IRS Issues New Regulations Impacting Foreign Government Investments in the United States

On December 12, 2025, the U.S. Internal Revenue Service (the “IRS”) and U.S. Department of Treasury issued proposed regulations¹ (“Proposed 892 Regulations”), temporary regulations², and final regulations³ which could substantially affect the way foreign governments make U.S. directed investments. This is the first Dechert OnPoint on these regulations, beginning with a brief summary of the Proposed 892 Regulations.

Under current law, foreign governments (including “controlled entities” of foreign governments, which typically includes sovereign wealth funds) are generally exempt from U.S. income and withholding taxes in respect of their investment activities. This exemption does not apply, however, in respect of income derived from commercial activities or in respect of income (such as interest, dividends or gains) derived from a “controlled commercial entity” by such foreign governments.

The Proposed 892 Regulations, if effective, would provide significant new guidance on two key issues: (1) when an acquisition of debt by a foreign government (or any of its controlled entities) is considered to be a commercial activity, and (2) when a foreign government (or any of its controlled entities) has “effective control” of an entity engaged in commercial activities, thus causing the entity to become a “controlled commercial entity.”  The summary below highlights certain aspects of the Proposed 892 Regulations, but is not a comprehensive summary of those regulations.

Debt Acquisition Rules

The Proposed 892 Regulations establish a framework for determining whether acquiring debt, including at original issuance, qualifies as an investment (and thus not as a commercial activity) for purposes of Section 892 of the U.S. Internal Revenue Code of 1986, as amended (the “Code”). This framework would constitute the exclusive set of rules for making this determination.

Under a general rule proposed by the new regulations, all acquisitions of debt would be treated as a commercial activity unless the acquisition is characterized as an investment (a) under either of two safe harbors, or (b) pursuant to a facts-and-circumstances test. Any acquisition of debt undertaken as a “dealer” (generally, being regularly engaged as a merchant in purchasing stocks or securities and selling them to customers with a view to the gains and profits) would be treated as a commercial activity in all cases.

Registered Offering Safe Harbor

The first safe harbor would treat acquisitions of bonds or other debt securities acquired in an offering registered under the U.S. Securities Act of 1933 (the “Securities Act”) as investments, provided that the underwriters of the offering are not related to the acquirer. The IRS is currently open to evaluating circumstances, if any, in which this safe harbor could be extended to offerings registered under foreign securities laws, in addition to the Securities Act.

Qualified Secondary Market Acquisition Safe Harbor

The second safe harbor would treat acquisitions of debt traded on an established securities market as investments, provided that: (1) the acquirer does not acquire the debt from the debt issuer or participate in the negotiation of the terms or issuance of the debt, and (2) the acquisition is not generally from a person that is under common management or control with the acquirer.

Facts and Circumstances Test

Given the rapid growth of private credit transactions, many debt issuances will not satisfy either safe harbor set forth above. However, such issuances may still be treated as investments based on the consideration of all relevant facts and circumstances. In general, facts and circumstances would be relevant to the extent they indicate that the foreign government’s expected return from acquiring the debt is exclusively a return on its capital rather than including a return on activities it conducts. The Proposed 892 Regulations offer a non-exclusive list of relevant factors that must be considered under such facts and circumstances determination. However, depending on the particular case, the weight given to each factor may vary. The relevant factors include:

• Whether the acquirer solicited prospective borrowers, or otherwise held itself out as willing to make loans or acquire debt at or in connection with its original issuance;
• Whether the acquirer materially participated in negotiating or structuring the terms of the debt;
• Whether the acquirer is entitled to compensation (whether or not labelled as a fee) that is not treated as interest (including original issue discount) for federal tax purposes;
• The form of the debt and the issuance process, including whether the debt is a bank loan or a privately placed debt security pursuant to the Securities Act;
• The percentage of the debt issuance acquired by the acquirer relative to the percentages acquired by other purchasers;
• The percentage of equity in the debt issuer held or to be held by the acquirer;
• The value of that equity relative to the amount of the debt acquired; and
• If debt is deemed to be acquired in a debt-for-debt exchange as a result of a significant modification, whether there was, at the time of acquisition of the original unmodified debt, a reasonable expectation that the original unmodified debt would default.

The Proposed 892 Regulations include a number of examples applying these principles:

