Treasury finalizes previously proposed regulations, with key modifications, regarding the Section 892 exemption for foreign sovereigns

On December 15, 2025, the US Department of the Treasury (“Treasury”) and the Internal Revenue Service published final regulations (the “Final Regulations”) under Section 892,¹ which contains the tax exemption for foreign sovereigns with respect to certain qualifying investment income from US sources. The Final Regulations expand upon rules relating to commercial activities and controlled commercial entities, including adopting, with modifications described herein, previous Treasury Regulations proposed in 2011 (the “2011 Proposed Regulations”) and previous Treasury Regulations proposed in 2022 (the “2022 Proposed Regulations”). 

Treasury and the Internal Revenue Service have also issued proposed regulations contemporaneously with the Final Regulations (the “2025 Proposed Regulations”), which provide guidance on when certain acquisitions of debt will amount to commercial activity, and when a foreign government is in “effective control” of an entity. See Treasury Proposes Regulations Addressing Key Aspects of the Section 892 Exemption for Foreign Sovereigns for a summary of the 2025 Proposed Regulations. 

The Final Regulations generally apply to tax years beginning on or after December 15, 2025. A taxpayer generally may apply the Final Regulations to prior open tax years, however, if the taxpayer and its affiliates apply the Final Regulations, in their entirety, to all such taxable years beginning before December 15, 2025.

Scope of “commercial activity”

The Final Regulations adopt the broad definition of “commercial activities” from the 2011 Proposed Regulations, rejecting comments recommending that “commercial activity” align with a “trade or business” under Section 864(b). They also clarify that, at a minimum, activities that constitute a trade or business under Section 162 or constitute (or would constitute if undertaken in the United States) a trade or business in the United States for purposes of Section 864(b) are commercial activities, except as expressly provided otherwise. 

Exceptions to “commercial activity”

The Final Regulations adopt the list of activities in the 2011 Proposed Regulations that do not constitute “commercial activities,”² but with several clarifications. 

• Investments in Financial Instruments: Broadened to conform to financial instruments that are within the scope of the trading safe harbor exception to being treated as engaged in a US trade or business.
• Holding of Bank Deposits: Expanded to include the holding of bank deposits in any currency.
• Holding of Partnership Interests: Clarified that the mere holding of equity in a partnership does not give rise to commercial activity. 

Key observation: The Final Regulations do not clarify the rule currently in effect that any gain earned on the disposition of a partnership interest is not exempt under Section 892. This rule has created uncertainty for foreign government investors with respect to the disposition of interests in partnerships where the Section 892 exemption is necessary to avoid US tax (e.g., where the partnership owns interests in United States real property holding corporations (“USRPHCs”) that are not otherwise controlled commercial entities). A note in the preamble, however, provides that depending on the partnership’s assets and activities, such disposition may be exempt under Section 892 under the generally applicable Code provisions. Although the preamble is not technically part of the Final Regulations, the statement supports the sensible view that gain arising from the disposition of a partnership interest is exempt under Section 892 to the extent such income or gain from the sale of the partnership’s underlying assets would be exempt.

The preamble to the Final Regulations also discusses the following items which Treasury opted not to except from commercial activities:

• Fee Income: Treasury declined to include an exception to commercial activity for the receipt of fees by a foreign government investor from a private equity fund (in its capacity as an investor therein) for services performed by the sponsor.

Key observation: Foreign government investors often waive their entitlement to fees received by the sponsor in excess of the fees applied to reduce management fees under a customary management fee offset due to concerns that such fees constitute commercial activity income and/or effectively connected income. Treasury’s decision to not except fee income may cause foreign government investors to maintain past practice in this regard. The preamble to the Final Regulations, however, seems to leave room for an alternative position. In particular, in the discussion of Treasury’s reasoning for not excepting certain fee income from commercial activity, it is suggested that if a foreign government investor’s interest in such a fund is a “qualified partnership interest” (as further discussed below), then the receipt of a fee from the fund will not cause the foreign government to be treated as engaged in commercial activity so long as the fee-earning activity is not otherwise directly imputed to the equity owners under agency principles. In such a case, the foreign government investor may have to contend only with the risk that the fees constitute effectively connected income, a showing of which, as the Final Regulations and the 2025 Proposed Regulations make clear, has a comparatively higher bar.

• Investment in Loans: Treasury declined to address the circumstances in which loan origination is a commercial activity. The 2025 Proposed Regulations provide guidance as to when acquiring a loan is treated as an investment (as opposed to commercial activity) for purposes of Section 892. 

