New Section 892 Guidance for Sovereign Investors: Key Changes, Proposed Rules, and Impact on Foreign Government Investment Structures

Key Takeaways:

• Clearer Definitions of Commercial Activities: The final regulations clarify what counts as a commercial activity and refine the “inadvertent commercial activity” exception.
• USRPHC Per Se Rule Narrowed: Only domestic USRPHCs are now subject to the per se commercial activity rule, reducing the risk of “commercial activity taint” cascading through foreign government investment structures.
• Updated Partnership and Limited Partner Exceptions: New rules clarify when partnership activities are attributed to sovereign investors, with a safe harbor for limited partners who meet certain conditions.
• Debt Acquisition Rules and Safe Harbors: Proposed regulations presume debt acquisitions are commercial activities unless they meet specific safe harbors or pass a facts-and-circumstances test, emphasizing careful structuring and documentation.

On December 12, 2025, the Treasury Department and IRS issued final and proposed regulations under Section 892 of the Internal Revenue Code, under which foreign governments and their controlled entities are granted a tax exemption on income from certain US investments.

Among other changes, the final regulations (the “Final Regulations”) provide additional guidance on the determination of when a foreign government is engaged in commercial activities, including clarifications on the earlier proposed inadvertent commercial activity and limited partner exceptions, and narrow the scope of a per se classification of United States real property holding corporations (“USRPHCs”) as controlled commercial entities.

The newly proposed regulations (the “Proposed Regulations”) provide helpful clarification on the meaning of “effective control” (formerly “effective practical control”) and create a new framework to evaluate when debt acquisitions will be treated as a commercial activity. This alert provides a high-level summary of some of the major changes made by the Final and Proposed Regulations.

Background on Section 892

Section 892 generally exempts from US federal income tax the income that foreign governments receive on (1) investments in US stocks, bonds, and domestic securities, (2) US financial instruments held in the execution of governmental financial or monetary policy, and (3) interest on deposits at US banks. However, the exemption does not extend to income derived from any commercial activity, income received by or from a controlled commercial entity (a “CCE”) or income from the disposition of an interest in a CCE.¹

While Section 892 does not define the term “foreign government,” regulations provide that a foreign government includes both “integral parts” of a foreign sovereign and any “controlled entity” of such government.² This distinction is critical. Whereas integral parts are denied a Section 892 exemption on only the income they derive from a commercial activity (and, therefore, may claim the exemption for other qualifying income), a controlled entity, if tainted as a CCE, is denied the exemption for all of its income.

Scope of “Commercial Activities” and the “Inadvertent Commercial Activity” Exception

Commercial Activities

The Final Regulations specify that “commercial activities” are broader than a “trade or business” for other tax purposes (including a trade or business within the United States that can give rise to a US income tax filing obligation for all non-US persons). Specifically, commercial activities are defined to include “all activities (whether conducted within or outside the United States) that are ordinarily conducted for the current or future production of income or gain.” The Final Regulations make clear that any activity qualifying as a trade or business (whether or not within the United States) will also constitute “commercial activity” for Section 892, but that an activity may be commercial under Section 892 even though it would not otherwise constitute a trade or business.

In determining what activities are not commercial, the Final Regulations carry forward a list of specifically protected activities. The list includes, among other activities, investments in stocks, bonds, and other securities, as well as trading in qualifying instruments in a non-dealer capacity. Concurrently, the Proposed Regulations set out a separate framework for when acquiring debt will be treated as investment versus commercial activity for Section 892 purposes, as discussed below.

Inadvertent Commercial Activities

The Final Regulations provide that a controlled entity will not be treated as engaged in commercial activities if: (1) the failure to avoid conducting the commercial activities was “reasonable,” (2) the commercial activity was promptly “cured,” by discontinuing the activity within 180 days of discovery, and (3) specific record maintenance requirements were met. If these requirements are satisfied, the items of income associated with commercial activities are ineligible for the Section 892 exemption, but the income of the applicable controlled entity from other investments is not tainted income and is thus still potentially exempt under Section 892.

