New Section 892 Regulations: Action Points for Private Fund Sponsors and Non-U.S. Pension Plan & Sovereign Investors

The Department of the Treasury has finalized highly anticipated Treasury regulations (the Final Regulations) that provide certain non-U.S. sovereign and pension plan investors who rely on the U.S. sovereign exemption under Section 892 of the U.S. Internal Revenue Code (Sovereign Investors) opportunities to greatly simplify the structuring of their U.S. and global investments. The Treasury also proposed new regulations that introduce a limited safe harbor for loan origination activities (the 2025 Proposed Regulations).

Key Takeaways

• Special structuring (and associated “bucketing” or “stuffing”) of direct or indirect U.S. real estate interests on a Sovereign Investor’s balance sheet to preserve Section 892 claims is no longer expected to be necessary going forward.
• Going forward, greater flexibility should apply for fund sponsors to admit Section 892 claimants in open-ended fund structures in an “unblocked” sleeve, which may permit optimization of dividend tax leakage.
• The LP exception has been finalized, which allows for LPAC seats, but sponsors of open-ended funds and funds-of-one structured as flow-throughs and their investors should verify exposure under the new requirements. 
• Sovereign investors who have actively relied on the LP exception under previously proposed regulations (the 2011 Proposed Regulations) as their sole protection against commercial activity treatment may wish to verify exposure before the Final Regulations apply.
• Sovereign Investors who were previously uncomfortable relying on proposed regulations can now act at greater comfort level in reliance on Final Regulations.
• The 2025 Proposed Regulations introduce a new regulatory framework for Sovereign Investors in private credit. Industry comments and guidance remain forthcoming, making the framework likely a first step in a long journey.

New Incentives to Invest in U.S. Infrastructure Assets & other U.S. Real Estate

Ordinarily, income derived by Sovereign Investors and certain entities wholly owned and controlled by such investors (CEs) from investments in U.S. stocks, bonds or other U.S. securities is exempt from taxation under Section 892 of the U.S. Internal Revenue Code of 1986, as amended (Section 892), unless the income is either realized by a CE that is engaged in commercial activity (a CCE) or derived from a CCE. Under current law, a CE that is a non-U.S. corporation is treated as a CCE and therefore is generally ineligible for the benefits of Section 892 if as of certain testing dates its assets largely consist of investments in U.S. real estate under a “deemed CCE” rule. This rule has caused great headache for Sovereign Investors who have been attempting to preserve their Section 892 claim when structuring their investments in privately held U.S. real estate interests (including interests in real estate investment trusts (REITs) and in U.S. blocker corporations that derive material value from U.S. real estate), and has required them to monitor sufficient “good” assets under the so-called “50%/50%” or “90%/10%” tests and to “bucket” U.S. real estate investments in a manner that did not necessarily align with commercial objectives. In 2022, in an effort to avoid disincentive to invest in U.S. real estate, the Treasury had already relaxed the deemed CCE rule in certain proposed regulations (the 2022 Proposed Regulations) for CEs that also qualify as qualified foreign pension funds (QFPFs) or for non-QFPFs if they are a deemed CCE solely because of their investment in U.S. real estate heavy stocks in corporations that are not controlled by the relevant non-U.S. sovereign (the minority interest exception). 

The Final Regulations effectively limit the application of the deemed CCE rule to U.S. corporations (that is, the rule continues to apply to those U.S. corporations that are U.S. real estate heavy at certain testing dates). Since preservation of Section 892 solely in connection with the making of a U.S. real estate investment is no longer a concern, Sovereign Investors should expect increased flexibility to use holding structures that align with their commercial objectives. Sovereign Investors who actively wish to restructure their existing U.S. real estate portfolio should, however, be careful to preserve the U.S. tax basis in the relevant assets (to manage Section 892 tainting risk over time) and to avoid incurring unnecessary U.S. withholding upon restructuring, depending on how the relevant interests are specifically held. Private fund sponsors who focus on real estate investments and have admitted Sovereign Investors may wish to reevaluate their exposure under tax covenants they may have given to anticipate information or transfer requests. 

