2025 Final Regulations and Proposed Regulations Regarding the Section 892 Tax Exemption for Foreign Governments

On December 15, 2025, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) published final regulations (Final Regulations) and proposed regulations (Proposed Regulations) regarding the Section 892 tax exemption for foreign governments.¹ This Advisory provides a high-level summary of the Final Regulations and the Proposed Regulations.

I.  Background

Under Section 892, income of foreign governments received from investments in the United States in stocks, bonds, or other domestic securities owned by such foreign governments, or financial instruments held in the execution of governmental financial or monetary policy, or interest on deposits in banks in the United States of moneys belonging to such foreign governments, is not included in gross income and is exempt from U.S. federal income tax.

This exemption does not apply, however, to any income that is (1) derived from the conduct of any commercial activity (whether within or outside the United States), (2) received by a controlled commercial entity (a CCE) or received (directly or indirectly) from a CCE, or (3) derived from the disposition of any interest in a CCE.

For purposes of this rule, a CCE is any entity engaged in commercial activities (whether within or outside the United States) if the foreign government (1) holds (directly or indirectly) any interest in such entity which (by value or voting interest) is 50% or more of the total of such interests in such entity, or (2) holds (directly or indirectly) any other interest in such entity which provides the foreign government with effective control of such entity.

II.  Final Regulations

a.  Defining Commercial Activities

The Final Regulations adopt a broad definition of “commercial activities.” Under the Final Regulations, all activities (whether conducted within or outside the United States) that are ordinarily conducted for the current or future production of income or gain are treated as commercial activities. The Final Regulations provide that only the nature of the activity, and not the purpose or motivation for conducting the activity, is determinative of whether the activity is commercial in character. In addition, the Final Regulations provide that activities that constitute a trade or business for purposes of Section 162, or that constitute (or would constitute if undertaken in the United States) a trade or business in the United States for purposes of Section 864(b), are treated as commercial activities, unless an exception applies. Furthermore, the preamble to the Final Regulations explains that “commercial activities” has a different and broader meaning than “trade or business” under Sections 162 and 864 and, therefore, may encompass activities that do not rise to the level of a trade or business for purposes of determining the “effectively connected income” of a non-U.S. corporation.

i.  Investing and Trading in Financial Instruments

The Final Regulations expand the exceptions under which investing and trading in “financial instruments” are not treated as commercial activities by revising the definition of “financial instrument” to include derivatives, which the Final Regulations define in a manner substantially similar to the definition in the derivatives trading safe harbor in the proposed Treasury regulations under Section 864(b).

ii.  Holding of Non-Functional Currency

The Final Regulations clarify that the exception under which the holding of bank deposits is not a commercial activity applies to bank deposits in any currency.

iii.  Receipt of Certain Fee Income

The Treasury and the IRS rejected a commentator’s recommendation to exclude from commercial activities the receipt of certain fee income as a passive investor in a private equity or private credit fund.

The preamble to the Final Regulations provides that, to the extent the commercial activities of a fund sponsor are attributable to a foreign government investor in a privately managed fund through a partnership, or on the basis of agency, the foreign government investor is considered to conduct commercial activity unless an exception applies (for example, the qualified partnership interest exception under the Final Regulations (the Qualified Partnership Interest Exception), discussed further below). The preamble further provides that this analysis applies without regard to whether the foreign government actually or constructively receives or otherwise shares in income labeled as a fee. The preamble also provides that the Final Regulations do not treat the receipt of any particular type of fee as alone determinative of whether a foreign government conducts commercial activities.

iv.  Partnership Equity Interests

The Final Regulations provide that merely holding or trading partnership equity interests for one’s own account, other than as a dealer, is not, by itself, commercial activity. The preamble to the Final Regulations provides, however, that holding equity interests in a partnership results in commercial activity if the partnership conducts commercial activity that is attributed to the holder.

b.  U.S. Real Property Holding Corporation (USRPHC) Per Se Rule

The 1988 temporary Treasury regulations under Section 892 provide that a USRPHC, including a non-U.S. corporation that would be a USRPHC if it were a U.S. corporation, is treated as engaged in commercial activity and, therefore, as a CCE, if a foreign government meets certain ownership or control thresholds with respect to that USRPHC or non-U.S. corporation (the USRPHC Per Se Rule).

The 2022 proposed Treasury regulations under Section 892 (which the preamble to such regulations provides may be relied on for taxable years ending on or after December 28, 2022) include an exclusion from the USRPHC Per Se Rule for a corporation that is a USRPHC solely by reason of its direct or indirect ownership interest in one or more other corporations that are not controlled by the foreign government (the Minority Interest Exception). Based on this exception, a foreign government could hold such minority interests through a U.S. holding company without that U.S. holding company being treated as a CCE.

The Final Regulations limit the USRPHC Per Se Rule to U.S. corporations. As such, a non-U.S. corporation is no longer treated as a CCE merely because it is a USRPHC. This change limits the utility of the Minority Interest Exception, which now solely benefits U.S. corporations seeking to avoid CCE status.

