1. November 8, 2011 New Tax Regulations Seek to Ameliorate Harsh Effects of
Commercial Activity Limitation Under Section 892 Sovereign Tax
Exemption
Tax Policy Client Alert
On November 2, 2011, the U.S. Treasury and Internal Revenue Service issued
This Alert provides only proposed regulations (the “Proposed Regulations”) under section 892 of the Internal
general information and Revenue Code of 1986, as amended (the “Code”), which provides an exemption from
U.S. federal income tax for certain categories of U.S. source income when that income
should not be relied upon as
is received by a foreign government. The Proposed Regulations represent the first
legal advice. This Alert may major overhaul of regulations issued in 1988 (the “Existing Regulations”) and generally
be considered attorney focus on issues related to the so-called “commercial activity” limitation, which has
advertising under court and particular relevance for those entities that qualify for the section 892 exemption as
bar rules in certain
“controlled entities” of a non-U.S. sovereign. This memorandum contains a brief
overview of the section 892 exemption and a summary of the Proposed Regulations.
jurisdictions.
The Proposed Regulations are subject to a 90-day public comment period before they
For more information, contact are finalized. While the Proposed Regulations may be changed in one or more
your Patton Boggs LLP respects as a result of submissions made during the comment period, the Proposed
attorney or the authors listed
Regulations may, as discussed below, be relied upon until final regulations are issued.
below.
I. Overview of the Section 892 Exemption
Section 892 provides an exemption from U.S. federal income tax for certain categories
Donald V. Moorehead of U.S. source income when that income is received by a foreign government. The
dmoorehead@pattonboggs.com section 892 exemption applies to income from investments in the United States in (1)
stocks, bonds and other domestic securities; and (2) financial instruments held in the
Richard E. Andersen
randersen@pattonboggs.com
execution of the foreign government’s financial or monetary policy. It also applies to
interest on deposits in banks in the United States of monies belonging to the foreign
Lindsay M. Fainé government.
lfaine@pattonboggs.com
The section 892 exemption does not apply to any income (1) derived from a
“commercial activity,” whether conducted within or outside the United States; (2)
WWW.PATTONBOGGS.COM received by a “controlled commercial entity” or received (directly or indirectly) from a
controlled commercial entity; or (3) derived from the disposition of an interest in a
controlled commercial entity.
For purposes of the section 892 exemption, the term “foreign government” includes
both integral parts and controlled entities of a non-U.S. sovereign. In the case of a
controlled entity, the section 892 exemption is conditioned on a requirement that the
entity not engage, directly or indirectly, in any “commercial activity” (as that term is
defined in the Existing Regulations).1 This commercial activity limitation is applied on a
global basis and not merely to investments and other activities in or with respect to the
United States. Moreover, under the Existing Regulations, there is no de minimis
exception to the commercial activity limitation. Thus, as the result of this so-called “all

2. or nothing” rule, the slightest commercial activity undertaken directly or indirectly
anywhere in the world – even inadvertently – converts the controlled entity into a
controlled commercial entity and results in its forfeiture of the section 892 exemption in
its entirety. For controlled entities there are thus two issues that arise under section
892 with respect to proposed investments and other income producing activities;
namely, whether the income and gain generated by the investment or other activity will
be eligible for the section 892 exemption2 and whether the investment or activity
involves a commercial activity that will be treated as having been undertaken, directly
or indirectly, by the controlled entity. The Proposed Regulations address issues related
to the second of these questions – the scope of the commercial activity limitation – and
do not make any changes to the provisions of the Existing Regulations that define the
types of U.S. source income that are eligible for the section 892 exemption.
II. Summary of the Proposed Regulations
A. What is a “Commercial Activity”?
1. General Definition of Commercial Activity. Subject to five enumerated exceptions,
the Existing Regulations contain a very broad definition of the term “commercial
activity.” Specifically, that term is defined to include “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.”3
The Proposed Regulations continue this rule, but with two important clarifications.4
First, only the “nature” of an activity and not the “purpose” or “motivation” of the section
892 entity for undertaking the activity will determine whether an activity will be
classified as a commercial activity. Second, an activity may be classified as a
commercial activity even if it does not constitute a trade or business under section 162
(relating to deductible business expenses) or does not constitute (or would not
constitute if undertaken in the United States) the conduct of a U.S. trade or business
for purposes of section 864(b).