The Final Regulations treat “reasonableness” as a facts‑and‑circumstances inquiry, but an entity must show continuing due diligence through adequate written policies and operational procedures that monitor worldwide activities. Employees who have oversight responsibilities must establish, follow, and enforce those policies; a tax opinion or legal advice alone is not enough.

The Final Regulations also extend a previously proposed safe harbor, deeming a failure to avoid commercial activity “reasonable” if adequate policies/procedures are in place and both (1) the value of assets used in, or held for use in, all commercial activities is less than or equal to 5% of total assets value reflected on the entity’s balance sheet, and (2) income from commercial activities is less than or equal to 5% of the entity’s gross income, as shown on its income statement.

The Final Regulations make clear that relying on the inadvertent commercial activity standard requires demonstrable and ongoing compliance efforts by a controlled entity. Section 892 controlled entities should thus ensure comprehensive written policies are in place to monitor worldwide activities for commercial activity and designate specific employees to implement and enforce such policies. Should the entity discover it has engaged in commercial activities, swift curative action should be taken.

USRPHC Per Se Rule

Under prior regulations, any corporation that was a USRPHC (whether domestic or foreign) was deemed to be engaged in commercial activities and, therefore, per se classified as a CCE if the foreign government met the ownership or “effective control” thresholds. The 2022 proposed regulations introduced an exception to this per se rule pursuant to which a corporation classified as a USRPHC solely due to its direct or indirect ownership of stock in other corporations that were not controlled by the foreign government (the “minority interest exception”) would not be automatically considered a CCE. Additional details on the mechanics of the minority interest exception are addressed in O’Melveny’s prior client alert on FIRPTA’s application to foreign governments, which can be found here.

The Final Regulations, instead, provide that only controlled domestic corporations are subject to the USRPHC per se rule. Thus, a USRPHC formed outside the US is no longer a per se CCE. While this approach eliminates the need for the “minority interest exception,” the Final Regulations retain the exception to avoid unnecessary compliance costs for taxpayers currently relying upon it.

By confining the per se USRPHC rule to domestic corporations, the Final Regulations eliminate the problem of cascading commercial activity taint through foreign companies in a foreign government’s corporate structure. For example, a controlled entity that invested in a foreign corporation that was a USRPHC could have itself become a USRPHC. If that controlled entity was a subsidiary of another controlled entity, that parent entity (and its other subsidiary) could then become a USRPHC as well—this chain reaction could result in many of the controlled entities of a foreign government losing their ability to rely on Section 892. This change eliminates this potentially massive risk to a foreign government’s tax position.³

Partnerships, Attribution, and the Qualified Partnership Interest Exception

Generally, the commercial activities of a partnership are attributed to its partners, subject to two exceptions finalized in the Final Regulations.

First, an earlier proposed exception, that has now been finalized, provides that an entity not otherwise engaged in commercial activities is not considered to be engaged in commercial activities merely because it is a member in a partnership that effects transactions in stocks, bonds, securities, partnership equity interests, commodities, or financial instruments for the partnership’s own account. This exception applies whether the trading is done by the partnership directly or through employees/agents with discretionary authority to do so. However, although the “commercial activity” taint is not attributed to the partner under this exception, the partner’s distributive share of income from a partnership remains ineligible for the Section 892 exemption to the extent the partnership’s income is otherwise derived from commercial activity.

