efforts to evaluate compliance with the debt safe harbors and the facts-and-circumstances test.
Background
Under section 892(a)(1), foreign governments are exempt from US income tax on income earned from investing in US stocks, bonds, or other types of domestic securities. Additionally, any interest income received by a foreign government from deposits held in US banks is also exempt from US income tax.
Section 892(a)(2) excludes from this exemption income derived from the conduct of any commercial activity (whether within or outside the US), income received by or from a controlled commercial entity (CCE), and income derived from the disposition of any interest in a CCE. A CCE is any entity engaged in commercial activities in which the foreign government holds (directly or indirectly) at least a 50 percent interest by value or vote, or any other interest that provides the foreign government with “effective control” of the entity.
Key Changes in the Final Regulations
The Final Regulations modify and clarify the rules under section 892 regarding the exemption from US income tax for foreign governments and their controlled entities, providing guidance for determining when a foreign government is engaged in commercial activity and when an entity is a CCE.
Definition of Commercial Activity
The Final Regulations retain a broad definition of “commercial activity,” as any activity ordinarily conducted with a view towards the current or future production of income or gain, even if it does not constitute a “trade or business” under Code section 864(b). The regulations generally provide that investments in stocks, bonds, other securities, partnership equity interests, financial instruments (including derivatives), net leases, non-income-producing property, and bank deposits are not commercial activities.
Partnership Interests and Fee Income
The Final Regulations provide rules for when a foreign government is deemed to conduct commercial activities through a partnership, such that the income derived will be subject to tax. A foreign government is not deemed to be engaged in commercial activities conducted by a partnership solely by reason of holding a partnership interest. However, the foreign government’s distributive share of partnership income derived from commercial activities remains taxable and is not exempt under section 892.
Holding an equity interest in a partnership may result in attribution of the partnership’s commercial activities to the partner unless the partnership interest is a “qualified partnership interest.” A partnership equity interest is a qualified partnership interest if the interest holder: (1) has limited liability, (2) does not possess the legal authority to bind or act on behalf of the partnership, (3) does not control the partnership, and (4) does not have management rights or rights to participate in the conduct of the partnership’s business at any time during the partnership’s taxable year. Generally, rights to monitor or protect a partner’s capital investment do not constitute participation in management if they do not involve day-to-day operations and do not result in effective control. A safe harbor treats an interest as qualified if the holder has limited liability, does not possess legal authority to bind or act on behalf of the partnership, is not the managing partner, and owns 5 percent or less of both the partnership’s capital and profits interests.
For tiered partnerships, if an upper-tier partnership holds only a qualified partnership interest in a lower-tier partnership conducting commercial activities, the commercial activity is not attributed to the upper-tier partnership. Nevertheless, the upper-tier partnership's distributive share of income from commercial activities remains taxable.
Fee income paid to private equity funds engaged in commercial activities that is attributable to a foreign government is not exempt from tax under section 892, regardless of whether the government directly receives the fee income.
US Real Property Holding Corporations
In a welcome development, the Final Regulations narrowed the US real property holding corporation (USRPHC) per se rule, described below, to apply only to domestic corporations and not foreign corporations. The 1988 temporary regulations provide that a USRPHC, as defined in section 897(c)(2), or a foreign corporation that would be a USRPHC if it were a domestic corporation, is treated as engaged in commercial activity and, therefore, is a CCE, if a foreign government meets certain ownership or control thresholds (Per Se Rule).
The Final Regulations limit the Per Se Rule to domestic corporations, so that a foreign corporation is not deemed to be engaged in commercial activity solely because of its status as a USRPHC. This change provides foreign sovereigns with greater flexibility and certainty in managing upper-tier structures. A foreign government may qualify for an exemption by using a domestic holding company to dispose of minority interests in a corporation that is a USRPHC solely because it has ownership interests in other corporations not controlled by the foreign government. However, income from disposing of US real property interests will not qualify as tax exempt.
