Treasury proposes regulations addressing key aspects of the Section 892 exemption for foreign sovereigns

On December 15, 2025, the US Department of the Treasury (“Treasury”) and the Internal Revenue Service published new proposed regulations (the “Proposed Regulations”) under Section 892¹, which contains the tax exemption for foreign sovereigns with respect to certain qualifying investment income from US sources. The Proposed Regulations provide guidance on two key topics related to the exemption on which guidance has long been sought: (1) when a foreign government is considered to be in “effective control” of an entity and (2) when a foreign government’s acquisition of debt constitutes “commercial activity.” Treasury and the Internal Revenue Service have also issued final regulations (the “Final Regulations”) contemporaneously with the Proposed Regulations. See Treasury Finalizes Previously Proposed Regulations, with Key Modifications, Regarding the Section 892 Exemption for Foreign Sovereigns for a summary of the Final Regulations.

The Proposed Regulations will apply only to tax years beginning on or after the date they are published in final form.

Effective control

The Proposed Regulations provide guidance on what constitutes “effective control” (formerly known as “effective practical control”) for purposes of determining whether an entity is a “controlled commercial entity” of a foreign government. A finding of “effective control” with respect to an entity would turn off the Section 892 exemption with respect to income received by or from that entity. Under the Proposed Regulations, “effective control” arises when the foreign government owns an interest in an entity that, directly or indirectly, either separately or in combination with other interests, results in control of either the operational, managerial, board-level, or investor-level decisions of such entity. All of the facts and circumstances related to the applicable interest would be considered in the analysis, with “interest” defined broadly to include, for example:

• equity and debt interests;
• voting rights, including the power to appoint directors or managers and to veto decisions, and contractual rights in or arrangements with the entity, or with other interest holders in the entity; and
• business relationships with key stakeholders of the entity such as major customers or suppliers.

Per se effective control will arise where a foreign government is, or controls an entity that is, a managing partner or managing member (or equivalent) of an entity.

The following examples help illustrate the application of the rules.

Example 1: No effective control where a foreign government investor has only a minority equity ownership interest with no unilateral veto or other arrangements with respect to the corporation, and is not entitled to elect a majority of the corporation’s directors or to appoint or replace the corporation’s officers.

Example 2: No effective control where, assuming the same facts as Example 1, but in addition, an investment agreement is entered into between the foreign government investor and the corporation containing criteria for what types of investments the corporation may make, but which does not otherwise confer voting, operational, managerial or other rights on the foreign government investor.

Example 3: No effective control where, assuming the same facts as Example 1, but in addition the foreign government investor is entitled to participate in an investment committee and has the right only to discuss acquisitions or sales, but with no other additional rights with respect to the corporation. 

Example 4: Effective control where the foreign government investor is entitled to appoint only one out of three of the corporation’s directors, but such director is authorized to unilaterally appoint or dismiss the manager tasked with managing the corporation’s operations. 

Example 5: Effective control where, assuming the same facts as Example 4, but instead of being entitled to unilaterally appoint or dismiss the manager, the foreign government investor’s appointed director, alone, has a unilateral veto right over dividend, material capital expenditures, sales of new equity interests and the entity’s operating budget.

Example 6: Effective control where a foreign government investor is entitled to appoint one out of three of the corporation’s directors, but one other investor derives significant revenues from other business dealings with the foreign government investor, and as a matter of course, causes its appointed director to always vote consistently with the foreign government investor’s appointed director. 

Example 7: Effective control where the corporation’s business consists of extracting and marketing a mineral located in another country, and a foreign government owns all rights to that mineral and regulates all businesses engaged in its extraction. 

Example 8: Effective control where a foreign government investor is a creditor of the corporation, and the credit agreement restricts the corporation’s ability to dispose of assets, incur future debt and distribute dividends, and grants the foreign government investor veto rights over dividend and stock repurchases, additional borrowing, capital expenditures, the corporation’s annual operating budget and redemption of subordinated debt.

Key observations

A key question arising from the Proposed Regulations is the extent to which veto and consent rights result in effective control. Example 5, in particular, implicates common place JV agreements where a foreign sovereign owns up to 49% of the equity, with certain consent and veto rights to protect its investment. Example 5 finds “effective control” through a combination of four such consent rights over dividends, material capital expenditures, sale of new equity interests and the entity’s operating budget.  In contrast to the foreign government investor’s right in Example 4, which produced the expected outcome, Example 4, it is unclear whether any one of the rights in Example 5 would have been fatal to the analysis on its own, or whether it was only the combination of multiple rights that was determinative, and which ones, if any, had the greatest weight.  In practice, JV agreements typically include far more than four consent rights for minority investors.

A notable assumed fact in all the examples is that no other owner had veto rights or effective control (and in Example 5 in particular, the foreign government investor alone had unilateral veto rights). This raises the question as to whether effective control for a foreign government investor can arise where the veto rights are shared by others, or where other owners alongside the foreign government otherwise have effective control. Treasury has requested comments as to when veto rights should not cause a foreign government to have effective control. Given the prevalence of minority investments by foreign governments coupled with veto and consent rights, meaningful feedback on this point is expected.  As currently drafted, the Proposed Regulations appear to raise as many questions as they answer given the many different permutations of consent rights that are seen in the market, and Treasury may have limited success in clarifying “effective control” with only these regulatory examples.

Debt

Temporary and prior proposed Treasury Regulations under Section 892 have long held that, even though the list of investments that are not treated as commercial activities includes “loans,” the Section 892 exemption does not apply to loans made by a banking, financing or similar business. In response to comments pointing to uncertainty as to when loan origination amounts to a banking, financing or similar business, the Proposed Regulations provide a framework for determining when acquiring debt (including any instrument treated as debt for US tax purposes), qualifies as investment for purposes of Section 892, as opposed to commercial activity.