2. Investments in Financial Instruments as Commercial Activities. The Existing
Regulations contain two exceptions for investment-type transactions. The first of these,
which is commonly referred to as the “investment” exception, provides that the term
“commercial activity” does not include investments in stock, bonds and other
securities, as well as certain other types of investment transactions, including
“investments in financial instruments held in the execution of governmental financial or
monetary policy.”5 The second exception, which is commonly referred to as the
“trading” exception, provides that the term “commercial activity” does not include
effecting transactions in stocks, securities or certain commodities for the government’s
own account, but makes no reference to trading financial instruments.6 Neither
exception applies to “dealers” or to transactions undertaken as part of a “banking,
financing, or similar business.”7
The Proposed Regulations amend both the investment exception and the trading
exception to provide that neither investing nor trading in financial instruments will be
classified as a commercial activity, whether or not the instruments are held in the
execution of governmental financial or monetary policy.8 The Proposed Regulations
continue the provision of the trading exception that limits the definition of
“commodities” to “commodities of a kind customarily dealt in on an organized

3. commodity exchange, but only if the transaction is of a kind customarily consummated
at such a place.”9
The provisions of the Proposed Regulations relating to financial instruments apply only
for purposes of the commercial activity limitation and, consistent with the language of
section 892 itself, the exemption continues to apply only with respect to income and
gain attributable to those financial instruments that are held in the execution of
governmental financial or monetary policy. Thus, under the Proposed Regulations as
under current law, to the extent income or gain from financial instruments that are not
held for these purposes is U.S. source income, a section 892 entity may be required to
file a U.S. tax return and pay U.S. tax with respect to that income or gain.
3. Certain Real Estate Investments as Commercial Activities. Under section 897(a)(1)
(part of the so-called FIRPTA provisions of the Code), if a non-resident alien individual
or a foreign corporation realizes gain on the sale or other disposition of a United States
real property interest (a “USRPI”), the gain is subject to U.S. tax as income that is
effectively connected with a U.S. trade or business.10 The Proposed Regulations clarify
that an entity that disposes of a USRPI will not be treated as engaged in a commercial
activity solely by reason of that disposition. The Preamble to the Proposed Regulations
states that “[t]he Treasury Department and the IRS believe that an entity that only
holds passive investments and is not otherwise engaged in commercial activities
should not be deemed to be engaged in commercial activities [and thus ineligible for
the section 892 exemption] solely by reason of the application of section 897(a)(1).”
For this reason, the Proposed Regulations provide that a disposition, including a
deemed disposition under section 897(h)(1), of a USRPI will not be treated as a
commercial activity.11 Significantly, however, the gain derived from the disposition of a
USRPI that is not stock in a United States real property holding corporation will not
qualify for the section 892 exemption;12 as a result, section 892 entities may be
required to file a U.S. tax return and pay U.S. tax on any such gain.
4. Investments in Partnerships as Commercial Activities. Under the Existing
Regulations, the commercial activities of a partnership (other than a publicly traded
partnership) are attributable to its general and limited partners.13 Under the Proposed
Regulations, this rule is continued, but subject to an exception under which a section
892 entity that is not otherwise engaged in commercial activities will not be treated as
so engaged solely because it holds an interest as a limited partner in a limited
partnership.14 For this purpose, a limited partnership interest is defined as an interest
in an entity that is properly classified as a partnership for U.S. federal income tax
purposes, but only if the holder of the limited partnership interest in question does not,
under either the law of the jurisdiction in which the partnership is organized or the
partnership’s governing instrument, have a right to participate in the management and
conduct of the partnership’s business at any time during the partnership’s taxable
year.15
The proposed limited partner rule applies only for purposes of determining whether the
section 892 entity is engaged in commercial activities. The section 892 entity’s
distributive share of the partnership’s income attributable to the non-exempt activities
of the partnership will not be exempt under section 892.16 Thus, if the income is U.S.
source income, the section 892 entity may have to file a U.S. tax return and pay U.S.
tax on that income.
