March 05, 2008
Current Law on Taxing Sovereign Wealth Funds: Why It's Good to Be The King
Posted by Victor Fleischer

For those interested in non-tax issues, The House Financial Services Committee is currently holding a hearing on Sovereign Wealth Funds.   

For the tax nerds out there, I thought I might offer a short overview of how SWFs are currently taxed.  In future posts, I will propose some reform alternatives for Congress to consider.

The big picture is that Sovereign Wealth Fund investments in the United States are generally exempt from tax under Section 892 of the Code.  The idea is that when a foreign sovereign makes a portfolio investment in the United States, the sovereign is acting as a sovereign and is entitled to sovereign immunity. 

There is an exception for commercial activity.  So, for example, if the government of Italy were to operate a cycling touring company in the United States, the profits from that active business activity would be taxed as business income.  (Similarly, if a customer of that touring company fell off the bicycle and got hurt, Italy would not be immune from tort liability.)  The key for Sovereign Wealth Funds is that portfolio investing is *not* treated as a commercial activity under current law.  So the returns from their investments -- interest, dividends, capital gains -- are categorically exempt from tax.

The detail start to get a little complex, so I'll continue below the fold.

General Rule.  The general provision is Section 892(a)(1).  That section says that a foreign government's income from investments in the United States in (1) stocks, bonds, and other domestic securities, (2) financial instruments held in the execution of governmental fiscal or monetary policy, and (3) interest on deposits in US banks isn't includible in gross income and is therefore exempt from US tax. 

Section 892(a)(2) then carves an exception for income derived from a commercial activity, a controlled commercial entity, or the disposition of an interest in a controlled commercial entity.  These are all terms of art, which I'll explain in a minute. 

If any income isn't exempt, then Section 892(a)(3) says that the foreign government will be taxed as a corporate resident of its own country.

Foreign Investors.  What would it mean to tax a SWF as a corporate resident of its own country?  If the income is effectively connected with a US trade or business (ECI), then the income would be taxed on terms similar to a US business.  For non-ECI investments, however, the rules are a little different for foreign investors than US investors.  For non-ECI investments, a foreign corporation would be subject to tax on its FDAP income.  FDAP stands for fixed or determinable, annual or periodic income -- which means things like dividends, interest, rents and royalties.  What makes these streams of income special is that they can be withheld at the U.S. source of that income.

So the tax Code imposes a 30% tax on FDAP income to foreign investors, withheld at the U.S. source, such as a US company paying a dividend.  This tax rate is often reduced by treaty agreement.  Also, certain portfolio interest is also exempt, allowing US companies to borrow more freely abroad.

Capital gains are not FDAP income.  Portfolio capital gains are not taxed in the US -- they are instead treated as foreign source income and therefore not taxed here.

Lastly, direct U.S. real estate holdings and certain indirect real estate holdings are subject to FIRPTA, which imposes a withholding tax on gains from the sale of US real property. 

Why It's Good To Be the King.   There are thus a limited but significant number of ways in which it's better to be treated as a foreign sovereign than a foreign private investor--most notably, dividends, certain types of interest payments, and real estate holdings.  Under the applicable 892 regulations, the exemption for sovereigns is extended to "integral parts" or a foreign sovereign (such as an agency) or a "controlled entity" of a foreign sovereign, i.e., a separate juridical entity (such as a corporation).  Foreign-controlled pension trusts for employees of the foreign government also qualify under the regulations. Under the regs, then, SWFs qualify as controlled entities of a foreign sovereign. 

The regs also require that to qualify as a controlled entity, the earnings must not inure to a private person.  For some government funds, like those controlled by Norway or Canada, this doesn't seem too difficult to show.  Singapore also seems pretty transparent on this point.  For others, like UAE, Saudi Arabia, and China, it's harder to know what happens to the earnings. 

How the rules work in practice.  SWFs are usually organized as separate juridical entities, funded and controlled by a foreign sovereign, and therefore qualify under the regulations as "controlled entities" of a sovereign.  The usual investments by SWFs in stocks, bonds, bank deposits, and government obligations are exempt from tax.  When these passive investment activities are mixed with commercial activities in the same investment vehicle, the tax rules get complicated.  There may also be circumstances where the SWF may blur the line between passive investing and operating a financing business.  But for present purposes, the analysis of current law is pretty straightforward.

To my knowledge -- and I welcome any comments from practitioners out there -- the Service has not looked into whether the earnings from SWF inure to a private person rather than the sovereign.  This inquiry is difficult, of course, in the case of royalty -- is a Prince a private person or a sovereign? 

That's enough current law for now.  In the next post, I'll talk a bit more about why all of this matters.

For more, check out the Tax Management Portfolio (913), U.S. Income Taxation of Foreign Governments, International Organizations and Their Employees.  Brett Dick (Heller Ehrman) is the author, and it's a great companion to the code and regs.

Prior posts: 

Taxing Sovereign Wealth Funds (March 4, 2008)

Related Research:

Two and Twenty (forthcoming NYU L Rev)
Taxing Blackstone
(forthcoming Tax L Rev)

Press Coverage:

Financial Week (March 5, 2008)
NYT Deal Book (March 5, 2008)
Dealbreaker (March 4, 2008)

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Comments (2)

1. Posted by Jake on March 5, 2008 @ 21:32 | Permalink

Go, Vic!

Should the Congress do anything to increase the US tax burden on SWFs, one hopes they keep the marginal tax rates low. Otherwise, the next time major US banks need a foreign hangover cure, for having drunk too deeply from the CDO cup (or whatever other kind of financial instrument that may cause the next financial debacle), they may find no help from SWFs.


2. Posted by bdg on March 6, 2008 @ 15:52 | Permalink

Pretty fascinating. You should check out, if you haven't already, Ellen Aprill's pieces on exemptions for U.S. states and related entities; there's also an anti-private inurement rule in some cases there. It's grafted from nonprofit law, and she challenges its application in the state entity context -- basically, our idea of nonprofits is that they serve the public good, but our idea of government is capacious enough to include benefits directed to single individuals (hello, earmarks?).

To extend Ellen's analysis, you could imagine a set of federal rules barring some kinds of inurement for state entities --for example, self-dealing -- on the grounds that it is sensible for the federal government to help fight state-level corruption. But it seems pretty hard to make that case about foreign governments.

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