• A single, isolated debt financing could qualify as commercial activity if the loan was solicited, structured and negotiated by the foreign government.  A single loan origination is not generally regarded as creating a “trade or business,” and so while the Proposed 892 Regulation does not describe why this example is relevant, this example seems designed to demonstrate the IRS’s belief that “commercial activity” is much broader than “trade or business” activity. By contrast, another example concludes that a single follow-on loan to a company that is significantly smaller in amount than an existing, controlling, equity investment by the foreign government in that same company, would not be considered commercial activity.
• A foreign government’s acquisition of debt securities in a private placement may not be a commercial activity where the foreign government communicates the terms upon which it would invest in debt securities directly to the placement agent but does not otherwise solicit, negotiate or structure the loans.  In an example concluding there is no commercial activity, the foreign government purchased in one year (in addition to U.S. Treasury debt securities at original issuance in a public auction) ten privately placed debt securities of several domestic corporations in respect of which the foreign government purchased less than one-third by principal amount of each such debt offering and at least one other unrelated purchaser purchased a larger percentage of each such debt offering than the foreign government.
• In the case of a debt modification or debt restructuring that is a “significant modification” under the rules of Treas. Reg. 1.1001-3, the holders are deemed (for federal income tax purposes) to acquire a new debt in exchange for the original (unmodified) debt.  In an example where (A) the initial investment in debt was not a commercial activity, (B) the investment was made when the loan was not in default and there were no objective indications at the time of the purchase (such as a declining trend in the borrower’s financial condition or credit rating) that the borrower would default on its debt, and (C) the foreign government was not a member of the creditors’ committee and did not materially participate in negotiating and structuring the modification or restructuring, the foreign government was not engaged in commercial activity. However, in another example with the same facts except that the foreign government was a member of the creditors’ committee, it is presumed to have materially participated in negotiating and structuring the terms of the modified debt and therefore the deemed acquisition resulting from the restructuring does not qualify as an “investment” (while reserving on further analysis of this example).

No guidance has been issued on whether acquisitions of distressed debt, broadly syndicated loans, revolving credit facilities, and delayed-draw debt obligations should be treated as investment rather than commercial activities for purposes of Section 892 of the Code, and the IRS has solicited comments in respect of these issues.

Effective Control Rules

As described above, the exemption from income and withholding tax under Section 892 does not apply in respect of income (such as interest or dividends, or gains) derived from a “controlled commercial entity.” The Code defines a “controlled commercial entity” as any entity engaged in commercial activities in which the foreign government holds (directly or indirectly) 50 percent or more of the total interests in the entity (by vote or value) or holds any “other interest” in the entity which provides the foreign government with “effective control” of the entity. The Proposed 892 Regulations provide expanded guidance on what is meant by the terms “other interest” and “effective control” (replacing the term “effective practical control” under current law).  

Other Interest

The Proposed 892 Regulations provide that 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. All facts and circumstances related to the interests are considered in determining effective control. “Interests” may include equity interests; debt interests; voting rights in the entity, including the power to appoint directors or managers, and to veto decisions; contractual rights in or arrangements with the entity (or with other interest holders in the entity); business relationships with the entity (or with other interest holders in the entity), including as a major customer or a supplier having control over a strategic natural resource used in the entity’s business; regulatory authority over the entity; or any other interest in or other relationship with the entity that may provide influence over decisions relating to the entity’s operations, management, board-level, or investor-level matters.

Deemed Effective Control

A foreign government that controls the managing partner or managing member (or similar arrangement) will be deemed to have effective control of an entity.

Examples

Through several examples (some of which bear on common structures used by foreign governments when investing in the U.S.), the Proposed 892 Regulations provide some important insights into what could be regarded as “effective control” and therefore causes an entity to be a “controlled commercial entity”:

• If the foreign government does not have sufficient voting power to unilaterally authorize or veto an entity’s actions or to appoint a majority of its directors or officers, and has no other interest in the entity, such investor will generally not be treated as having effective control over such entity.
• An investment agreement between the foreign government and the entity that limits the scope of investments that can be made by the entity does not amount to effective control, so long as the foreign government does not otherwise have voting, operational, managerial control or other rights with respect to such entity.
• A mere consultation right with respect to operational, managerial, board-level, or investor-level decisions of an entity will not convey effective control (e.g. where the foreign government has mere participation rights in the entity’s investment committee and the right to discuss acquisitions and sales of property by the entity, but no right to decide or execute such acquisitions or sales and no other rights with respect to such entity).
• Having the right to appoint a member of the board that alone has the right to appoint or dismiss the “manager” of the entity” (broadly defined in the Proposed 892 Regulations as an officer of the entity whose responsibilities are to manage the entity’s operations) would amount to effective control.
• Having the right to appoint a member of the board that alone has the right to veto dividend distributions, material capital expenditures, sales of new equity interests, and the operating budget, would result in effective control.
• One example illustrates a relationship solely in the context of a credit agreement between a foreign government and an entity. Pursuant to the terms of a credit agreement, the borrower is subject to restrictions on the type of investments that the entity can make, asset dispositions, levels of future borrowing, and dividend distributions by the entity; and the lender (the foreign government) has veto rights over dividend and stock repurchases, additional borrowing, capital expenditures, the entity’s annual operating budget, and redemption of subordinated debt. The example concludes that the “creditor interest” of the foreign government provides it with control over both investor-level and operational decisions of the entity, and therefore effective control of that entity, and as a result the entity is a “controlled commercial entity” with respect to the foreign government.

Applicability Date

The Proposed 892 Regulations would apply to taxable years beginning on or after the date of publication of these rules as final regulations in the Federal Register.