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In PLR 202343034 (PLR), the IRS ruled that a foreign limited partnership (Entity), which is indirectly wholly owned by a foreign government through multiple "controlled entities," as defined under Temporary Treas. Reg. Section 1.892-2T(a)(3), is not a "per se" corporation for purposes of Treas. Reg. Section 301.7701-2(b)(6) or (b)(7). At issue was whether the Entity should be classified as a corporation or a partnership for US federal tax purposes. The Entity was beneficially owned by investors, some but not all of which qualified as qualified foreign pension funds (QFPF).¹ If the Entity were classified as a corporation for US federal tax purposes, it would not be exempt under IRC Section 897(l) (Section 897(l) Exception) from taxation imposed by IRC Section 897(a) (i.e., the Foreign Investment in Real Property Tax Act (FIRPTA)) because it is not a corporation wholly-owned by QFPFs as required by IRC Section 897(l)(1). The QFPF investors would, however, be eligible for the Section 897(l) Exception on their respective shares of FIRPTA gain allocated to them from an entity classified as a partnership for US federal tax purposes. The Entity filed a Form 8832, Entity Classification Election, to be treated as a partnership for US federal tax purposes.

Background

An entity that is a corporation under either Treas. Reg. Section 301.7701-2(b)(6) or (b)(7) (or any other definition in Treas. Reg. Section 301.7701-2(b)) is a per se corporation and not eligible to file an Entity Classification Election. In contrast, an eligible entity (i.e., an entity that is not a per se corporation) that defaults to a corporation for US federal tax purposes may elect to be treated as: (1) disregarded as separate from its owner (a disregarded entity) if it has a single owner that is regarded for US federal income tax purposes, or (2) a partnership if it has two or more owners that are regarded for US federal income tax purposes.

Treas. Reg. Section 301.7701-2(b)(6)

Under Treas. Reg. Section 301.7701-2(b)(6), a business entity is a per se corporation if it is "wholly owned by a foreign government or any other entity described in [Treas. Reg. Section] 1.892-2T." Treas. Reg. Section 1.892-2T defines the term "foreign government" for purposes of the exemption in IRC Section 892(a) (Section 892 Exemption), which applies to certain investment income derived by a foreign government.

Treas. Reg. Section 1.892-2T(a) states that the term foreign government means an "integral part" or a "controlled entity" of a foreign sovereign.

• An "integral part" of a foreign sovereign is "any person, body of persons, organization, agency, bureau, fund, instrumentality, or other body, however designated, that constitutes a governing authority of a foreign country," provided that the net earnings of the governing authority are credited only to its account and not to the account of a private person.
• A "controlled entity" is defined in Treas. Reg. Section 1.892-2T(a)(3) as any entity that is separate in form from a foreign sovereign, or otherwise constitutes a separate judicial entity, and: (i) is wholly owned or controlled by the foreign sovereign directly or indirectly through one or more controlled entities; (ii) is organized under the laws of the foreign sovereign; (iii) has its net earnings credited to its own account or to that of the sovereign with no portion inuring to the benefit of a private person; and (iv) has its assets vest in the foreign sovereign upon dissolution.

Both an integral part and a controlled entity of a foreign sovereign are eligible for the Section 892 Exemption. An integral part may claim the Section 892 Exemption for income derived from non-commercial activities, even if it also derives income from commercial activities. In contrast, a controlled entity that conducts (or is treated as conducting) commercial activity loses the Section 892 Exemption for any income.

Treas. Reg. Section 301.7701-2(b)(7)

Under Treas. Reg. Section 301.7701-2(b)(7), a business entity is a per se corporation if a provision of the Code (other than Section 7701(a)(3)) treats the entity as a taxable corporation. As relevant here, IRC Section 892(a)(3) treats a foreign government as a "corporate resident" of its country for purposes of the Code.

Discussion of the PLR

Facts

The Entity, a foreign limited partnership, was organized under the laws of a province of a foreign country. The Entity was formed as an investment vehicle to hold assets invested by 12 limited partners and 1 general partner. It was represented that the Entity is not a governing authority or an integral part of the province.

