Enhancing after-tax returns on direct or co-direct investment opportunities

Sovereign Wealth Funds (“SWFs”) and government pensions often pursue direct and/or co-investment opportunities in the US as a strategy to generate additional risk-adjusted returns alongside their fund investments. While direct investment into private companies or assets might be challenging to contemplate for various regulatory and logistical reasons, co-investment opportunities could be easier to pursue provided there are strong relationships with the market leading asset managers. Both direct and co-investment arrangements may result in increased returns as a result of reduced management fees and/or carried interest because, unlike a fund investment, the structure does not typically involve a fund sponsor or a general partner. 

As investors consider these potential US investments, they may want to examine the post-tax returns of the investment, and whether the investor qualifies for any tax privileges. Although non-US investors are generally not taxed on capital gains from the sale of shares of US companies, certain investments may lead to taxable results. For example, the Foreign Investment in Real Property Tax Act (“FIRPTA”) imposes federal income tax on gains from the sale of certain interests in US real property (“USRPI”) at combined tax rates of up to 44.7 percent under current law. Alternatively, investors focused on dividend paying investments should be aware of the potential for withholding taxes. Specifically, dividend distributions from US companies are generally subject to 30 percent withholding tax if no reduction or exemption applies. 

However, there are three key tax privileges that SWF investors should be mindful of when seeking to enhance after-tax returns on these direct or co-investment opportunities.

1. Section 892 Exemption 

Under Section 892 of the Internal Revenue Code (the “IRC”) and the relevant regulations issued thereunder, a foreign government is exempt from US federal income taxation on certain investment income, including dividends, interest, capital gains related to the disposal of certain securities (including minority interests in US real property holding corporations (“USRPHCs”), and income from financial instruments held in the execution of governmental financial and monetary policy (the “Section 892 Exemption”). Entities wholly owned by a foreign government – often including SWFs and government pension plans – meeting certain requirements may be eligible for the Section 892 Exemption. However, the Section 892 Exemption restricts the investor from engaging in any “commercial activity” inside or outside the US in order to preserve the benefits. Commercial activity generally includes all activities, wherever performed, that “are ordinarily conducted by the taxpayer or by other persons with a view towards the current or future production of income or gain.”1

As a result of how the rules are applied, this commercial activity restriction may limit the ability to make a controlling or majority stake in an investment. Other rules limit the way that SWFs gain exposure to US real estate by generally requiring minority stakes in USRPI, in order to preserve the Section 892 Exemption. Accordingly, many investors strive to maintain the exemption through careful structuring and planning. 

There may be opportunities for like-minded Section 892 investors to form “club” deal structures to invest in US real estate which would otherwise not be eligible for Section 892 if only held by one investor. For example, Section 892 investors could each hold a non-controlling interest in a shared “blocker” corporation or a Real Estate Investment Trust (“REIT”) holding a US real estate investment. Under such arrangements, the investors may be able to individually claim Section 892 benefits on the respective investment, such as nil withholding tax on dividend distributions or the non-application of FIRPTA . Note that a REIT is also exempt from corporate income tax provided certain qualifications are met, further enhancing the potential for post-tax return. 

Alternatively, to the extent a REIT can be owned more than 50 percent by US investors, the REIT would be considered domestically controlled (“DC-REIT”), and no longer considered a USRPHC for US federal income tax purposes. The sale of shares of a DC-REIT is not subject to FIRPTA.

Other non-real estate investment opportunities might be more common in the private equity sector. For instance, Section 892 investors might partner with other institutional or strategic investors to jointly own a US business through a ‘corporate blocker’ where the Section 892 investor does not have either actual (by reason of vote or value) or “effective practical control”2 of the US blocker, and thereby maintain eligibility for the Section 892 Exemption on income or gains derived from such an investment.

2. Qualified Foreign Pension Funds

Certain non-US pensions, if considered qualified foreign pension funds (“QFPFs”) under US federal income tax law, are eligible for a full exemption from FIRPTA, irrespective of ownership percentage in a USRPI. Many QFPFs may still choose to utilize US corporate blocker structures, including Real Estate Investment Trusts (“REITs”), for US real estate investment in order to avoid generating effectively connected income (“ECI”) that is subject to normal federal income tax and potential US tax filing obligations. A QFPF is exempt from US federal income tax on exit gains from investment in the USRPI, as well as capital gains dividends from a REIT attributable to gains from the sale of an underlying real property asset.3 However, a QFPF is not generally exempt from withholding tax on operating dividends from a REIT or a regular US corporation unless the QFPF also qualifies for the Section 892 Exemption or benefits from an exemption or reduction in tax or pursuant to an applicable tax treaty. Note that, certain treaties may limit the ownership percentage in the investment for the benefit to apply, and therefore reducing the tax benefits to a QFPF.4 Thus, while there may be commercial drivers to acquire a majority interest, it may be helpful to assess the pre vs. post-tax return of a majority vs. minority interest, taking into consideration the anticipated income stream(s) of the target investment.5

3. Tax Treaties

Bilateral tax treaties can offer substantial tax relief to otherwise applicable domestic tax rules. Some tax treaties may specify certain government organizations as being eligible for benefits of the treaty, thus providing some Institutional Investors with structuring opportunities. Tax treaties may reduce income, capital gains or withholding taxes. As mentioned above, certain treaties impose certain requirements in terms of ownership in an investee company, and/or the substantiality in the ultimate beneficial owner of the investment. These requirements need to be addressed on a case-by-case basis to ensure the eligibility of the desired treaty benefits. Further, as noted above, it may be possible to pair tax treaty eligibility with the US domestic exemptions to achieve optimal tax relief.


As SWFs assess direct and co-investment US opportunities on a pre/post-tax basis, they should be aware of potential structuring opportunities. These opportunities require some analysis to confirm their suitability for a particular investment, but the tax savings can be substantial to qualifying investors.


David Dietz, Managing Director, Institutional Investor Group, KPMG in the U.S.

Eric Janowak, Managing Director, KPMG US, seconded to KPMG Lower Gulf

Nicole Li, Managing Director, KPMG Lower Gulf


1 Regulation Section 1.892-4T

2 Regulation Section 1.892-5T

3 Contrary to the treatment for a Section 892 investor under IRS Notice 2007-55

4 For example, the UAE – Canada tax treaty prescribes different rates of withholding tax on dividends paid by an investee company in Canada based on a 10% ownership threshold for the investor company from the UAE, subject to certain exceptions.

5 For example, a property that is likely to produce a greater amount of capital gain at disposition than the anticipated operating dividends over the life of the property.


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