March 04, 2008
Taxing Sovereign Wealth Funds
Posted by Victor Fleischer

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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