The Treasury has also finalized the minority interest exception rule for Sovereign Investors who have structured their U.S. real estate investments via a U.S. blocker corporation in reliance on the 2022 Proposed Regulations, with some clarifying changes. Any exit strategy previously contemplated for such U.S. blocker corporations or U.S. real estate investments can therefore generally be expected to remain in place. Finalization of the minority interest exception means the usage of levered U.S. blocker corporations remains available as a structuring technique for minority investments by non-QFPF Sovereign Investors in REITs that are expected to produce material capital gain dividends. 

Commercial Activity Taint Associated with Active Trading and Cash Diversification Strategies

The general rule for commercial activity “taint” that may result in loss of Section 892 exemption (also referred to as the “all or nothing” rule) remains unchanged: all activities ordinarily conducted for the current or future production of income or gain are commercial activities, unless they are eligible for an exception under applicable regulations. Under prior law, traditional trading strategies focusing on long/short positions in stocks, securities or commodities offered by private fund sponsors (whether via a fund vehicle or separately managed account (SMA) structure) and proprietary trading platforms of Sovereign Investors could already benefit from a broad exception from commercial activity treatment (essentially, acting in a non-dealer capacity). However, limited relief was available for trading in certain swaps, futures, forwards and other derivative instruments. 

The Final Regulations adopt a new safe harbor for trading in derivatives that is intended to align the commercial activity rules with the trading safe harbor that generally also protects offshore feeders in traditional master-feeder structures from having a taxable U.S. trade or business on account of securities or commodities trading activity conducted by the fund. This does not mean that every conceivable derivative will be exempt from commercial activity treatment going forward, but rather that tainting risk associated with most open-ended funds—even if they are trader funds—can generally be expected to be commensurate with the risk that the activity conducted via a U.S. sponsor or broker becomes taxable on a net income basis under U.S. tax principles. Sponsors should therefore likely expect increased attention from investors eligible for the Section 892 exemption for investing “unblocked” in trading platforms (e.g., the onshore feeder in a traditional master-feeder structure) in reliance on the Final Regulations in an effort to minimize the potential for U.S. dividend withholding those investors may incur if they were to invest in a “blocked” manner (e.g., the offshore feeder in such structure). Sovereign Investors who wish to roll over from an offshore to onshore feeder should consider withdrawal restrictions and existing side letter protections and should note the requirements under the revised exceptions from the all or nothing rule below. Sovereign Investors considering such a rollover in any credit funds should also fully consider the impact of the 2025 Proposed Regulations (discussed below).

The Final Regulations also helpfully clarify that merely depositing cash does not rise to the level of commercial activity, irrespective of whether the account is denominated in the U.S. dollar or a non-U.S. currency. This change likely increases the flexibility for Sovereign Investors to deploy excess cash positions without the need for intricate cash pooling in certain vehicles that do not seek to claim Section 892 exemption.

Sovereign Investors should also note that no specific rules have been adopted for trading in cryptocurrencies and other digital assets. This suggests that “unblocked” exposure to crypto spot trading and trading in derivatives (e.g., Bitcoin or Ethereum futures) likely needs to be analyzed for eligibility under the general commodity trading rules.

Limited Partner and Inadvertent Commercial Exceptions

The Treasury also finalized two important exceptions from the “all or nothing” rule. First, commercial activity does not cause a CE to be treated as a CCE solely because the CE’s taint arises from an interest held in a limited partnership. This is now referred to as the qualified partnership interest (QPI) exception, and the Final Regulations helpfully clarify that the exception applies to interests in vehicles treated as partnerships under U.S. tax principles whether or not formed as state law partnerships (e.g., LLCs taxed as partnerships). However, QPI treatment requires that the relevant interest meet four conditions: the holder cannot have (i) personal liability for claims against the partnership, (ii) the right to enter into contracts or act on behalf of the partnership, (iii) rights to participate in management and conduct of the partnership’s business, and (iv) control over the partnership within the meaning of the Section 892 regulations. The revised control prong stands for the principle that the QPI exception cannot be claimed by a 50% or greater interest holder in a partnership, irrespective of whether the investor has any managerial rights. This is a departure from the language under the 2011 Proposed Regulations, suggesting that it would at least be prudent for Sovereign Investors who have relied on the limited partner (LP) exception under such 2011 Proposed Regulations as their sole protection against commercial activity treatment immediately to verify exposure.

