IRS Proposed Regulations Would Narrow the Exemption For Passive Income of Foreign Governments Under Section 892

The Internal Revenue Service (IRS) and the U.S. Treasury Department last Friday released final and proposed regulations addressing various rules under section 892. The rules are a mixed bag – some are favourable and provide clarity, while others may be unfavourable – and ambiguity may lead taxpayers to take more conservative positions. In particular, the proposed regulations would broadly treat debt acquisitions, whether or not at original issuance, as commercial activities, with limited safe harbors and require detailed analysis under a non-exclusive list of relevant factors. Additionally, the proposed rules for determining when a minority position results in controlled commercial entity status may disrupt current practices.

Foreign governments and fund sponsors with section 892 investors should consider their structures, undertakings and investments in light of these regulations and consider submitting comments by the deadline of February 13, 2026. We briefly summarize below certain highlights in the final and proposed regulations. 

Proposed Regulations

1. Loan origination and debt acquisition (Prop. Reg. §1.892-4(c)(1)(ii)) treated as commercial activities. The proposed regulations establish a comprehensive regime under which acquiring debt is per se a commercial activity unless one of two safe harbors applies or the acquisition qualifies as an investment based on all the facts and circumstances. All debt is covered, whether acquired at original issuance or as a secondary acquisition; and debt for this purpose includes financial instruments treated as debt for tax purposes. Surprisingly, as considered further below, an acquisition of a single debt instrument can be treated as commercial activity.

   • Safe harbor for registered offerings. An acquisition of debt in an offering registered under the Securities Act is treated as an investment, provided that the underwriters are unrelated to the acquirer under sections 267(b) and 707(b). Treasury requests comments on whether analogous foreign‑law registered offerings should qualify.
   • Safe harbor for qualified secondary market acquisitions. An acquisition of debt on an established market is treated as an investment if (1) it is not acquired from the issuer, (2) the acquirer does not participate in negotiating issuance or terms, and (3) the seller is not under common management or control with the acquirer (unless the seller originally acquired the debt as an investment under these rules). Treasury requests comments on extending this safe harbor to non‑exchange‑traded debt.

   Beyond the safe harbors, a taxpayer may illustrate via facts and circumstances that the acquisition of debt is an investment – meaning, under the regulations, that the expected return from the debt is exclusively a return on capital rather than a return on the acquirer’s activities. The regulations provide a non-exhaustive list of factors, such as 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 amount of the debt acquired.

   An example in the proposed regulations illustrates that a single directly-negotiated loan may be treated as a commercial activity; however, another example indicates how, in contrast, a $50 million shareholder loan to an 80% subsidiary, valued at $100 million, was treated as an investment, because the shareholder owned a substantial percentage of the issuer’s equity and acquired a smaller amount of debt. Debt/equity ratios of controlled subsidiaries might need to be revisited in light of this example.

   If the regulations are finalized as proposed, given the limited nature of the two safe harbors, it seems clear that most debt acquisitions would be subject to the facts-and-circumstances test. Treating all debt acquisitions, whether or not at original issuance, and including investments that would have qualified under the securities trading safe harbor, as potentially giving rise to commercial activities could significantly increase the commercial activities risk for foreign governments, including with respect to their fund investments. Foreign governments and fund sponsors should separately review their existing structures, undertakings and investments in light of these regulations, and should consider the rules when structuring new investments and commitments. Serious consideration should be given to submitting comments to Treasury in favour of adopting broader safe harbors, presuming investments are not commercial activities if they seem to be routine and standard investment structures absent a principal purpose of avoiding the limitation under the commercial activities kickout.

2. “Effective [practical] control” standard expanded and potentially broader in application (Prop. Reg. §1.892-5(c)(2)). The proposed regulations’ “effective control” test (formerly “effective practical control”) for purposes of qualification as a controlled commercial entity considers any combination of interests an investor may have (including equity, voting rights, debt, contractual or regulatory rights, and business relationships with the entity or interest holders) that confer control over operational, managerial, board‑level, or investor‑level decisions. The proposed regulations present substantial ambiguity because the magnitude, quantity and quality of control rights that would constitute such  control are not addressed, and the proffered examples are themselves ambiguous.

