New York: The US Internal Revenue Service threw a grenade into the international private markets just before Christmas. The proposed Section 892 tax reforms appear technical. They are anything but.
The rulebook upon which foreign governments invest in the US tax-free is being rewritten. We should pay attention to sovereign wealth funds, state pension plans, and the private-market managers who are wooing them.
What Section 892 Actually Does?
Section 892 is buried far into the US tax code, and hardly anyone outside the sphere of state money management can comprehend it. Its purpose is straightforward. It protects foreign governments and their constituent parts, as well as certain controlled entities, from US taxation of investment income.
That protection has been the foundation for how sovereign wealth funds and certain public pension funds invest capital in the US. Dividends, capital gains, interest. All clean. All legal.
There’s a hard line, though. Business is not an exception. Conducting a business, issuing loans, and managing operations is TAXABLE. Always has been.
It has always been the grey area in between that counts as an investment. What economically resembles commercial activity? Lawyers have been living in this fog comfortably for decades.
The IRS now proposes to eliminate much of that ambiguity.
The Line Is Moving. A Lot.
The proposed reform of Section 892 radically reduces what is considered an investment.
Debt is the big target.
In the new structure, the procurement of a loan at the time of origination can be classified as a commercial activity if the investor actively provides financing, negotiates, or structures the transaction. In other words, acting as an active lender rather than a passive investor may forfeit the exemption.
The IRS has gone further. The presumption that debt investment is non-commercial is removed. It is a silent statement with resonant effects.
There are safe harbours. Debt acquired in a registered issue by unrelated underwriters is eligible. The same applies to debt issued in an established securities market. Most corporate bonds and government bonds survive.
Privately originated credit generally does not.
In the case of those assets, investors would have to meet a facts-and-circumstances test. The returns should reflect passive capital returns, not compensation for origination or lending activity.
That is a high threshold. And for any sovereign wealth fund that has its own private credit team sourcing in the US, it is a red flag.
Why is private credit in the spotlight?
The state-owned investors are not peripheral players in the privately held credit. Global SWF argues that sovereign wealth funds and government pension funds own about a quarter of the total of the private credit market.
Part of it is through LP interest in private credit funds. Some through co-investments. Others via in-house development.
The majority of the sovereign wealth funds utilise section 892 exemptions. The treatment of public pension funds is mixed. Others are included in the rules of portfolio debt or pension exemptions. Others lean on Section 892.
In case direct lending is considered as commercial activity, any fund based on Section 892 would find itself in the situation where its investment income could be taxed by the US on some or all of its investment income.
IRS goes so far as to give an example. A single loan acquired at origination and involving active financing or negotiation can taint the entire entity. That’s not ambiguity. That’s the intent.
And it gets worse.
The suggested regulations are not limited to origination. As soon as a sovereign investor joins a creditor committee, the IRS treats the activity as commercial, according to the proposed regulations.
The time of purchasing the debt does not matter. It does not matter whether it is public or not. Par or distressed. Efforts to restructure or salvage a distressed loan may be treated as commercial activity.
Kirstin Gallagher of KPMG did not beat around the bush. The assumption that all debt acquisition is a commercial activity is a significant change. One that requires urgent consideration.
In the case of controlled entities, the stakes are even greater.
The “All or Nothing” Trap
A large number of sovereign wealth funds are organised as controlled entities, and not as components of a foreign government. Under Section 892, that matters.
Controlled entities are subject to an all-or-nothing exemption. Carry on any business, on any part of the globe, and you forfeit your exemption on all the US revenues.
A European subsidiary is one small source of loans. A single humble restructuring position. That is all it takes to taint hundreds of billions of dollars of otherwise tax-free US investment earnings.
The exercise does not even have to occur in the US. The location of the activity is not determinative.
Neither is Private Equity Safe.
These risks have existed within the sphere of private equity. Direct ownership of a company in operation is a commercial activity. Corporate taxation is 21 percent.
Blockers have been the workaround. Between the functioning business and the tax-exempt investor, special-purpose vehicles are placed. Taxes stop at the blocker. Section 892 provides flow of dividends without withholding. US tax on exit is not imposed on capital gains.
That architecture is subject to a single important condition. No effective control over the operating business.
In the past, this has been addressed through funds, which pooled the capital. Several sovereign investors. None of them passed 50 percent by vote or value. Everyone relaxed.
The IRS is no longer relaxed.
In accordance with the suggested regulations, effective control is no longer only about the percentage of ownership. The leverage of governance is now important.
Control is assessed by the Treasury and the IRS based on influence rather than ownership alone. Economic pressure. Regulatory sway. Veto rights. Even informal or indirect influence may be considered.
You do not need equity to influence an entity. All you need is the capacity to impact key decisions.
That is okay in case you are an all-passive LP. It’s a problem if you co-invest. And it is even larger when you bargain over rights of governance, sit on committees, or even over exit timing.
Large sovereign investors have frequently exercised such influence.
The Scale of What’s at Risk
There are approximately 100 sovereign wealth funds managed by the top 100 funds, not including U.S.-based funds. The top 100 public pension funds add the figure to $27 trillion.
Approximately 40 percent of SWF assets are invested outside their home jurisdictions. That is about $8.4 trillion in foreign deployment. A big chunk sits in the US.
Even unrefined assumptions give squirmy figures. An implicit tax shield would be tens of billions per annum if 60 per cent of that foreign capital were in the US, where it is receiving a respectable payoff.
Estimates of $75 billion in avoided US tax are almost certainly imprecise. But they’re wrong in a direction that still makes policymakers pay attention.
Will This Actually Happen?
Nothing is final. Comments remain open until February 13. Washington has a long history of floating market-shaking proposals that quietly die. Section 899 did exactly that last year. It threatened chaos in the Treasury market. Then it vanished.
Politics cuts both ways. The Trump ecosystem has built deep ties with sovereign wealth funds. Some have invested heavily in Trump-linked ventures. Penalising active sovereign investors doesn’t scream diplomacy.
Then again, unpredictability is the brand.
What Investors Should Do Now?
Assume nothing. Review everything.
Private credit strategies that involve origination, negotiation, or restructuring need immediate scrutiny. Private equity governance rights deserve a second look. Controlled entity structures need stress-testing.
Expect lawyers to get busy. Expect new structures. Expect slower deal execution. Passive strategies may suddenly look very attractive. The era of sovereign capital quietly operating like a private lender or buyout shop may be ending.