USRPHCs

Foreign governments have long had to manage their affairs to avoid USRPHC status for their controlled entities. This is because of a per se rule in the temporary Treasury Regulations providing that a controlled entity that would be a USRPHC if it were a domestic corporation is treated as engaged in commercial activity and, therefore, is a controlled commercial entity. This classification would turn off the Section 892 exemption for all income of the entity, an outcome that was often viewed as a “trap for the unwary.” 

The 2022 Proposed Regulations (on which taxpayers were permitted to rely for taxable years ending on or after December 28, 2022) provided some relief by excepting from this per se rule (i) foreign qualified pension funds (which have a more general FIRPTA exemption than Section 892 investors who are not foreign qualified pension funds) and (ii) corporations that were USRPHCs solely by reason of their direct or indirect minority ownership interests in one or more other corporations (“minority interest exception”).

Citing to legislative history in support of their reasoning, Treasury and IRS decided to limit the USRPHC per se rule to only domestic corporations. The Final Regulations have thus removed the possibility that a foreign government’s-controlled entities could become controlled commercial entities solely by reason of being USRPHCs. 

This change renders the prior relief granted under the prior proposed Treasury Regulations unnecessary for controlled entities seeking to avoid USRPHCs status. With respect to foreign government investors who relied on the minority interest exception with respect to domestic subsidiary holding companies, however, the minority interest exemption may remain necessary. For this reason, Final Regulations retain this exception, but with the important clarification (in response to comments pointing to uncertainty) that “solely by reason” language means that USRPHC status for purposes of this rule is tested by removing the “good” assets (i.e., the non-controlled USRPHCs) from an entity’s balance sheet before performing the general asset test under the FIRPTA rules. Accordingly, if, for example, a domestic holding corporation of a foreign government investor holds only interests in USRPHCs, and one such interest is a controlled position, the minority interest exemption would not apply. 

Key Observation: This change is a welcome relief for foreign governments who will no longer need to monitor the ratio of USRPHC investments to non-USRPHCs held by their controlled entities. The change in the Final Regulations goes further than the minority interest exception, which still required monitoring due to the possibility that even one controlled position in a USRPHC could turn off the exception.

Inadvertence

The Final Regulations keep, with certain clarifying changes, the rule in the 2011 Proposed Treasury Regulations that excepted certain “inadvertent” commercial activity from causing an entity to become a controlled commercial entity so long as (1) the failure to avoid conducting commercial activity was reasonable (which requires, among other things, adequate written policies and operational procedures to monitor activities), (2) the commercial activity was promptly cured and (3) adequate records relating to discovered commercial activity and the remedial actions taken to cure the activity were maintained. 

The Final Regulations provide the following modifications to the 2011 Proposed Treasury Regulations:

• a non-exclusive list of factors that may be used to determine whether a written policy or operational procedure is adequate.³
• with respect to entities relying on the safe harbor for showing that a failure to avoid commercial activity was “reasonable,”⁴ additional rules for purposes of determining the portion of an entity’s assets used in, and income earned from, commercial activities, including (i) permission for certain entities that do not prepare financial statements to rely on books and records, (ii) a uniform definition of “financial statement” and (iii) exclusion from the applicable numerator (but inclusion in the applicable denominator) of assets in, and income from, a “qualified partnership interest;” and
• with respect to the “cure” requirement, (i) an increase in the time period during which an entity may cure inadvertent commercial activity from 120 days to 180 days, (ii) a clarification that such period is measured from the date of discovery by the relevant employees and (iii) guidance that inadvertent commercial activity attributable to a partnership interest may be cured through an exchange of such interest for a “qualified partnership interest.”

Key Observation: Many foreign government investors already have manuals and other procedures in place documenting best practices for avoiding commercial activity, but they may seek to revisit internal guidelines to specifically conform them to the additional factors listed in the Final Regulations described above, particularly with respect to ensuring that minimum undertakings for avoiding commercial activity are secured from fund sponsors or other counterparties in connection with investments. 

Timing of determining controlled commercial entity status

Under the 2011 Proposed Regulations, if an entity engaged in commercial activities at any time during a taxable year, the entity was considered a controlled commercial entity for the entire taxable year. 

The Final Regulations clarify two aspects of this rule: 

• The annual determination of whether an entity is a controlled commercial entity is made with respect to the entity’s table year, which may be less than a 12-month period as a result of a transaction that closes the taxable year.
• Commercial activity “taint” does not generally attach to an entity that becomes the successor of another predecessor entity under a transaction to which Section 381(a) applies (e.g., a reorganization), unless the predecessor entity’s year end does not close (e.g., an “F” reorganization) or the Section 381(a) transaction is between two corporations controlled by the same foreign sovereign.