The manager is a corporation classified as a foreign government under Treas. Reg. Section 1.892-2T(a) by reason of its relationship to the province. The manager serves as the asset manager for the Entity and is organized by the province to invest funds on behalf of public-sector clients located in the province, including the investors (described later). Due to the nature of the investors' investments, which often involve complex infrastructure, private equity and real estate transactions, the manager has established investment vehicles to hold the investors' assets. Historically, these investments have included a significant allocation to US real estate, infrastructure and timber assets.

The general partner is a corporation organized under province law, is a controlled entity, and is not an integral part of the province. The general partner is directly wholly owned and controlled by the manager.

Each limited partner is a controlled entity, and not an integral part, of the province. Most of the limited partners are QFPFs, and each of these is a corporation formed under province law and taxable as a corporation for US federal income tax purposes. The remaining limited partners are not QFPFs.

Each limited partner is beneficially owned by a separate investor. All investors are classified as foreign governments under Treas. Reg. Section 1.892-2T(a) because of their relationship to the province.

Although the Entity has not yet made any investments, its investment program contemplates dealings in stocks of domestic corporations that are US real property holding corporations (USRPHCs) for purposes of IRC Section 897 (i.e., FIRPTA). If the Entity were treated as a corporation for US federal income tax purposes, gain that it derived from the disposition of these domestic corporations would not be eligible for the Section 897(l) Exception because the corporation would not satisfy Section 897(l)(1)'s requirement to be wholly-owned by QFPFs. If, instead, the Entity were treated as a partnership for US federal income tax purposes, the QFPF Investors would be eligible for the Section 897(l) Exception on their respective shares of FIRPTA gains allocated to them by the partnership.

Issue 1: Whether the Entity is a per se corporation under Treas. Reg. Section 301.7701-2(b)(6)

The first issue analyzed was whether the Entity is a business entity "wholly owned by a foreign government or any other entity described in [Treas. Reg. Section] 1.892-2T" and thus a per se corporation under Treas. Reg. Section 301.7701-2(b)(6).

In evaluating the scope and purpose of Treas. Reg. Section 301.7701-2(b)(6), the IRS explained that before Treas. Reg. Section 301.7701-2(b)(6) was amended in 2002, it was possible "for an integral part of a foreign sovereign to form a disregarded entity for U.S. federal tax purposes and claim the exemption under section 892 with respect to income not derived from commercial activities, even if the disregarded entity was conducting commercial activities." As noted above, a controlled entity that conducts (or is treated as conducting) commercial activity loses the Section 892 Exemption. The IRS stated that "the purpose of the modification was to ensure that a business entity whose sole owner is either an integral part or a controlled entity, and which otherwise would be treated as a disregarded entity, is a corporation" and thus subject to the controlled commercial entity (CCE) rules under IRC Section 892(a)(2)(B). Based on the regulatory history, the IRS concluded that the entities to which Treas. Reg. Section 301.7701-2(b)(6) applies should be limited to "a business entity that is wholly owned directly by a single controlled entity or integral part and thus does not have two or more owners."

The IRS acknowledged that Treasury and the IRS had similar concerns if foreign governments used partnerships to achieve favorable tax treatment. However, Treasury and the IRS issued Treas. Reg. Section 1.892-5(a)(3), under which partnerships can be treated as CCEs, thus rendering a controlling foreign government's share of income from the partnership ineligible for the Section 892 Exemption. Further, Treas. Reg. Section 1.892-4T(d)(3) attributes any commercial activities of a partnership to its partners for purposes of IRC Section 892.

Based on this analysis, the IRS concluded that the Entity is not a per se corporation under Treas. Reg. Section 301.7701-2(b)(6) because it has more than one owner and thus cannot be considered "wholly owned."

Issue 2: Whether the Entity is a per se corporation under Treas. Reg. Section 301.7701-2(b)(7)

The IRS also analyzed whether the Entity is a per se corporation under Treas. Reg. Section 301.7701-2(b)(7) by reason of IRC Section 892(a)(3). A business entity is considered a per se corporation under Treas. Reg. Section 301.7701-2(b)(7) if any provision of the Code treats it as a taxable corporation.