Nevertheless, the Final Regulations retain the Minority Interest Exception, with certain clarifying modifications. The preamble to the Final Regulations acknowledges that the Treasury and the IRS did so in light of foreign governments’ reliance on the Minority Interest Exception in entering into long-term minority interest investments in USRPHCs through U.S. holding companies.

c.  Qualified Partnership Interest Exception

Consistent with the 2011 proposed Treasury regulations under Section 892, the Final Regulations provide that a partnership’s commercial activities generally are attributable to its partners. The 2011 proposed Treasury regulations include an exception under which an entity not otherwise engaged in commercial activities is not treated as engaged in commercial activities solely by reason of being a limited partner in a limited partnership. The Final Regulations expand this limited partner exception and rename it the “Qualified Partnership Interest Exception.”

Under the Qualified Partnership Interest Exception, an entity that is not otherwise engaged in commercial activities will not be treated as engaged in commercial activities solely because it holds a qualified partnership interest (QPI) in a partnership. An interest may qualify as a QPI under either a general test or a safe harbor, both of which are discussed further below.

Under the general test, an interest is a QPI if the holder (1) has limited liability, (2) does not possess the legal authority to bind, or to act on behalf of, the partnership, (3) does not control the partnership (i.e., does not directly or indirectly hold 50% or more, by vote or value, of the interests in the partnership, or otherwise have “effective control” of the partnership), and (4) does not have rights to participate in the management and conduct of the partnership’s business at any time during the partnership’s taxable year. With respect to the fourth requirement, the Final Regulations provide that such rights generally do not include participation rights with respect to monitoring or protecting the partner’s capital investment in the partnership. The Final Regulations further provide that such rights may include oversight and supervision rights in the case of major strategic decisions, such as the admission or expulsion of a partner, the hiring or firing of key strategic personnel, amendment of the partnership agreement, dissolution, merger, or conversion of the partnership, unusual and non-ordinary course deviations from previously determined investment parameters, extension of the term of the partnership’s governing agreement, and disposition of all or substantially all of the partnership’s property outside of the ordinary course of the partnership’s business.

As noted above, the Final Regulations also adopt a safe harbor for holders of de minimis interests. Under this safe harbor, an interest may qualify as a QPI if, at all times during the partnership’s taxable year, the holder (1) has limited liability, (2) does not possess the legal authority to bind, or to act on behalf of, the partnership, (3) is not the partnership’s managing partner, managing member, or in an equivalent role under applicable law, and (4) does not own, directly or indirectly, more than 5% of either the partnership’s capital interests or the partnership’s profits interests.

With respect to foreign governments that hold more than one interest in a partnership, the Final Regulations provide that, if a holder directly or indirectly holds more than one partnership interest, the interests are aggregated for purposes of the “does not participate in the management and conduct of the partnership’s business” requirement.

With respect to tiered partnerships, the Final Regulations provide that, if an upper-tier partnership holds no interest in a lower-tier partnership other than a QPI, the lower-tier partnership’s commercial activities will not be attributed to the upper-tier partnership.

d.  Inadvertent Commercial Activity Exception

The Final Regulations generally retain the exception under which inadvertent commercial activities do not, by themselves, cause an entity to be treated as engaged in commercial activities (the Inadvertent Commercial Activity Exception).

With respect to the requirement that a failure to avoid conducting a commercial activity be reasonable, the Final Regulations provide examples of facts and circumstances that may be considered in determining whether a written policy or operational procedure is considered adequate.

The 2011 proposed Treasury regulations provide that a failure to avoid commercial activity will not be considered reasonable if the entity’s management-level employees have not undertaken reasonable efforts to establish, follow, and enforce written policies and operational procedures. The Final Regulations provide that either employees of the entity claiming the Inadvertent Commercial Activity Exception or employees of any of its controlling entities may be designated to establish, follow, and enforce the adequate written policies and operational procedures to appropriately monitor the worldwide activities of the entity claiming the Inadvertent Commercial Activity Exception.

The Final Regulations retain a safe harbor from the 2011 proposed Treasury regulations, with certain modifications. Under this safe harbor, provided that adequate written policies and operational procedures are in place to monitor the tested entity’s worldwide activities, the tested entity’s failure to avoid commercial activity during the taxable year will be considered reasonable if both:

(1) The value of the assets used in, or held for use in, all commercial activity does not exceed 5% of the total value of the assets reflected on the tested entity’s balance sheet for the taxable year

(2) The income earned by the tested entity from commercial activity does not exceed 5% of the tested entity’s gross income as reflected on its income statement for the taxable year

To qualify for the Inadvertent Commercial Activity Exception, the commercial activity must be promptly cured. Under the 2011 proposed Treasury regulations, a cure is considered prompt if the entity engaging in inadvertent commercial activity discontinues the activity within 120 days of discovering it. The Final Regulations extend the cure period to 180 days from the date of the discovery by the employees who are responsible for monitoring and reviewing the entity’s commercial activity.

e.  Annual CCE Determination

The Final Regulations generally retain the annual CCE determination rule from the 2011 proposed Treasury regulations. The Final Regulations clarify that this annual determination is made by reference to the entity’s taxable year. In addition, for purposes of determining whether an entity is engaged in commercial activities during its taxable year, the Final Regulations provide that the entity’s activities during its immediately preceding taxable year will be taken into account to the extent relevant in characterizing the entity’s activities in the current taxable year.