Private fund sponsors should specifically note that the right to participate in management has been defined by reference to day-to-day operations, and should therefore expect an increased comfort level from Sovereign Investors when negotiating a seat on the fund’s advisory or limited partner action committee (LPAC). Sovereign Investors may in turn expect increased scrutiny from private fund sponsors in understanding requests for covenants to apply the QPI exception. Namely, in determining whether a specific partnership interest is eligible for QPI treatment, all interests in the relevant partnership held by a Sovereign Investor and its CEs (or CCEs), as well as interests held by other entities in which such Sovereign Investor directly or indirectly holds 50% or more by vote or value or has effective practical control, are aggregated, which facts may be beyond the knowledge of the sponsor. It is unclear, however, if such aggregation rule extends to the determination whether there is “control” over a partnership at a particular entity level (prong (iv) above). Further, the QPI rules contain a new safe harbor for investors with a less than 5% interest in capital and profits of a partnership (the “de minimis interest” safe harbor), provided the investor also has limited liability, cannot bind or act on behalf of the partnership, and is not its managing partner or member. For purposes of this de minimis safe harbor, the rules apparently do require aggregation of interests. The Final Regulations also provide clarifying rules for applying upstream attribution of commercial activity through tiered partnerships. It would be prudent for fund sponsors and their investors who have participated in so-called GP stakes platforms and other seed arrangements to determine whether the QPI exception remains available at any particular level. 

The Final Regulations have also improved and finalized the inadvertent commercial activity exception, which is intended to apply in situations where the Sovereign Investor does not reasonably expect to be exposed to commercial activity but does end up with a taint. Sovereign Investors who wish to rely on this exception should revisit their existing written policies and operational procedures to ensure continued compliance.

In adopting these exceptions, the Treasury was thoughtful in preserving the general architecture of the Section 892 attribution rules. It is therefore also important to point out that the exceptions from the all or nothing rule clearly apply to all entities, whether they are formed under U.S. or non-U.S. law.   

Private Credit

In the 2025 Proposed Regulations, the Treasury appears to acknowledge the advent of private credit investments as an alternative asset focus for private fund sponsors and their Sovereign Investors. However, going forward, the default rule would be that any type of debt acquisition rises to the level of commercial activity, unless an exception applies. Two limited safe harbors would be provided for the acquisition of debt (i) in a registered offering from an unrelated issuer, and (ii) in the secondary market where the seller is not the issuer and is unrelated to the buyer. Absent compliance with these safe harbors, the Proposed Regulations envision a facts and circumstances test to determine whether a return on a debt acquisition is expected to be commensurate with the return of a capital investment such that it does not rise to the level of commercial activity. The Treasury has requested comments on workout situations (i.e., distressed debt), broadly syndicated debt, delayed-draw and revolving credit facilities. 

Sovereign Investors may choose to rely on the 2025 Proposed Regulations pending finalization, subject, however, to a consistency requirement that applies at the foreign government level and may correspondingly be very difficult to verify or rely upon. For the time being, it would be prudent for Sovereign Investors to continue to insulate credit-related investment activities from other activities that require an affirmative claim for Section 892 exemption. The better view is therefore that any effort to optimize tax efficiency for credit-related investments should preferably focus on tax treaty rules and domestic law tax exemptions (e.g., the 0% tax rate for portfolio interest). 

Applicability Dates

The Final Regulations have immediate effect for tax years beginning on or after the date that the regulations are published in the Federal Register, which means that for most Sovereign Investors and any withholding agents the changes will first become relevant as of January 1, 2026. The Treasury is of the view that the Final Regulations are broadly consistent with previously proposed regulations, such that no transition period is required. The Treasury has also allowed applying the Final Regulations to all open taxable years, but Sovereign Investors and relevant withholding agents who wish to do so should note that doing so is subject to a consistency requirement. The 2025 Proposed Regulations can be relied upon pending finalization.