   For instance, one example in the proposed regulations lists a number of lender rights common in credit agreements (including control over asset dispositions, additional borrowing and dividend distributions) as part of the package of rights (including certain veto rights) that would be considered to constitute control. Further examples make clear that veto rights are a strong indicator of control, with one example concluding that control existed based on the taxpayer’s sole director having veto rights over dividend distributions, material capital expenditures, sales of new equity interests and the operating budget. In addition, the examples raise the possibility of informal controls being considered, with one example describing a scenario in which a non-affiliated party that derives significant income from the foreign sovereign through extrinsic business dealings consistently votes in line with the foreign sovereign, causing the foreign sovereign to be treated as controlling the entity. The examples are ambiguous in part because they do not indicate whether a different result would apply if one or more of the listed powers was absent.

   The proposed regulations thus introduce considerable uncertainty with respect to the availability of section 892 benefits in minority investments (whether in equity, debt or otherwise) that feature standard contractual protections. Potentially even more troubling is that government investors will be forced to analyze extrinsic factors with respect to their investments for potential indicia of informal control. 

3. Partnerships not treated as “controlled entities” (Prop. Reg. §1.892-2(a)(4)). The proposed regulations clarify that a partnership cannot be a controlled entity. This approach is in line with recent IRS private letter rulings and confirms that a partnership would not be classified as a corporation by reason of being treated as a “controlled entity” under section 892. Note, however, that a partnership can still be a controlled commercial entity  if it engages in commercial activities and the foreign government meets the ownership or effective‑control thresholds in the regulations.

Final Regulations

Compared with the proposed regulations, the final regulations make relatively few and tamer changes to the previously proposed regulations.

1. Foreign Investment in Real Property Tax Act / U.S. Real Property Holding Corporation  (FIRPTA/USRPHC) per se rule narrowed to domestic corporations (§1.892-5(b)(1)). Under the final regulations, a foreign corporation is no longer deemed a controlled commercial entity solely because it is a U.S. real property holding corporation. In addition, Treasury finalized inclusion of the “minority interest” exception, permitting a domestic corporation not to be treated as a controlled commercial entity if it would be a USRPHC solely by reason of its direct or indirect ownership of one or more other corporations that are not controlled by the foreign government. 

2. Limited partner exception recast as “qualified partnership interest” (§1.892-5(d)(5)(iii)). The final regulations generally retain the prior “limited partnership interest exception” (renaming it as the "qualified partnership interest exception") where commercial activities of a partnership are not attributed to a partner if certain conditions are met, . The regulations provide additional specificity regarding the management and control rights that could threaten this status, with a facts-and-circumstances test to determine whether the partner has rights to participate in the day-to-day management or operation of the partnership’s business – for example, the right to participate in ordinary-course personnel and compensation decisions, or take active roles in formulating the partnership’s business strategy or in respect of the partnership’s acquisition or disposition of a specific investment. Notably, under a special aggregation rule, interests held by integral parts or controlled entities of a foreign sovereign or entities controlled by such foreign sovereign are aggregated for such purposes. This means that management and control rights held by a foreign governmental entity could cause the exception to not apply to another foreign governmental entity of the same foreign sovereign.

   In addition, the final regulations provide for a de minimis safe harbor that treats an interest as a qualified partnership interest if the holder (aggregating direct and indirect interests of a foreign sovereign under the special aggregation rule noted above) owns no more than 5% of its capital or profits and is not a managing member/partner, lacks binding authority and has limited liability. 

3. Commercial activities (§1.892-4). The final regulations clarify that “commercial activities” under section 892 has a different and broader meaning from U.S. trade or business under section 864, potentially including as commercial activities those that would not be treated as constituting a U.S. trade or business (if they were conducted in the United States). On the other hand, effecting transactions in stocks, bonds, other securities, partnership equity interests, commodities or financial instruments for a foreign government’s own account do not constitute commercial activity. 

Effective Date and Comment Period

The final regulations generally apply to taxable years beginning on or after December 15, 2025 (the date of publication in the Federal Register), and taxpayers may elect to apply the final rules to open prior taxable years, subject to consistency requirements.

The proposed regulations would apply to taxable years beginning on or after the date that a Treasury decision adopting them as final is published in the Federal Register, with limited elective early application (once finalized) for the rules excepting partnerships from treatment as a controlled commercial entity, subject to consistency requirements.

Comments and requests for a public hearing are due on February 13, 2026. Foreign governments and fund sponsors with section 892 investors should strongly consider submitting comments. In particular, there is a strong rationale to suggest broader safe harbors with respect to debt investments, presuming that such investments are not commercial activities if they seem to be routine and standard investment structures absent a principal purpose of avoiding the limitation under the commercial activities kickout, and establishing clearer guidelines with respect to effective control.