The Proposed Treasury Regulations prescribe a general rule under which all acquisitions of debt are treated as commercial activity unless the acquisition is characterized as investment for purposes of Section 892 under either of two safe harbors, or under a facts and circumstances test. 

Under the first safe harbor, acquisitions of debt in an offering registered under the Securities Act of 1933 are treated as investment so long as the underwriters are not related to the acquirer under Section 267(b) and Section 707(b).

Under the second safe harbor, acquisitions of debt traded on an established securities market² are also treated as investment, so long as the acquirer is not acquiring the debt from the issuer (or from a person under common control with the acquirer who, in turn, acquired the debt from the issuer) or participating in negotiation of the terms or issuance of the debt. 

An acquisition of debt may also qualify as investment under a general facts and circumstances test, with the following non-exclusive factors specifically cited in the regulations:

• whether the acquirer solicited, or held itself out as willing to loan to, prospective borrowers;
• material participation in negotiating or structuring terms;
• entitlement to compensation that is not treated as interest for US federal income tax purposes;
• the form of the debt and the issuance process (e.g., whether the debt is a bank loan or privately placed);
• percentage of debt issuance acquired by the acquirer relative to percentages acquired by other purchasers;
• percentage of equity in the debt issuer held by the acquirer; and
• if the debt is deemed acquired as a result of a “significant modification,” whether there was, at the time of acquisition of the original unmodified debt, a reasonable expectation based on “objective evidence” that the original unmodified debt would default

The Proposed Regulations provide examples applying the factors to different fact patterns.

Example 1: The making of even a single loan that does not qualify for the safe harbors and is not otherwise treated as investment under the facts and circumstances test (i.e., because the foreign government structured and negotiated the loan terms and did not otherwise own any equity in the issuer) can give rise to commercial activity.

Example 2: A loan to a borrower which the foreign government structured and negotiated is treated as investment where the foreign government owns a “substantial percentage” (with 80% ownership used in the example) and the loan is not “significant” relative to the value of such equity (with $100 million being the equity value and $50 million being the debt loaned in the example).

Example 3: Acquisitions of multiple privately placed loans from financial institutions acting as placement agents for a number of issuers does not give rise to commercial activity, where (i) the foreign government met beforehand with the placements agents and communicated its interest in acquiring loans and the terms on which it would be willing to acquire them and (ii) less than one-third of the loans were acquired by the foreign government and at least one other unrelated investor purchased a larger percentage of each loan. 

Example 4: Debt that is deemed acquired by a foreign government as a result of a significant modification in connection with a workout does not give rise to commercial activity where (i) the original debt was acquired in a secondary market acquisition constituting investment, at a time when such debt was not in default, and there were no objective indications (such as declining trend in the borrower’s financial condition or credit rating) at the time of the purchase that the issuer would default on the debt and (ii) the foreign government did not participate in the creditors’ committee negotiating the loan modifications. 

Example 5: Debt deemed acquired as a result of a significant modification was commercial activity on the same facts as Example 4, except that the foreign government was a member of the borrower’s creditors’ committee, which materially participated in negotiating and structuring the terms of the modified debt. 

Key observations

The two safe harbors may be of limited utility to many foreign sovereigns with significant holdings in privately placed debt that is not traded. Treasury requested comments as to the circumstances (if any) in which the second safe harbor should apply to an acquisition of debt that is not traded on an established securities market. A safe harbor which sanctions a debt acquisition as investment so long as minimum “seasoning” is present (which may vary depending on the facts (e.g., a longer period for transactions between related parties and a shorter period for unrelated parties) would be particularly useful. 

Example 1 is the clearest example of Treasury’s view, expressed in the preamble to the Final Regulations, that “commercial activity” is broader than “trade or business.” The broad application of commercial activity may invite more caution by foreign sovereigns in approaching and structuring debt investments, including siloing such investments where practical to isolate risk. 

One question looming over the application of these rules is when origination activity undertaken by another person would be imputed to a foreign government investor. The Proposed Regulations provide that actions by an agent or any person otherwise acting on behalf of the acquirer are treated as the actions of the acquirer. While the clear implication in Example 3 is that the financial institutions were independent agents acting on behalf of the borrowers, the example also implies that the result did not turn on only the application of traditional agency principles. The application of the rules to other common arrangements where the independence of the intermediary is not as clear cut, particularly those involving investment fund sponsors (e.g., “season and sell” structures, or arrangements, such as a separately managed account, whereby sponsors periodically present loan investment opportunities to foreign sovereign clients), is uncertain.

The fact that “debt” for purposes of these rules includes any obligation treated as debt for US federal income tax purposes, while not surprising, leaves open the question as to whether a customary “repo” transaction treated as a secured loan for tax purposes could give rise to commercial activity where the foreign government is acting as the securities borrower (i.e., the cash lender). In recent guidance,  the IRS concluded that customary “repo” transactions undertaken by a hedge fund to invest excess cash did not give rise to a US trade or business on the basis that such transactions were “investment activities.” Additional guidance on whether similar principles would apply in the context of Section 892 would be helpful given the significant presence foreign government investors have in the repo market.

_{1 References to “Section” refer to Sections of the Internal Revenue Code of 1986, as amended.
2 An established securities market is defined by reference to Treasury Regulations relating to publicly traded partnerships and is intended to pick up national securities exchanges, such as NYSE and NASDAQ and foreign equivalents, regional or local exchanges and interdealer quotation systems such as the OTC.
3 See ILM 202548004.}

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