Partnerships

The Final Regulations substantially adopt the general rule in the 2011 Proposed Regulations that commercial activity of a partnership would be imputed to its partners, except where the partnership engages in only trading activity for the partnership’s own account which activity would have otherwise qualified for the trading exception if undertaken directly by the foreign government investor.

The Final Regulations replace, however, the other exception to imputation of commercial activity from partnership to partners in the 2011 Proposed Regulations, known as the “limited partner exception,” with a similar exception which applies to “qualified partnership interests.”⁵ A holder of a “qualified partnership interest” in a partnership that engages in commercial activity will not, by reason of holding such partnership interest, be treated as engaged in commercial activity (provided that any commercial activity income allocable to the entity will retain its status as such and may be taxed accordingly). 

To be a “qualified partnership interest,” the holder of such interest must not have:

• personal liability for claims against the partnership;
• the right to enter into contracts or act on behalf of the partnership;
• rights to participate in management or conduct the partnership’s business; or
• “control” over the partnership (i.e., cannot own 50% or more, by value or vote, of the equity or have “effective control.”

Rights to participate: With respect to the third requirement, the Final Regulations clarify that rights to participate in monitoring or protecting the holder’s capital investment⁶ do not constitute participation in management to the extent such rights do not confer rights to participate in day-to-day management or operation of the business. Rights to participate in ordinary-course personnel and compensation decisions, and the right to take active roles in formulating the partnership’s business strategy, however, would amount to such participation. 

Qualified Partnership Interest Safe Harbor: Under a safe harbor in the Final Regulations, a partnership interest will be a qualified partnership interest if, at all times during the partnership’s tax year, the holder:

• Has no personal liability for claims against the partnership;
• Has no right to enter into contracts or act on behalf of the partnership;
• Is not a managing member or engaged in a similar role; and
• Does not, directly or indirectly, own more than five percent of either the partnership’s capital or profits interests.

Tiering: In tiered partnership structures, a “bottom-up” approach will apply, meaning that an upper-tier partnership that holds a qualified partnership interest in a lower-tier partnership is not attributed the lower-tier partnership’s commercial activities. 

Multiple Partnership Interests: All interests held by a foreign government in the partnership, whether reflected in different partnership interests or held through one or more integral parts or controlled entities, are aggregated for purposes of the qualified partnership interest exemption.

Key observation

• The rules appear to bless customary minority investments by foreign government investors in private investment funds where the investor is granted several limited rights and protections, including the right to sit on the limited partnership advisory committee. Guidance has long been sought that participation on such a committee did not turn off the limited partner exception.

_{1 References to “Section” refer to Sections of the Internal Revenue Code of 1986, as amended (the “Code”). 
2 Investments in stocks, bonds, and other securities; loans; investments in financial instruments (as defined in Treasury Regulations §1.892-3T(a)(4)); the holding of net leases on real property; the holding of real property which is not producing income (other than on its sale or from an investment in net leases on real property); the holding of bank deposits in banks; and the transferring of securities under a loan agreement which meets the requirements of section 1058.
3 The factors include whether written policies and operational procedures (1) prohibit the entity from engaging in commercial activity directly or indirectly through investments, (2) are communicated in writing to persons exercising discretionary authority, (3) require an advance determination (i.e., an opinion of counsel or otherwise), as to whether an investment is commercial activity, (4) include annual audits or reviews of investments and (5) require the result of periodic tests to be reviewed and certified by responsible employees tasked with curing any commercial activity.
4 The safe harbor requires generally that (1) adequate written policies and operational procedures are in place to monitor an entity’s activities, and (2) the value of an entity’s assets used for, and the income earned by the entity from, commercial activity does not exceed 5% of the total value of the assets and income reflected on the entity’s financial statements. 
5 The Final Regulations opted for the term “qualified partnership interest” rather than “interest as a limited partner in a limited partnership” to denote the broader application of this exception to any entity that is classified as a partnership for U.S. federal income tax purposes.
6 These include oversight or supervisory rights in the case of major strategic decisions, such as admission or expulsion of a partner, amendment of the partnership agreement, dissolution of the partnership, unusual and non-ordinary course deviations from previously determined investment parameters, extending the term of the partnership’s governing agreement, merger or conversion of the partnership, or disposition of all or substantially all of the partnership’s property outside the ordinary course of business.} 

_{White & Case means the international legal practice comprising White & Case LLP, a New York State registered limited liability partnership, White & Case LLP, a limited liability partnership incorporated under English law and all other affiliated partnerships, companies and entities.}

_{This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.}

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