5. Partnership Trading Activity. The Proposed Regulations extend the protection of the
revised ”trading” exception (as discussed above) to section 892 entities that are

4. members of a partnership that effects transactions in stocks, securities, certain
commodities or financial instruments for the partnership’s own account.17 As a result, a
section 892 entity that is a partner (including a general partner) in such a partnership
will not be deemed to be engaged in commercial activities so long as the partnership’s
activity is itself exempt under the trading exception. This new rule does not apply,
however, if the partnership is classified as a “dealer” in stocks, securities, commodities
or financial instruments.
B. Inadvertent Violations of the Commercial Activity Limitation
The Proposed Regulations contain a special provision that ameliorate the effects of the
“all or nothing” rule in certain cases.18 Specifically, an entity is not treated as engaged
in commercial activities (and therefore classified as a controlled commercial entity that
is outside the scope of the section 892 exemption) if its only commercial activities
qualify as “inadvertent.” For this purpose, a commercial activity is “inadvertent” only if
(1) the failure to avoid engaging in the commercial activity is “reasonable;”19 (2) the
commercial activity is promptly “cured;”20 and (3) certain record maintenance
requirements are satisfied.21
The Proposed Regulations provide a safe harbor under which a section 892 entity’s
failure to avoid engaging in a commercial activity will be treated as “reasonable” if (1)
the value of the assets used in, or held for use in, the commercial activity does not
exceed five percent of the total value of the assets reflected on the entity’s balance
sheet for the taxable year as prepared for financial accounting purposes; and (2) the
income earned by the entity from the commercial activity does not exceed five percent
of the entity’s gross income as reflected on its income statement for the taxable year
as prepared for financial accounting purposes. Importantly, the proposed safe harbor
will apply only if the section 892 entity has “adequate written policies and operational
procedures” in place to monitor its activities on a global basis.
In the case of a commercial activity that qualifies as “inadvertent” under these
standards, the income attributable to the activity will retain its character as commercial
income and will not be exempt under section 892. Thus, if the income or gain is U.S.
source income, the section 892 entity may be required to file a U.S. tax return and pay
U.S. tax on that income or gain.
C. Year-by-Year Approach to Violations of Commercial Activity Limitation
The Existing Regulations do not expressly address the question of whether a violation
of the commercial activity limitation in one taxable year will result in the loss of the
section 892 exemption for that year and all future years. The Proposed Regulations
clarify this issue by providing that the determination of whether a controlled entity is
eligible for the section 892 exemption will be made on an annual basis, with the result
that an entity will not be classified as a “controlled commercial entity” (and thus as
ineligible for the section 892 exemption) solely because it engaged in a commercial
activity in a prior taxable year.22
D. Effective Date and Reliance on Proposed Regulations
By their terms, the Proposed Regulations apply from the date they are published in
final regulations in the Federal Register. However, the Preamble to the Proposed
Regulations states that “[t]axpayers may rely on the proposed regulations until final
regulations are issued.”

5. This Alert provides only general information and should not be relied upon as legal advice. This Alert may
also be considered attorney advertising under court and bar rules in certain jurisdictions.
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1
A “controlled entity” is defined as an entity that is separate in form from a foreign sovereign or
otherwise constitutes a separate juridical entity if it meets certain requirements. These include that it be
wholly-owned by the foreign sovereign, organized under the laws of the foreign sovereign by which it is
owned and its assets pass to the foreign sovereign when it is dissolved. Treas. Reg. section 1.892-
2T(a)(3). A controlled entity is classified as a “corporation” for U.S. tax purposes.
2
As a practical matter, given the general tax rules applicable with respect to passive non-U.S.
investors, the section 892 exemption generally is essential only with respect to (1) avoiding the U.S.
withholding tax on dividends from non-controlled U.S. corporations; (2) avoiding the U.S. withholding
tax on those types of U.S. source interest (i.e., contingent interest and interest from related but non-
controlled obligors) that are not eligible for the general withholding exemption applicable to “portfolio
interest”; and (3) avoiding the U.S. tax otherwise imposed under the FIRPTA provisions of the Code on
the disposition of interests in certain U.S. real property holding corporations.
