My newest research project looks at the taxation of sovereign wealth funds. The paper is still a work-in-progress, but here is where I think I am headed: Under current law, Sovereign Wealth Funds are exempt from U.S. tax. Congress should consider amending Section 892 of the code to tax these state-owned investments under certain conditions, and the Code should not favor state-owned investors over private foreign investors. As with Two and Twenty, I think this is an example where the investment world has changed since Congress wrote the rules, and it is time for an update.
Overview. Under current law, based on the principle of sovereign immunity, investments by foreign state-owned funds and controlled entities are generally exempt from tax. Commercial activities in the US may be taxed, but portfolio investing is not considered a commercial activity.
By contrast, investment returns by private foreign individuals and corporations are taxed at rates as high as 30%, although this rate is often reduced by treaty agreement, or, in the case of most capital gains, treated as foreign source income and therefore exempt from U.S. tax. Encouraging foreign investment in the United States generally increases overall welfare. But there is no sound policy reason to unconditionally exempt state-owned investment funds from U.S. taxation, and it is not at all clear that we should give state-owned funds a competitive advantage that crowds out private investment. At the same time, policymakers should proceed with caution, as raising tax rates on Sovereign Wealth Funds could be perceived as a protectionist signal that could discourage both state-owned and private foreign investment.
Regulatory arbitrage between investment regulation and tax. One policy concern is how the funds want to have it both ways. On the one hand, they present themselves to the SEC and other regulators as if they are just like any other institutional investor, investing for purely commercial purposes. And thus, they argue, they should not be subject to any additional regulatory burden of disclosure, transparency, or anything else. On the other hand, for tax purposes they are treated as sovereign states and thus entitled to sovereign immunity from taxes. The net result of our regulatory scheme, then, is to give state-owned funds a competitive edge over private investment.
Continued below the fold.
What Are SWFs? Sovereign Wealth Funds are investment vehicles funded and controlled by foreign governments. The largest funds are controlled by Abu Dhabi (UAE), Saudi Arabia, Norway, Singapore and China. These funds have grown rapidly in recent years. Together these funds control perhaps $2-$3 trillion in capital, an amount which exceeds the size of the US private equity industry. Fueled by oil profits and/or trade surplus, SWFs are expected to grow to as much as $10 trillion or more over the next ten years. Historically, foreign governments would often recycle trade surplus back into the United States by buying Treasury bonds. More recently, these governments are taking a more active investment role, seeking a higher yield than what Treasury bonds offer. SWFs are the investment vehicles they use to do that. Their portfolio investments include a mix of corporate debt, governmental obligations, and corporate equity stakes.
Sovereign Wealth Funds have a complex relationship with the private equity industry. For the last 20 years or so, SWFs have often been limited partners in private equity funds. At times, SWFs make direct investments in target companies, competing with PE funds for deal flow. Most recently, SWFs have purchased direct equity stakes in private equity sponsors and other US financial institutions such as Blackstone, Citigroup, and Merrill Lynch. One way to think about SWFs is as a low-cost (and tax-subsidized) provider of capital to the PE industry.
Why This Matters. The big worry is that these sovereign wealth funds are Trojan horses which will allow foreign governments to shape and influence American enterprise in a manner inconsistent with our economic and national security interests. Even if funds are currently acting in a manner consistent with other, non-governmental institutional investors--and by most accounts they are--there's no guarantee that they will continue to do so in the future in circumstances where the financial interests of the fund and the political interests of the government that controls the fund diverge. Giving foreign governments partial ownership of companies like Citigroup and Merrill Lynch gives those countries new leverage in foreign policy discussions; sudden withdrawal of foreign state-owned investment could harm the financial services sector of the U.S. economy. Of course, one can also view these investments in a more positive light; China's investment in Blackstone might help it learn to modernize its own financial infrastructure, a development which would benefit the U.S. and China alike.
How They Are Taxed Currently. Section 892 of the Internal Revenue Code exempts foreign sovereigns from income tax on their passive investment activities. Foreign individuals and corporations, by contrast, pay taxes on most passive investment activities at rates ranging from 0% to 30%, depending on treaty agreements and the nature of the investment. With the exception of certain real estate investments, foreign investors generally don't pay tax on capital gains from portfolio investments. The tax code thus has the unintended effect of subsidizing state-owned capital over private capital, particularly on debt investments.
What To Do About It. The policy objective is to tax Sovereign Wealth Funds as we tax private foreign investors, and perhaps only on the condition that they are investing in a manner consistent with commercial portfolio investment.
The most far-reaching option would be to raise the baseline tax rate on all returns from sovereign wealth portfolio investments, including capital gains, at a 30% rate. Like the flat 30% rate on passive "FDAP" income to foreign individuals and corporations, this tax rate would be reduced by treaty agreement. This approach would raise significant amounts of tax revenue, and it would give the U.S. a new policy lever to achieve nontax objectives, such as encouraging SWFs to comply with best practices of transparency, disclosure, and accountability. Because capital gains cannot be withheld at a US source, however, this approach would be very difficult to administer.