Second, the Final Regulations also finalize a modified version of the “limited partner exception” pursuant to which an entity that is not otherwise engaged in commercial activities is not deemed to be so engaged merely because it was a limited partner in a partnership that is engaged in commercial activities. The Final Regulations clarify what constitutes a “limited partner” and designates an interest qualifying for this exception as a “qualified partnership interest” (a “QPI”). Under the general rule, a partner holds a QPI if the partner does not (1) have personal liability for claims against the partnership, (2) have the right to legally bind or act on behalf of the partnership, (3) have the right to participate in the management or conduct of the partnership’s business, or (4) “control” the partnership. In addition to the general rule, the Final Regulations adopt a QPI safe harbor for those with de minimis ownership interests in a partnership. This safe harbor classifies any partnership interest as a QPI if at all times during the partnership’s taxable year, the first two requirements of the general rule are met, and additionally, the interest holder (3) is not the partnership’s managing partner, a managing member or an equivalent role, and (4) owns (directly and indirectly) 5% or less of either the partnership’s capital interests or profit interests. Importantly, the QPI exception is not limited to state-law limited partnerships – it applies to interests in any entity classified as a partnership for U.S. federal tax purposes (including multi‑member LLCs), which the Final Regulations make explicit to resolve prior uncertainty under the previous proposed regulations.

Under the general rule, a right to participate in the management and conduct of a partnership means a right to participate in the day-to-day management or operation of the partnership’s business, whether conferred by law, governing documents, or contract. However, mere rights to monitor or protect the interest holder’s capital investment in a partnership do not rise to the level of “management” for purposes of the exception. The Final Regulations include examples that illustrate this distinction between prohibited day-to-day operational control and permissible protective or oversight rights. If a foreign sovereign holds multiple interests in a partnership, either directly or indirectly, such interests are aggregated in determining the foreign sovereign’s rights to participate in the management and conduct. Separately, the Final Regulations also address how such rules apply to “tiered partnership” situations wherein an upper-tier partnership owns a QPI in a lower-tier partnership.

In light of these changes and the newly clarified exceptions, foreign governments and their controlled-entity investors should reconsider how to structure their investments in funds and other partnerships. If investing in an unblocked fund, particular care should be taken to avoid obtaining any management-like rights to participate in the day-to-day operations of the fund. For those investors wishing to take advantage of the safe harbor, monitoring the entity’s investments to keep below the 5% ownership threshold is critical. Finally, it is essential to remember that even if the safe harbor applies to prevent attribution of commercial activities to a controlled entity, any income received by that entity from a partnership that is attributable to commercial activities remains ineligible for the Section 892 exemption.

Investments in Debt

One area of lingering uncertainty under prior regulations were the circumstances under which investments in debt would be deemed a commercial activity. Under the 2011 proposed regulations, investments in loans were included in the “angel list” of protected activities, but an exception provided that any investments (including loans) made by a banking, financing, or similar business were commercial activities. The Proposed Regulations clarify this exception by proposing a (largely taxpayer unfriendly) presumption that all acquisitions of debt are presumed to be a commercial activity unless the requirements of one of two safe harbors are satisfied or a facts-and-circumstances analysis categorizes the acquisition as an investment.

Under the safe harbors, an acquisition of debt will not be considered a commercial activity if:

• (1) bonds or debt securities are acquired in an offering registered under the Securities Act of 1933 from an unrelated issuer;⁴ or
• (2) debt is acquired on an established securities market, provided that
  • (i) the acquirer does not acquire the debt from the issuer or participate in the negotiation of the terms or issuance of the debt; and
  • (ii) the acquisition is not from a person under common management or control with the acquirer (subject to an exception).

If neither safe harbor is met, the Proposed Regulations provide the parameters of a facts-and-circumstances test for differentiating investments from commercial activity when acquiring debt, including a list of considerations that focus on whether expected returns reflect passive return on capital or compensation for activities conducted by the entity (e.g., solicitation, negotiation, etc.).

Notably, the Final Regulations also reject a proposal that would treat loan origination as a non-commercial investment based on the frequency of the loans made. Indeed, an example in the Proposed Regulations makes clear that even the issuance of a single loan may give rise to commercial activity if no safe harbor is met and, for instance, the entity materially participates in negotiating or structuring the terms of the transaction, or else solicits prospective borrowers.

This is contrary to the more favorable approach taken with respect to whether loan origination gives rise to a US trade or business (e.g., the “five or fewer” rule of thumb).

Section 892 investors who engage in any loan origination or debt acquisition should carefully review Section 892 eligibility under the safe harbors and factors laid out in the Proposed Regulations to determine if their activities will be classified as commercial, even if they might not rise to the level of a trade or business.