Under the Final Regulations, if the taxable year of a corporation engaged in commercial activities is terminated as a result of an acquisition to which Section 381(a) applies (other than a complete liquidation under Section 332(a)), the acquiring corporation generally does not succeed to the distributor or transferor corporation’s commercial activities for the acquiring corporation’s applicable taxable year, provided that, after the acquisition, the acquiring corporation is not the entity that directly carries on those commercial activities. However, if the corporation engages in an acquisition to which Section 381(a) applies with another corporation controlled by the same foreign government, the distributor or transferor corporation’s commercial activities will cause the acquiring corporation to be treated as a CCE for the acquiring corporation’s taxable year in which the acquisition occurred.

III.  Proposed Regulations

a.  Definition of Controlled Entity

The Proposed Regulations clarify that an entity that is a partnership for U.S. federal income tax purposes is not a controlled entity.

b.  Acquisition of Debt

The Proposed Regulations provide, as a general rule, that any acquisition of debt is treated as a commercial activity unless the acquisition is characterized as an investment for purposes of Section 892 under one of two safe harbors or under a facts-and-circumstances test.

The first safe harbor treats acquisitions of bonds or other debt securities in an offering registered under the U.S. Securities Act of 1933, as amended (the Securities Act), as an investment, provided that the underwriters of the offering are not related to the acquirer. The Treasury and the IRS request comments regarding circumstances in which this safe harbor should be extended to offerings registered under non-U.S. securities laws.

The second safe harbor treats acquisitions of debt traded on an established securities market as an investment, provided that (1) the acquirer does not acquire the debt from the issuer or participate in negotiating the terms or issuance of the debt, and (2) the acquisition is not from a person under common management or control with the acquirer, unless that person acquired the debt as an investment. The Treasury and the IRS request comments regarding circumstances, if any, in which this safe harbor should apply to an acquisition of debt that is not traded on an established securities market.

As mentioned above, the Proposed Regulations also provide a facts-and-circumstances test to determine whether a debt acquisition is treated as an investment. The Proposed Regulations identify eight factors to be considered:

1. Whether the acquirer solicited prospective borrowers, or otherwise held itself out as willing to make loans or otherwise acquire debt at, or in connection with, its original issuance
2. Whether the acquirer materially participated in negotiating or structuring the terms of the debt
3. Whether the acquirer is entitled to compensation (whether or not labeled as a fee) that is not treated as interest (including original issue discount) for federal tax purposes
4. The form of the debt and the issuance process, including, for example, whether the debt is a bank loan or instead a privately placed debt security pursuant to Regulation S or Rule 144A under the Securities Act
5. The percentage of the debt issuance acquired by the acquirer relative to the percentages acquired by other purchasers
6. The percentage of equity in the debt issuer held, or to be held, by the acquirer
7. The value of that equity relative to the amount of debt acquired
8. 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, based on objective evidence, such as a decline in the financial condition or credit rating of the debt issuer between original issuance and the time of the acquisition of the original unmodified debt, that the original unmodified debt would default.

The Proposed Regulations include five examples illustrating the application of the facts-and-circumstances test. The Treasury and the IRS request comments on whether additional factors or examples should be included, and in particular on the circumstances, if any, in which acquisitions of distressed debt, broadly syndicated loans, revolving credit facilities, and delayed-draw debt obligations should be treated as investments rather than commercial activities.

c.  Defining Effective Control

As described above, a CCE includes any entity engaged in commercial activities (whether within or outside the United States) if the foreign government holds (directly or indirectly) any interest in such entity which provides the foreign government with effective control of such entity. The Proposed Regulations provide additional guidance on what constitutes “effective control.”

Under the Proposed Regulations, effective control is achieved by any interest in an entity that, directly or indirectly, either separately or in combination with other interests, results in control of the operational, managerial, board-level, or investor-level decisions of the entity. The Proposed Regulations also provide, however, that mere consultation rights with respect to operational, managerial, board-level, or investor-level decisions of an entity (such as extending the term of the entity’s investment period, change in control of the entity, or liquidation of the entity) do not alone give rise to effective control. The Proposed Regulations further provide that the determination of effective control is made considering all of the facts and circumstances related to the interests in an entity.

The Treasury and the IRS request comments as to the circumstances, if any, in which a determination could be made that controlled entities are functionally independent of one another and therefore may be appropriately considered separately for purposes of an effective control analysis. The Treasury and the IRS also request comments as to the circumstances, if any, in which the holder of a minority equity interest in an entity should not be treated as having effective control of the entity if managerial or board-level decisions of the entity are subject to veto or “blocking” rights of the holder and other holders.

IV.  Applicability Dates

The Final Regulations generally apply to taxable years beginning on or after December 15, 2025. A taxpayer may generally elect to apply the Final Regulations to certain earlier open taxable years if applied consistently.

The Proposed Regulations will generally only apply to taxable years beginning on or after they are published in final form. 

© Arnold & Porter Kaye Scholer LLP 2026 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.