An intermediate option would simply put SWFs on equal footing with other foreign investors. As such, most capital gains would be exempt from tax, but passive FDAP income (interest, dividends, etc.) would be taxed at a 30% rate (withheld at the source), unless a lower rate were negotiated by treaty. This option would be easier to administer and enforce, and it would still help achieve some of the nontax policy objectives noted above.
I'll discuss other reform alternatives--and the many complexities of the proposals--in future postings.
Prior Related Research:
Two and Twenty (forthcoming NYU L Rev)
Taxing Blackstone (forthcoming Tax L Rev)
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1. Posted by David on March 4, 2008 @ 14:56 | Permalink
Good stuff, Vic. Is the immunity from tax due to a particular tax statute or is it part of the Foreign Sovereign Immunities Act? That statute exempts immunity from sovereign-owned businesses when they engage in purely commercial transactions - and that might be relevant to the analysis, in a way that looks to me like it would support it.
International lawyers would worry about foreign reciprocation. Would the state of Alaska be for or against these proposals, I wonder?
2. Posted by Vic on March 4, 2008 @ 21:20 | Permalink
The tax exemption is in IRC section 892 and accompanying regs, although I gather the statute was written with FSIA in mind. As with FSIA, section 892 carves an exception for commercial activity. Portfolio investing, however, is defined as a non-commercial activity.
Yes, reciprocity may be an important principle here. I plan to address that in the paper--and I actually have a call in to the Alaska Permanent Fund to see what they think.
3. Posted by Mark on March 5, 2008 @ 15:00 | Permalink
I too have thought about writing on SWFs. I've been particularly amused by the difficulty of determining whether a given entity which purports to act on behalf of a government is in fact acting for a few specific individuals. Some SWFs (e.g., those in Singapore and Norway) are fairly transparent. Others, however, are completely opaque. How can one verify that an entity created by a country ruled by a dictator with seemingly unlimited power forms what it purports to be a SWF acting on behalf of its general population. To put it another way, what representation should the payor of a dividend accept from a putative SWF to avoid withholding? See regs. sec. 1.892-2T(b).
4. Posted by Rachel on March 5, 2008 @ 15:36 | Permalink
Interesting piece. What about foreign public pension funds? How are they taxed?
5. Posted by Michael Rice on March 6, 2008 @ 1:33 | Permalink
I'm kind of new to all this (2L)... but, if you're concerned that the SWF's will pull out, doesn't that suggest that you don't want to encourage them to do so by taxing them? Or are you less concerned about them doing something radical like that now than later, after they've accumulated even more influence (i.e., because of your observation that they may grow to $10 trillion)?
6. Posted by Ian on March 6, 2008 @ 10:47 | Permalink
Certainly other foreign investors are at a disadvantage when it comes to certain U.S. source dividends. However, the same cannot be said when other exemptions are clearly available to foreigners. Let's place in this into perspective: portfolio interest s. 871(h); bank deposit interest s. 871(i)(3); 80/20 company dividends s. 871(i)(2); gain from the sale of non-USRPHC stock s. 865(a); gain from the sale of domestically controlled REIT stock s. 897(h)(2); certain gains from the sale of publicly traded REITs s. 897(c)(3); let's not forget about shared appreciation mortgages 1.897-1(h) example 2; or how about a hybrid instrument that is similar to what is described in Rev. Rul 2003-97 and the distributions thereon qualify as portfolio interest.
There are also existing tax treaties that contain a reciprocal 892, see e.g. U.S.-Denmark tax treaty.
7. Posted by Vic on March 6, 2008 @ 14:35 | Permalink
Ian - that's right. One thing I'm not sure of is how far the portfolio interest exemption applies. I would think that a fair amount of interest income in the PE fund context (where the SWF is an LP) would not qualify. But I appreciate the point.
8. Posted by Ally on March 6, 2008 @ 15:26 | Permalink
Wouldn't this be a moot point if the fair tax were enacted? I tell you, sometimes the simplest solutions are over looked.
9. Posted by Ian on March 6, 2008 @ 15:44 | Permalink
Vic - certainly the portfolio interest exemption in mezzanine debt funds is an issue for the SWF as this may be viewed as a commercial activity. Treasury resolved the issue of whether the 10% shareholder test is applied at the partner or entity level when it amended 1.871-14. So, if an SWF owns less than 10% of the capital or profits interest in a PE fund then presumably the portfolio interest exemption is available if all requirements are satisfied.
10. Posted by Erich on March 26, 2008 @ 10:59 | Permalink
About two weeks ago, Senator Baucus and Senator Grassley asked the Joint Committee on Taxation to investigate the U.S. tax rules applicable to SWF. Their major concern seemed to be transparency. If indeed this is the case, wouldn't the proper step be changing our regulatory policy with respect to disclosure, not necessarily taxation?
Sure, altering 892 would generate additional revenue and would be a step toward putting private foreign investors on the same footing as SWFs, but taxation wouldn't solve the transparency problem at all.