Background
On December 15, 2025, the IRS issued final and proposed regulations relating to taxation of the income of foreign governments and international organizations from investments in the United States.
Section 892 of the Internal Revenue Code conditionally exempts certain U.S. source income of foreign governments and international organizations from U.S. federal income tax. Generally, foreign governments are exempt from tax on income earned from investing in U.S. stocks, bonds, or other domestic securities or financial instruments held in the execution of governmental financial or monetary policy. However, this tax exemption does not cover income gained through commercial activities or from controlled commercial entities (CCE).
Final Regulations
The final regulations, effective December 15,2025, provide guidance for determining when a foreign government is engaged in commercial activity and when an entity is a CCE. After taking into account and addressing comments received on 2011 proposed regulations and 2022 proposed regulations issued under §892, these final regulations confirm, with modifications, such proposed regulations. The key modifications are summarized below.
- Commercial Activity – The final regulations largely define commercial activity as all activities that are ordinarily conducted for the current or future production of income or gain, whether the activities are conducted within or outside of the U.S. Only the nature of the activity, not the purpose or motivation, is determinative of whether the activity is commercial in nature. Commercial activity is a broader definition than a “trade or business” under §§162 or 864.
- Non-commercial Investments – The following activities are not commercial activities: investments in stocks, bonds, and other securities (as defined in §1.892-3T(a)(3)); loans; investments in financial instruments, the holding of partnership equity interests; the holding of net leases on real property; the holding of real property which is not producing income; and the holding of deposits in any currency in banks. Not included in this list are certain loan origination activities. The proposed regulations, discussed below, take issue with when acquiring a loan or other debt including in connection with original issuance, is treated as an investment for purposes of §892.
- Commercial activities of partnerships are generally attributed to partners unless the partner holds a qualified partnership interest. For an entity that is not otherwise engaged in commercial activities, it will not be deemed to be engaged in commercial activities solely because it holds an interest as a limited partner in a limited partnership. The limited partner must have limited liability, does not possess the legal authority to bind or act on behalf of the partnership, does not control the partnership (<50% interest), and does not have rights to participate in the management and conduct of the partnership’s business at any time during the taxable year.
- For an entity that inadvertently conducts commercial activity there is targeted relief available so that investment income is not taxed under this section. For commercial activity to be considered inadvertent, the failure to avoid conducting the activity must be reasonable, the commercial activity must be timely cured (180 days), and the record maintenance requirements must be met. Any income derived from any foreign government’s inadvertent commercial activity will not qualify for exemption from tax.
- A safe harbor applies if assets and income from inadvertent commercial activity are ≤5% of the total amount, and written policies and operational procedures are in place to monitor the entity’s worldwide activities.
- The final regulations state that the commercial activity asset of a qualified partnership interest is not included as an asset used in commercial activity of the tested entity for purposes of the safe harbor, but the value of the qualified partnership interest is included in the entity’s calculation of its total assets for that purpose.
- A safe harbor applies if assets and income from inadvertent commercial activity are ≤5% of the total amount, and written policies and operational procedures are in place to monitor the entity’s worldwide activities.
- Controlled Commercial Entities – An entity is a CCE if it is engaged in commercial activities and the foreign government holds at least 50% interest, value or voting power, or it has effective control over such entity.
- The U.S. real property holding corporation (USRPHC) per se rule in §1.892-5(b)(1)(ii)(A) is limited to domestic corporations and foreign corporations are not deemed to be engaged in commercial activities solely by reason of USRPHC status.
- A domestic corporation that is a USRPHC as defined in §897(c)(2), is treated as engaged in commercial activity and is therefore a CCE if the above discussed qualifications are met (foreign government holds at least 50% interest, vote or value, or has effective control over such entity).
- Section 897(c)(2) states that a USRPHC means any corporation if the fair market value of its U.S. real property interests equals or exceeds 50% of the fair market value its U.S. real property interests, its interests in real property located outside the U.S., plus any other of its assets which are used or held for use in a trade or business.
Proposed Regulations
The proposed regulations provide additional support in determining the application of §892.
- Definition of Controlled Entity – Partnerships, for U.S. tax purposes, are not “controlled entities” under §892, including ones wholly owned and controlled by a single foreign sovereign, even if indirectly owned through controlled entities.
- Acquisition of Debt – Generally, the acquisition of debt of a foreign government is treated as a commercial activity unless the procurement is characterized as an investment under either of two safe harbors, or under a facts-and-circumstances test.
- Safe Harbors – Debt acquired in a registered offering under the Securities Act of 1933 or in a qualified secondary market acquisition is treated as an investment.
- Facts-and-circumstances – If the acquisition of debt does not fall under one of the safe harbors, a determination may be made based on the relevant facts and circumstances if the expected return from the debt acquisition is exclusively a return on its capital and not on activities conducted by the acquirer.
- Definition of effective control – As discussed above, an entity is considered a CCE if the foreign government has effective control over it. Generally, effective control is achieved by any interest in the entity that, either separately or in combination, results in control over the operational, managerial, board-level, or investor-level decisions of the entity. The proposed regulations provide multiple examples of what constitutes effective control to help the taxpayer make the determination.
These proposed regulations would apply to tax years starting on or after their finalization. Once finalized, taxpayers may elect to retroactively exclude partnerships from the definition of controlled entities for open prior years if they meet consistency requirements. Comments and hearing requests are due by February 13, 2026.
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