Just before Christmas, the Internal Revenue Service proposed a number of changes to Section 892 of the U.S. Tax Code. Unless you’re a tax professional working for a government estate or a public pension fund, hey there?
Wrong. This proposal could be a bombshell for the investment climate in the private market.
Section 892 is a part of the U.S. tax code that you will be very concerned about if you are a foreign government entity, one of its integral parts, or a controlled entity seeking tax-exempt status for your investment activities (such as SWFs and some PPFs).
What about commercial activities? These are never tax exempt. Generations of tax lawyers and legislators seem to agree, but that would be madness.
Okay, but where is the line between investment and commercial activity? It’s complicated. An army of tax experts probably think they know. And they seem to agree that the IRS is proposing to move the line and move it significantly. This threatens to undermine all the arrangements that have been in place for decades for SWFs and some PPFs to qualify for some or all of their U.S. investment income to be tax-free.
Excluding U.S.-based funds like the Alaska Permanent Fund, the top 100 sovereign wealth funds have approximately $15 trillion in assets under management, according to Global SWF. Including the top 100 public pension funds, the total amount reaches approximately $27 trillion. So it’s not like there’s nothing.
What it means for personal credit
Just last week, we wrote that a quarter of all private credit is owned by what GlobalSWF calls state-owned investors. And there was a chart to prove it.
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Click on the treemap to see which individual SWFs or PPFs hold private credits. Some of them will have accumulated exposure as LPs through private credit managers. Some will be co-investments and some will be set up directly by internal teams.
From what we understand, almost all SWFs rely on the s892 exemption. However, this does not apply to all public pension funds. Some public pension funds rely on exemptions available to foreign investors in general, or foreign pension funds in particular, such as portfolio debt forgiveness. However, some may rely on section 892. The impact of the proposed rule changes on each fund will depend on its individual corporate structure.
But what happens if, for example, Section 892 is amended so that acquiring debt is considered a commercial activity? This could mean that investors who relied on the Section 892 exemption could suddenly find themselves liable to pay taxes on some or all of their U.S. investment income. International law firm Cleary Golieb’s view (emphasis) is as follows:
…Under the proposed regulations, a single loan purchased by a section 892 investor at the time of original issuance could give rise to commercial activity if the loan purchase has certain characteristics (e.g., the section 892 investor offers to provide debt financing to the borrower and structures and negotiates the terms of the debt, rather than being offered an investment opportunity to purchase the loan).
Oh, oh.
In fact, “loans” have been removed from the Internal Revenue Service’s list of investments that are not treated as commercial activities.
But things aren’t completely simple. Some bond investments have a “safe zone.” DLA Piper’s Investment Management and Funds team explains that these are triggered when these obligations are (1) “acquired as part of a registered offering from an unrelated underwriter” or (2) are instruments traded on an established securities market. Therefore, government bonds and corporate bonds are probably anti-china.
As far as Alphaville is concerned, for everything else, including directly originated private credit in its entirety, s892 investors must rely on the so-called “facts and circumstances” test if they wish to classify their bond holdings as investments. This test focuses on whether the expected return reflects only the return on capital and not compensation for financing or origination activities.
We are not lawyers, but it is clear that if you recruit borrowers who can directly make loans and play a significant role in structuring and negotiating these originations, as SWFs in the US private credit origination business do, maintaining s892 tax exemption can be an issue.
Helpfully, the IRS provides examples of when a loan may be considered a commercial activity. While unhelpful for SWFs, this example seems to clarify what the IRS really means by reclassifying direct loans from investments to evidence of commercial activity.
And the Treasury makes it clear, in a series of paragraphs written in legalese, that the moment an SWF walks into a creditor committee, they are absolutely, completely, unequivocally no longer the type of investor that should be exempt from tax. And in this regard, it doesn’t seem to matter whether the debt is public or private debt, whether it was purchased at face value years ago when the issuer had a perfect credit rating, or for pennies upon default. Trying to recover money from bad debts would be classified as a commercial activity.
Additionally, for some SWFs that organize themselves as so-called “controlled entities” rather than “an integral part,” the particular takeaway here is that what the IRS considers to be commercial activity doesn’t even have to take place in the United States.
Jeffrey Koppel, a tax partner at the law firm Squire Patton Boggs, patiently explained to Alphaville:
The “all-or-nothing” rule for managed entities remains in effect under the new regulations. If a controlled entity SWF engages in even a small amount of commercial activity, whether within or outside the United States, the Section 892 exemption for all of that entity’s U.S. income may be excluded.
Therefore, if a hypothetical s892 “controlled entity” investor with $100 billion invested in income-producing investments in the United States originated a direct loan of just €10 million from a Eurozone subsidiary to a small French machinery and equipment manufacturer, it would be very likely that he would not be able to claim the 892 exemption on any of his investment income in the United States.
