KPMG report: New guidance on section 892 entity classification of foreign investment partnerships
New guidance on interpretation of whether a partnership that has controlled entity partners is classified as a corporation for U.S. tax purposes
New guidance on section 892 entity classification of foreign investment partnerships
The IRS on October 27, 2023, released several private letter rulings* (PLRs) providing new guidance on its interpretation of whether a partnership that has controlled entity partners is classified as a corporation for U.S. tax purposes. The rulings also provide the IRS’s views on the treatment of foreign governments as foreign corporations under the Code.
Read the PLRs:
The three PLRs involve slightly different facts, this summary focuses on PLR 20243034, which involves a limited partnership formed in a foreign jurisdiction, Province, and classified as a partnership for U.S. tax purposes. Each of the limited partners is a “controlled entity” (and not an “integral part”) of the Province by reason of its relationship to the Province, and each limited partner is treated as a corporation for U.S. tax purposes. Five of the Partners are also treated as qualified foreign pension funds (“QFPFs”). The IRS considered two issues on whether the Entity should be classified as a partnership or a corporation for U.S. federal income tax purposes.
Issue 1 — Whether the limited partnership is a corporation for U.S. tax purposes because it is a foreign government under the entity classification regulations.
In general, Treasury regulations provide that a business entity wholly owned by a foreign government is treated as a foreign corporation. In addition, the code provides that foreign governments are treated as corporate residents of their country of origin. The term foreign government means the “integral parts” or “controlled entities” of a foreign sovereign. Both integral parts and controlled entities are eligible for the Section 892 exemption. Section 892 generally prohibits a foreign government from the direct performance of commercial activity, and such activity generally turns off the application of Section 892. However, an integral part does not lose its ability to claim the exemption for income not derived from commercial activities even if it engages in commercial activities, while a controlled entity carrying out commercial and non-commercial activities loses the exemption with respect to all its income. The Section 892 exemption does not apply to income derived from the conduct of any commercial activity or to any income received by, or to certain payments from, a controlled commercial entity (“CCE”).
According to the ruling, the regulation classifies a business entity wholly owned by a foreign government as a corporation (and not as a disregarded entity) in order to prevent a foreign sovereign from claiming the Section 892 exemption for a foreign disregarded entity engaged in commercial activities. Such an arrangement is contrary to the rule under the Code that denies the Section 892 exemption CCEs on all their income, including income from investments or other activities that are not commercial activities. On this basis, the IRS found that the phrase in the regulation “business entity wholly owned by a foreign government or any other entity described in §1.892-2T” is properly construed as a business entity that is wholly owned directly by a single controlled entity or integral part and which does not have two or more owners.
While partnerships could present similar concerns, the IRS concluded that those concerns were addressed by providing that for purposes of defining a CCE, the term “entity” includes a partnership. Thus, the IRS reasoned, classifying a partnership as a corporation pursuant to Treas. Reg. §301.7701-2(b)(6) was unnecessary to protect the purposes of Section 892 because the Entity has at least two owners and is, therefore, unable to classified as a disregarded entity for U.S. federal tax purposes). A regarded partnership engaged in commercial activities would therefore be treated as a CCE and all the partnership’s income would be denied the exemption at the partnership level.
Issue 2 — Whether the limited partnership is a corporation because of Section 892(a)(3).
The entity classification regulations provide that, for U.S. tax purposes, the term corporation includes a business entity that is taxable as a corporation under a provision of the Code other than Section 7701(a)(3). Section 892(a)(3) provides that for purposes of the Code, a foreign government shall be treated as a “corporate resident of its country.” Under the applicable regulation, a foreign government includes controlled entities of a foreign sovereign. Thus, an inference could be drawn that each controlled entity is the foreign government thereby a corporation because of Section 892(a)(3).
In the ruling, the IRS noted that the phrase “corporate resident” is not otherwise used in the Code, but Treasury regulations have interpreted it to mean that a foreign government is treated as a foreign corporation. As it is clear how foreign corporations and foreign partnerships are classified under the Code, the ruling concludes the purposes of Section 892(a)(3) is to clarify that an integral part of a foreign government is treated as a foreign corporation.
The IRS distinguishes partnerships from corporations in this context, concluding that partnerships generally have been treated as aggregates (rather than separate entities) for purposes of Section 892. The addition of partnerships to the definition of the term “entity” for purposes of a CCE under Section 892(a)(2)(B) was a limited departure from the treatment of partnerships as aggregates and does not dictate the meaning of the term “entity” in the phrase “controlled entity” more generally in Section 892. The addition applied to a different and broader class of partnerships through which foreign governments invested and was not limited to controlled entities. Specifically, a CCE includes any entity at least 50 percent owned by a foreign government, while only an entity that is 100 percent owned by a foreign sovereign can be a controlled entity. Accordingly, the IRS concluded the entity would not be classified as a per se corporation as a result of Section 892(a)(3).
The rulings set forth several policy grounds for why Congress would not have intended for Section 892(a)(3) to cause a partnership that is indirectly wholly owned by a single foreign government to be treated as a corporation for U.S. tax purposes. In particular, the ruling notes that the term “entity” is not defined in Section 892 or its regulations for this purpose. However, the rulings do not quote or analyze the reference in existing regulations to a separate juridical entity, which determines whether an entity is a “controlled entity.” Taxpayers and their advisors will need to consider the relevance of that omitted language in evaluating the significance of these rulings to their circumstances.
By ruling that the partnership is not a corporation for U.S. tax purposes, the partnership’s income that is eligible for the QFPF exemption that is properly allocable to QFPFs Partners is eligible for the QFPF exemption because those partners are eligible QFPFs. The rulings make clear this would not be the case if the partnership were classified as a corporation and the corporation itself did not qualify as a QFPF.
Section 892 and QFPF investors, as well as fund sponsors may wish to review their existing and contemplated investment structures in light of the rulings. Section 892 investors may also wish to review their analysis of what constitutes an “integral part” of a foreign sovereign under Treas. Reg. §1.892-2T(a)(2), and the consequences of the treatment of “integral parts” of a foreign sovereign as foreign corporations for all U.S. tax purposes.
As is the case with all IRS private letter rulings, the rulings apply only to the taxpayer who requested it and may not be used or cited as precedent.
If you would like to obtain more information about this topic, please contact a member of our Sovereign Wealth and Pension Funds tax team:
Eric Janowak | ericjanowak@kpmg.com
Sam Riesenberg | sriesenberg@kpmg.com
Dan Winnick | danielwinnick@kpmg.com
Janice Russell | janicerussell@kpmg.com
* Private letter rulings are taxpayer-specific rulings furnished by the IRS Office of Chief Counsel in response to requests made by taxpayers and can only be relied upon by the taxpayer to whom issued. Pursuant to section 6110(k)(3), written determinations such as private letter rulings are not intended to be relied upon by third parties and may not be cited as precedent. These written determinations may, however, offer an indication of the IRS’s position on the issues addressed.
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