FIN 48 Quantifying the unknowable Serious people shortage hits tax - PDF document

SPONSORED FEATURES: Switzerland Outsourcing: fool’s gold? Doing business in Malta A Euromoney publication April 2008 The future for double tax treaties Italy revises thin cap rules China issues raft of new tax rules FIN 48 Quantifying the unknowable Serious people shortage hits tax departments Sovereign wealth funds become visible Interview: Frank Ng of the IRS www.internationaltaxreview.com

US | www.internationaltaxreview.com Sovereign wealth funds become visible Sovereign wealth funds have recently become a talking point worldwide. Yet Babak Nikravesh, of law firm Jones Day , says that they have been a consistent feature of US investment for decades T he US has long been an attractive stock – typically preferred stock received in inuring to the benefit of any private person.A market for foreign investors, in part certain tax-free corporate reorganisations nation’s parliament or governmental min- because of its favourable income tax and divisions that generally give rise to istries are classic examples of integral parts. regime. Foreign investors generally are not ordinary income rather than capital gain on An individual, such as a king or other ruler, subject to US tax on capital gains from the its disposition – is also exempt under sec- can also qualify as an integral part as long as sale of stocks and securities or on interest tion 892. And whereas the portfolio interest that person is acting in an official and not a income from bank deposits and debt obli- exemption does not extend to interest private or personal capacity. gations that produce portfolio interest. received by a 10% shareholder, such The distinction between the two types of Additional tax benefits also may be avail- income is exempt under section 892, as long foreign governments is not well defined. able to those investors whose countries as it is not received by or from a controlled Because the focus of the test for each differs have concluded an income tax treaty with commercial entity (discussed below). – on form in the case of controlled entities the US. and on function in the case of integral parts Eligible investors: foreign But for a particular breed of foreign – there is the possibility of overlap between investor, the tax advantages of US invest- governments the two. The analysis is complicated by the ment are even more absence of any coordina- extensive. Sovereign tion rule between the two The consequences of commercial activity wealth funds (SWFs), regimes and the Internal attribution and controlled commercial entity status though only recently Revenue Service’s unwill- gaining attention in ingness to issue rulings are potentially wide-reaching the popular US press, on the correct determina- have for decades been tion of foreign govern- significant investors in the US, and it is their Though SWFs may take a number of guises ment status. The distinction between types capital that is behind many of the promi- and may be capitalised with funds from a of foreign governments is immaterial to nent investment funds making news. The variety of sources, the exemption applies determining the scope of the section 892 US Internal Revenue Code devotes an only to those SWFs which meet the regula- exemption, but it is nevertheless important entire section to these types of investors, tory definition of a foreign government. in assessing the impact to the foreign gov- known in US tax parlance as foreign gov- Notably, a foreign government need not be ernment of commercial activities. ernments, and affords them special treat- a national level body to qualify; political ment. subdivisions, such as provincial or munici- The commercial activity problem pal bodies, can also enjoy the exemption. The exemption from US income tax under Exempt income A foreign government is the exempt section 892 is not available for income For SWFs that qualify as foreign govern- portion of a foreign sovereign, and to qual- derived from the conduct of any commer- ments, income from the following types of ify under section 892 must take one of two cial activity. Commercial activities are those investments is exempt from US tax under forms. A foreign government can be a con- which are ordinarily conducted with a view section 892 of the code: trolled entity, which is an entity that is sep- towards the current or future production of • Stocks, bonds or other domestic securi- arate in form from the foreign sovereign; is income or gain. The commercial activity ties. wholly owned and controlled by the foreign concept is broader than the more familiar • Financial instruments held in the execu- sovereign; is organised under the laws of US trade or business concept – even activi- tion of governmental financial or mone- the foreign sovereign; whose net earnings ties outside the US, which have no connec- tary policy. are credited to its own account, with no tion with US businesses, fall within its net. • Interest on bank deposits. portion inuring to the benefit of any private By contrast, pure investment activities, such To some extent, the foreign government person; and whose assets vest in the foreign as investments in stocks or financial instru- exemption overlaps with the exemption sovereign upon dissolution. Examples of a ments, net leases on real property or loans afforded to foreign investors in general. controlled entity include a company estab- that do not rise to the level of a banking, One need not qualify as a foreign govern- lished to invest government monies, or a financing or similar business, are not com- ment to be exempt from bank deposit inter- pension trust established to fund retire- mercial, regardless of volume. est, for example. In several key respects, ment, disability or death benefits for gov- The exemption is also unavailable for however, the foreign government exemp- ernmental employees. income received by or from a controlled com- tion is considerably broader. Dividend A foreign government can also be an inte- mercial entity of a foreign government. An income is exempt under section 892, as are gral part, which is any organisation or other entity is a controlled commercial entity if it is gains from the sale of stock in US corpora- body that constitutes a governing authority controlled by the foreign government and is tions whose assets consist mostly of US real of a foreign country, and whose earnings are engaged in commercial activities anywhere estate. The receipt of so-called section 306 credited to its own account with no portion in the world. Thus, an entity whose US 18 | April 2008