IRC Section 892(a)(3) generally treats a foreign government as a "corporate resident" of its country, including for purposes of any income tax treaty obligation of the US. Because IRC Section 892(a)(3) refers to the term "foreign government," the IRS first considered whether to interpret the term as referring to an integral part or controlled entity by reference to Treas. Reg. Section 1.892-2T(a)(1). The IRS reasoned that the term "foreign government" may have been intended to be read as referring only to integral parts and not to controlled entities on the basis that IRC Section 892(a)(3) designates a foreign government as a treaty resident, a classification that may be unnecessary or unwarranted for a controlled entity.

Nevertheless, the IRS examined the purpose and history of controlled entity in the context of IRC Section 892. Noting that the term "entity" is not defined for purposes of Treas. Reg. Section 1.892-2T(a)(3), the IRS assessed the general treatment of partnerships as aggregates rather than separate entities for purposes of IRC Section 892. In describing the need to develop the concept of "controlled entity," the IRS distinguished the treatment of corporations owned by a foreign sovereign and not expressly exempt from US taxation under the statute, from partnerships that are generally not subject to tax. The PLR explains that the concept of a "controlled entity" addresses "whether an entity that otherwise would have been subject to US tax on its investment income could rely on the [S]ection 892 exemption."

Relying on the historic treatment of partnerships for purposes of IRC Section 892, and the history and purpose of the concept of controlled entity, the PLR concludes that partnerships are not within the intended scope of "controlled entity." In considering the reference to "partnerships" in the flush language of Treas. Reg. Section 1.892-2T(a)(3), the PLR states that this language "should not be read to imply that a partnership wholly owned and controlled by a single foreign sovereign (indirectly through multiple controlled entities) is itself a "controlled entity." Citing the representation that the Entity was not an integral part of the province, and the conclusion that the Entity should not be treated as a controlled entity, the IRS concluded that the Entity is not a per se corporation under Treas. Reg. Section 301.7701-2(b)(7) by reason of IRC Section 892(a)(3).

Implications

The PLR describes a fairly common fact pattern where a group of controlled, corporate investors from the same country pool their money in what they believe is a partnership for US federal income tax purposes that would allow them to benefit from any preferential status that they have under the Code, i.e., either the Section 892 Exemption, the Section 897(l) Exemption or both. Where all of the investors are entities described in IRC Section 892, however, the tax consequences may not have always been as expected because of the per se rules in Treas. Reg. Sections 301.7701-2(b)(6) and (7). The concern that Treasury was trying to address in Treas. Reg. Section 301.7701-2(b)(6), as applied to partnerships that are wholly-owned by foreign governments and their controlled entities, has been a subject of debate among tax practitioners.

While the PLR is directed to the taxpayer that requested it, and cannot be cited as precedent by other taxpayers, the IRS's explanation of the purpose and scope of the relevant rules will be helpful in interpreting and applying the per se rules. Managers establishing investment vehicles to invest funds on behalf of foreign governments, including QFPFs, should evaluate and consider the implications of the PLR for their particular arrangements, including the ability to preserve the benefit of the exception under IRC Section 897(l).

It should be noted, however, that even under the PLR's analysis, a controlled partnership engaged in commercial activity remains classified as a CCE under Treas. Reg. Section 1.892-5(a)(3). As such, income received by a CCE and income received (directly or indirectly) from a CCE does not qualify for the Section 892 exemption. Further, an LLC or other entity that is wholly owned by a single foreign government or controlled entity will continue to be treated as a per se corporation.

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Published by NTD’s Tax Technical Knowledge Services group; Maureen Sanelli, legal editor

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ENDNOTE

¹ Treas. Reg. Section 1.897(l)-1(b) provides: "Gain or loss of a qualified holder from the disposition of a United States real property interest … is not subject to Section 897(a)." The term qualified holder means a qualified foreign pension fund or a non-US entity, other than a partnership, wholly owned by qualified foreign pension funds directly or indirectly through other entities wholly owned by qualified foreign pension funds. For purposes of this Tax Alert, the defined term "QFPF" references "qualified holders" as defined in Treas. Reg. Section 1.897(l)-1(b).