Proposed Changes to the Deemed “CCE” Rules Benefit IRC Sec. 892 Investors

On December 29, 2022, the Treasury Department and IRS released guidance related to exemptions for foreign government investors under IRC Sec. 892. This exception, if finalized, would simplify the structuring needed for foreign governments investing in U.S. real estate. Below is a summary of background and the impact these proposed regulations may have on taxpayers. 

Background/Current Temporary Regulations

IRC Sec. 892 generally exempts foreign governments (including sovereign wealth funds) from U.S. tax on passive income from certain securities if the income is not derived from “commercial activities” conducted by the foreign government or a “controlled commercial entity” (“CCE”). A CCE is a corporation that is majority owned or controlled by a foreign government that conducts commercial activities in the U.S.

Under the existing temporary regulations, any U.S. real property holding company (“USRPHC”) (or a foreign corporation that would be treated as a USRPHC had it been a U.S. corporation) is deemed to be a CCE. (A USRPHC is generally a corporation with more than 50% of its asset represented by U.S. real property interest). The deemed CCE treatment applies even though the USRPHC is only invested in the stock of other corporations that generate income or are comprised of assets that are typically not treated as commercial activities. Essentially this means that a foreign government owning 50% of stock of a USRPHC, with no commercial activity other than owning minority stock in another USRPHC, would be considered a CCE, and the foreign government would be subject to tax on dividends or gains on the sale of its stock.

Recent Proposed Regulations

The most recent proposed regulations added some taxpayer-friendly guidance in this area.  Specifically, a corporation that is determined to be a USRPHC will not be deemed a CCE solely based on stock ownership of other USRPHCs that are not foreign controlled. For example, a sovereign wealth fund that owns majority stock of a USRPHC, which owns a minority stake in a domestically controlled corporation or REIT, would not be considered a CCE, even if it would meet the definition of a USRPHC. This rule would apply to qualified foreign pension funds and entities wholly owned by them as well.

Although the proposed regulations would be effective after they are finalized, taxpayers may rely on proposed regulations in the meantime. As stated above, these rules would simplify the structuring needed for foreign governments, as foreign governments that own a minority interest in a USRPHC through a blocker corporation would now be exempt from tax on dividends paid by the blocker corporation or capital gains from the sale of the corporation’s stock. Previously, such a structure would result in the blocker corporation being treated as a deemed CCE.