Inadvertent Commercial Activity Exception
The Final Regulations contain a safe harbor for entities that inadvertently conduct commercial activity, provided the activity is cured within 180 days of discovery, the inadvertent conduct is reasonable, and adequate records are maintained. Generally, an entity’s failure to avoid commercial activity will be considered reasonable if: (1) the value of assets used in all inadvertent commercial activity does not exceed 5 percent of the entity’s total assets for the taxable year, and (2) income earned from all inadvertent commercial activity does not exceed 5 percent of the entity’s gross income for the taxable year. The entity must also have adequate written policies and operational procedures in place to monitor its worldwide activities.
Applicability Date
The Final Regulations generally apply to tax years beginning on or after December 15, 2025. Taxpayers may elect to apply the rules to open prior years, subject to consistency requirements.
Key Changes in the Proposed Regulations
The Proposed Regulations provide guidance for determining when an acquisition of debt by a foreign government is considered to be commercial activity, and when a foreign government has effective control of an entity engaged in commercial activities. The Proposed Regulations address three key areas: (1) establishing a new framework for determining when US debt acquisitions constitute commercial activity, (2) clarifying that partnerships are not controlled entities for purposes of section 892, and (3) expanding the definition of “effective control” for purposes of evaluating CCE status. These changes are discussed more fully below.
New Framework for Debt Investments: Rebuttable Commercial Activity Presumption
Under the new framework of the Proposed Regulations, all debt acquisitions are treated as commercial activity for purposes of applying section 892 unless the acquisition is characterized as an investment for purposes of section 892 under either one of two safe harbors or under a facts-and-circumstances test.
Safe Harbors
The Proposed Regulations establish the following two safe harbors that allow a debt acquisition to be treated as an investment activity instead of commercial activity:
- Registered Offerings: Acquisitions of debt securities in offerings registered under the Securities Act of 1933 are considered tax exempt investments, provided underwriters are not related to the acquirer. The Proposed Regulations incorporate standard definitions of relatedness under sections 267 and 707 without modification.
- Qualified secondary market acquisitions: Qualified secondary market acquisitions of debt traded on established securities markets are considered tax exempt investments if the foreign government neither purchases debt from the issuer nor participates in negotiating the debt’s terms or issuance, and does not acquire the debt from persons under common control, unless that person acquired the debt as an investment.
Facts-and-Circumstances Test
For debt acquisitions that do not satisfy a safe harbor, the Proposed Regulations establish a facts-and-circumstances test under which a debt acquisition may qualify as an exempt investment (provided the foreign government is not a dealer). Relevant factors include (but are not limited to):
- Whether the acquirer solicited prospective borrowers or held itself out as willing to do so;
- Whether the acquirer materially participated in negotiating or structuring debt terms;
- Whether the acquirer was entitled to non-interest compensation;
- The form of the debt and issuance process;
- The percentage of the debt issuance acquired by the acquirer relative to other purchasers;
- The percentage of equity in the debt issuer held or to be held by the acquirer, and the value of that equity relative to the debt acquired; and
- For debt deemed acquired in a significant modification, whether there was a reasonable expectation that the original unmodified debt would default.
Partnerships are Not Controlled Entities
Section 892 does not define “foreign government,” but the prior temporary regulations provide a definition that extends to integral parts and “controlled entities” of a foreign sovereign. The Proposed Regulations clarify that entities classified as partnerships for US federal income tax purposes are not “controlled entities” of a foreign sovereign, and would not fall within the definition of “foreign government.” This is because partnerships generally are not subject to federal income tax under Chapter 1 of the Internal Revenue Code, so the question addressed by the controlled entity concept—whether an entity separate from a foreign sovereign and otherwise subject to federal income tax could be exempt under section 892—does not arise for partnerships.
However, partnerships are still treated as “entities” for purposes of the controlled commercial entity (CCE) definition under section 892(a)(2)(B). This means that while a partnership itself cannot be a “controlled entity” eligible for the section 892 exemption, a partnership can still be a CCE if it is engaged in commercial activities and the foreign government has effective control of it, including where the foreign government is, or controls an entity that is, a managing partner or managing member of the partnership.