We would like to list which SWFs were managed entities for U.S. tax purposes, but that information is not yet publicly available.
What it means for private equity
Directly owning a widget creation company has always been understood to be a commercial activity. And you’ll pay 21 percent U.S. corporate tax on your share of the profits the company generates, even if you’re a foreign government that’s supposed to be tax-exempt. But how do you stop the stake in a widget maker you acquired in the process of assembling a portfolio of co-investments solicited by your PE peers from destroying the tax exemption of your entire SWF? Hire an army of lawyers and accountants.
The solution for lawyers and accountants has been to create a myriad of special purpose vehicles called “blockers” to block the flow of tax liability to tax-exempt investors. SWFs and PPFs can use one or more blockers to hold all interests in LP interests, co-investments, and direct equity.
And indeed, the blocker will be responsible for a portion of the taxes payable on the profits. However, the s892 exemption can be deployed to distribute funds from blockers without incurring 30% withholding tax on distributions.
And when the SWF sells the blocker’s shares, s892 helps prevent US capital gains tax. Given that the United States taxes capital gains earned by foreigners whose assets are largely land, buildings, and tacked onto the ground, this could pose a major problem for their real estate and infrastructure holdings.
Now, what does that change? Well, at this point a SWF cannot own 100% of a disincentive and magically get rid of its tax liability. It’s too easy. They need to make sure they are not “effectively controlling” the blocker. And to do this, the various SWFs have tended to pool their interests in blockers so that each individually owns less than 50 percent of the blocker by vote or value. No one can control it effectively. Problem solved. Taxes were evaded.
But “effective” and “control” are just words. What they mean in a U.S. tax context is what the IRS says they mean. And the meaning will also change. While it is difficult to pinpoint the new definition, Treasury has provided a number of examples of the breadth of the new interpretation. Law firm Evershed Sutherland explains this approach:
The Treasury Department and the IRS appear to view the use of governance as a proxy for effective management. These examples demonstrate that even if a foreign government does not own stock in a company, effective control can occur under arrangements where the foreign government can influence or direct important decisions, such as through economic and regulatory pressure. The practical question, therefore, is where customary creditor protection ends and control over important decisions begins.
We can see that this may not be a deal-breaker for SWFs and PPFs that take private market exposure completely passively. This means they do not have governance powers, such as ensuring consultation on exits or approving strategic plans. But for those involved in co-investments and direct investments, it seems like an even bigger problem.
And it’s not like there was little co-investment or direct investment. Below is a graph of US SWF/PPF private equity deals outside of traditional LP channels over the past few years.
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Furthermore, there were not only PE transactions, but also real estate transactions, infrastructure transactions, and all sorts of other transactions.
In a world where the effective tax rate on profits was closer to 50 percent than 20 percent, we don’t know how many of these trades would never have taken place. But we imagine that number to be greater than zero.
maybe it won’t happen
No one Alphaville spoke to attempted to speculate on how much tax was being saved by SWFs using the s892 exemption, or even suggested how to hazard a guess. But let’s try.
Alphaville suspects that many public pension funds will not be organized as s892 investors, so this may only apply to SWFs. And if you just focus on the top 100 SWFs in AuM, you’re probably talking about $15 trillion in global investments.
Of this $15 trillion, just over four-tenths is invested domestically. GlobalSWF estimates, for example, that Saudi Arabia’s Public Investment Fund manages $1.15 trillion in assets, of which $920 billion is invested domestically. If you add up all non-domestic assets of the top 100 SWFs, their foreign investments amount to $8.4 trillion.
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If we poke our heads in the sand and calculate that perhaps 60 per cent of this $8.4 trillion is invested in the US, and then imagine that these assets generate perhaps 5 per cent of taxable US income, we get the figure that SWFs could avoid around $75 billion in US tax by taking advantage of the s892 exemption.
This number is clearly wrong. Even if that’s true, that doesn’t mean SWF behavior won’t shift from active direct investing, which is under the microscope, to more passive strategies, which seem less tricky. Furthermore, it is almost certainly possible that lawyers and accountants will be able to upend the current legal structure and weave new companies into business in ways that will evade the IRS’s dragnet. But we thought we’d throw you a figure.
we know what you’re thinking. Last year, there was a lot of talk about changes to certain sections of the U.S. tax code. Section 899 threatened to cause massive market turmoil by disrupting the U.S. Treasury market, consuming brain space and ultimately coming to nothing. And there is a good chance that this set of proposals will suffer the same fate. Nothing has been finalized. Comments will be accepted until February 13th.
After all, the Trump family has close ties to a growing number of SWF principals, at least one of whom has funneled billions of dollars into the family’s stablecoin. It seems decidedly un-Trumpy to hand his new friends and business partners new taxes that they must cough up if they want to be anything other than reluctant private market investors.
Wait, what are you talking about? This sounds completely in line with the administration.