3
Treas. Reg. section 1.892-4T(b).
4
Treas. Reg. section 1.892-4T(b).
5
Treas. Reg. section 1.892-4T(c)(1)(ii).
6
Treas. Reg. section 1.892-4T(c)(1)(ii).
7
Treas. Reg. section 1.892-4T(c)(1)(ii) and (iii).
8
Prop. Treas. Reg. section 1.892-4(e) (setting forth the “dealer” and “banking” business limitations).
9
Prop. Treas. Reg. section 1.892-4(e)(ii).
10
Under section 897(c)(1), a USRPI includes (1) an interest in real property located in the United States
or the Virgin Islands and (2) any interest (other than an interest solely as a creditor) in any U.S.
corporation that is a United States Real Property Holding Corporation (a “USRPHC”) during a
prescribed time period. In general, a USRPHC is, with certain exceptions, a corporation the value of
whose USRPIs equals or exceeds 50 percent of the value of the sum of its USRPIs, its non-U.S. real
property interests and its other assets if used or held for use in a trade or business. See section
897(c)(2).
11
Under section 897(h) and with certain exceptions, if a real estate investment trust (a “REIT”) or other
qualified investment entity (as defined) makes a distribution to a non-resident alien individual or a
foreign corporation that is attributable to the sale by the distributing entity of USRPI, the gain is taxed to
the recipient as if it were effectively connected with the conduct of a U.S. trade or business. Such a rule
was provided on the ground that, since REITs and other qualified investment entities are not subject to
U.S. tax if they distribute substantially all their income to their equity holders, gain on the sale of a
USRPI by such an entity would be entirely exempt from U.S. tax.
12
In Notice 2007-55, the IRS announced that it would issue regulations under which the section 892
exemption for gain on the sale of stock does not override section 897(h). The Proposed Regulations are
consistent with such an approach and the limitation to dispositions by a covered REIT or other qualified
investment entity of a direct interest in U.S. real property is consistent with provisions of the Existing
Regulations. See Treas. Reg. section 1.892-3T(a)(1).
13
Treas. Reg. section 1.892-5T(d)(3). In addition, under section 875(1), a non-resident alien individual
or foreign corporation that is a member of a partnership is treated as engaged in any U.S. trade or
business in which the partnership is engaged. In contrast, the commercial activities of a corporation
generally are not, however, attributed to its shareholders and likewise shareholders of a corporation are
generally not treated as engaged in any U.S. trade or business in which the corporation is engaged.
14
Prop. Treas. Reg. section 1.892-5(d)(i) and (iii).
15
Prop. Treas. Reg. section 1.892-5(d)(iii)(B), which also provides that rights to participate in the
management and conduct of a partnership’s business do not include consent rights in the case of
extraordinary events such as the admission or expulsion of a general or limited partner, disposition of
all or substantially all of the partnership’s property outside the ordinary course of the partnership’s
activities, merger or conversion.

6. 16
Prop. Treas. Reg. section 1.892-5(d)(iii) states that “pursuant to sections 875, 882, and
892(a)(2)(A)(i), a foreign government member’s distributive share of partnership income will not be
exempt from taxation under section 892 to the extent that the partnership derived such income from the
conduct of a commercial activity.”
17
Prop. Treas. Reg. section 1.892-5(d)(ii).
18
Prop. Treas. Reg. section 1.892-5(a)(2).
19
Prop. Treas. Reg. section 1.892-5(a)(2)(ii) specifies a general facts and circumstances test for this
determination, subject to a continuing due diligence requirement to identify commercial activities and,
as noted in the text, provides a safe harbor for reasonableness determinations.
20
Prop. Treas. Reg. section 1.892-5(a)(2)(iii) specifies that a timely cure will be considered to have
been made if the conduct of the commercial activity is discontinued within 120 days after its discovery.
21
Prop. Treas. Reg. section 1.892-5(a)(2)(iv).
22
Prop. Treas. Reg. section 1.892-5(a)(3).