Definition of “Effective Control”

Section 892 defines a CCE to include not only an entity in which a foreign government holds (directly or indirectly) more than a 50% interest, but also an entity in which the foreign government holds any interest that gives it “effective control” over such entity.

Under the Proposed Regulations, the prior concept of “effective practical control” is renamed as “effective control” without changing the substantive meaning of the term. The Proposed Regulations clarify that a foreign government has “effective control” over an entity if the interests it holds (individually or in the aggregate with other arms of the same foreign sovereign) give it control over the operational, managerial, board-level, or investor-level decisions of such entity. These interests may include (but are not limited to) equity interests, debt interests, voting power, contractual rights with the entity or its owners, significant business relationships, or regulatory authority. The Proposed Regulations include useful illustrative examples.

A categorical rule under the Proposed Regulations deems a foreign government to have effective control over an entity where it controls (or is itself) a managing party or managing member of the entity. However, isolated rights to be consulted about operational or managerial decisions, without more, do not establish effective control. As a series of examples make clear, even in the absence of a majority equity interest in an entity, additional creditor rights, regulatory authority over the entity’s activities, or the power to affect an entity’s dividends/distributions may result in effective control for purposes of making CCE determinations.

Applicability Dates

The Final Regulations are applicable to tax years beginning on or after December 15, 2025. With limited exceptions, a taxpayer can elect to apply the Final Regulations to an earlier year provided that the limitation period for assessments on that year is open and the taxpayer (and all of its related entities) consistently apply such rules for both that year and all succeeding taxable years before the finalization date. Similarly, the Proposed Regulations will generally apply to tax years after their finalization. Notably, the Proposed Regulations do not explicitly permit taxpayer reliance upon such regulations prior to their finalization. Once the Proposed Regulations are finalized, however, a foreign government may apply the rule that partnerships are not controlled entities to an earlier taxable year provided that the limitation period for assessments for that year is open and the foreign government consistently applies that rule for both that year and all succeeding taxable years of its directly or indirectly wholly-owned entities beginning before the finalization date.

The foregoing is a summary of only some of the key provisions of the Final and Proposed Regulations. Other provisions may be relevant to you as well. O’Melveny will be closely monitoring further developments in this area and can assist clients with analyzing and complying with the Final and Proposed Regulations and any future guidance related to Section 892. Please contact the attorneys listed on this Client Alert or your O’Melveny counsel for questions regarding the information discussed herein.

¹ A CCE is an entity engaged in commercial activities anywhere in the world in which a foreign government holds (directly or indirectly) more than 50% interest, or an entity in which the foreign government holds any interest that gives it “effective control” over such entity.

² Controlled entities are those that are wholly owned and controlled by a foreign government, organized under the laws of such country, whose earnings do not inure to the benefit of a private person, and whose assets vest in the foreign sovereign upon dissolution. The Proposed Regulations provide that entities treated as partnerships are not controlled entities.

³ Note that this does not change the rule that controlled USRPHCs are still per se CCEs, and therefore, a foreign government would be subject to tax on the sale of controlled USRPHC stock and/or dividends a controlled USRPHC pays.

⁴ The Proposed Regulations note that although the first safe harbor is limited to offerings under the Securities Act of 1933, certain foreign securities laws may sufficiently approximate the Securities Act that the exception would be applicable in those circumstances. To that end, comments were requested regarding under what circumstances the safe harbor should be extended to offerings registered under those foreign securities laws.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Billy Abbot, an O’Melveny partner licensed to practice law in California and New York; Luc Moritz, an O’Melveny partner licensed to practice law in California; Jan Birtwell, an O’Melveny partner licensed to practice law in England and Wales; George W. Duncan, an O’Melveny associate licensed to practice law in England and Wales; Arsalan Memon, an O’Melveny associate licensed to practice law in California, New Jersey, and New York; and Ben Morain, an O’Melveny law clerk contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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