Therefore, the planning implications are nuanced: foreign governments investing through partnerships may avoid certain controlled entity issues, but income received by a CCE or received (directly or indirectly) from a CCE remains ineligible for the section 892 exemption. This matters particularly for credit funds organized as partnerships, as foreign governments must carefully structure their investments to avoid CCE status.
Redefining “Effective Control”
The Proposed Regulations significantly broaden the meaning of “effective control” for purposes of determining CCE status. A foreign government has effective control when its stand-alone or combined interests (which may include equity holdings, debt positions, voting or board rights, contractual provisions, key business relationships, regulatory authority or other means of influence), enable it to control operational, managerial, board-level, or investor-level decisions of an entity. However, mere consultation rights with respect to such functions and decisions, standing alone, are insufficient to establish effective control. The regulations also provide that a foreign government is deemed to have effective control if it, or an entity it controls, serves as the managing partner, managing member, or functional equivalent.
The Proposed Regulations set forth several examples illustrating the application and breadth of the proposed rules. Treasury and the IRS apparently view governance leverage as a proxy for effective control. The examples indicate that effective control can arise under any arrangement that allows a foreign government to influence or direct important decisions, including through economic and regulatory pressure, even if the foreign government owns no equity in the entity. The practical question, therefore, is where customary creditor protections end and control over key decisions begins.
Treasury Denies Certain Taxpayer Suggestions
Treasury rejected several taxpayer recommendations as outside the scope of this guidance. For example, commentators requested modifications to existing regulations on per se corporate classification of entities wholly owned by foreign governments to permit business entities wholly owned by foreign governments to elect disregarded entity status. Although the Proposed Regulations specify that the term “controlled entity” excludes partnership entities, which confirms guidance from recent letter rulings, the Proposed Regulations do not grant commentators’ request for a complete elimination of the per se corporation provision and do not permit foreign governments to establish disregarded entities.
Treasury similarly declined to address recommendations concerning incentive compensation structures for controlled entities, foreign government interest expense deductibility limitations, and the integral part definition under section 892 because they were considered outside the scope of this guidance.
Applicability Dates
The Proposed Regulations are proposed to apply to taxable years beginning on or after the date the final regulations are published in the Federal Register. A foreign government may elect to apply section 1.892-2(a)(4), which provides that a partnership is not a controlled entity, to taxable years of its directly or indirectly wholly-owned entities beginning before the finalization date, provided that the tax years remain open for assessment and the rules are consistently applied.
Written or electronic comments and requests for a public hearing must be received within 60 days after publication in the Federal Register, or by February 13, 2026.
Eversheds Sutherland Observations and Practical Guidance for Fund Managers with Section 892 Investors
The regulatory changes under section 892 will significantly influence how foreign governments invest in private funds. Fund managers and section 892 investors should focus on the following critical areas:
- Commercial Activity: Most debt acquisitions are now classified as commercial activities unless specific safe harbors or facts-and-circumstances tests are met. This could affect foreign government investors in credit funds or those making direct loans.
- CCE Definitions: The definition of “effective control” has broadened to include any situation where a foreign government can direct key decisions of an entity, potentially capturing more fund structures than before.
- USRPHC Flexibility: The USRPHC rule now only applies to domestic corporations, offering foreign sovereigns more flexibility in structuring their investments, especially when using home-country blockers.
- Partnership Structures: Partnerships are not considered controlled entities of a foreign sovereign (and, accordingly, are not within the scope of the definition of “foreign government”), perhaps presenting planning opportunities. However, foreign governments should be cautious of the attribution rules for partnership activities.
Practical Guidance:
- Maintain thorough documentation for debt acquisitions, ensuring compliance with safe harbors and demonstrating non-solicitation and limited participation in structuring terms.
- Consider partnership structures for funds, as these are not controlled entities under section 892. Limit foreign government investor interests to qualified partnership interests meeting the four-part test (limited liability, no authority to bind, no control, no management rights).
- Carefully structure governance rights to avoid “effective control.” Allow only consultation rights and avoid veto or appointment powers over key decisions. Ensure any protective rights for investors are clearly documented as limited to capital monitoring, not daily operations.
By following these guidelines, fund managers can help section 892 investors maintain exemption eligibility and minimize tax inefficiencies.
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