Just ahead of Christmas, the US Inland Revenue Service dropped a bunch of proposed changes to Section 892 of the US tax code. Unless you’re a tax specialist working in a sovereign wealth or public pension fund, yaaaaawn?
Wrong. The proposals are a potential bombshell for the private market investment landscape.
Section 892 is the bit of the US tax code that you really really care about if you’re a foreign government entity, one of their integral parts, or a controlled entity (eg, SWFs and some PPFs) seeking to qualify as tax exempt for your investment activities.
What about your commercial activities? These will never be tax-exempt. That, generations of tax lawyers and legislators appear to have agreed, would be madness.
OK, but where is the line drawn between investment and commercial activities? It’s complicated. Armies of tax specialists reckon they probably know. And they seem to agree that the IRS is proposing to move the line, and move it a lot. This threatens to screw with all the arrangements erected over decades that enable SWFs and some PPFs to qualify as tax-exempt on anything between some and all of their US investment income.
According to Global SWF, total assets under management of the top 100 sovereign wealth funds come to around $15tn once we’ve stripped out US-based funds like Alaska Permanent Fund. When we chuck in the top 100 public pension funds, the total rises to around $27tn. So not nothing.
What it means for private credit
Only last week we wrote that a quarter of all private credit is owned by what GlobalSWF call state-owned investors. And we had the chart to prove it:
Click through the treemap to see which individual SWF or PPF holds whatever quantity of private credit. Some of them will have accumulated exposure as LPs through private credit managers. Some will be co-investments, and some direct originations by in-house teams.
From what we’ve understood, pretty much all SWFs rely on s892 exemptions. But this is not the case for all public pension funds. Some public pension funds rely on exemptions available to foreign investors in general — like the Portfolio Debt Exemption — or foreign pension funds specifically. But some might rely on Section 892. The impact of the proposed rule change on each fund will vary according to its individual corporate structure.
But what would happen if, let’s say, Section 892 was amended such that the acquisition of debt was deemed a commercial activity? This could make any investor that does rely on Section 892 for exemption suddenly liable to pay tax on some, or even all, of their US investment income. Here’s international law firm Cleary Gollieb’s take (their emphasis):
… under the proposed regulations a single loan purchased by a section 892 investor at original issuance can give rise to commercial activity if the loan purchase has certain characteristics (e,g., the section 892 investor offers to provide debt financing to a borrower, as opposed to being offered an investment opportunity to buy the loan, and structures and negotiates the terms of the debt).
Uh oh.
Indeed, “loans” are removed from the Internal Revenue Service’s list of investments that are not treated as commercial activities.
But things are not entirely straightforward. There are ‘safe harbours’ for some debt investments. DLA Piper’s Investment Management and Funds Team explains that these kick in when the debts are instruments that are either (1) ‘acquired as part of a registered offering from unrelated underwriters’, or (2) traded on an established securities market. So government and corporate bonds are probably unch.
For everything else — including, as far as Alphaville can tell, the entirety of directly originated private credit — an s892 investor needs to rely on a so-called ‘facts-and-circumstances’ test if it wants a debt holding to be classed as investment. The test focuses on whether expected returns reflect solely a return on capital rather than compensation for lending or origination activities.
We’re not lawyers, but if you go out and solicit borrowers to whom you can make direct loans, and have a material role in structuring or negotiating these originations — like any SWF with a US private credit origination business might do — it looks pretty clear that retaining s892 tax exemptions could be a problem.
Helpfully, the IRS provides a worked example of when a loan might count as commercial activity. Unhelpfully for SWFs, the example appears to clarify that the IRS really means business in re-categorising directly originated loans from being investments to being evidence of commercial activity.
And in a series of paragraphs written in legalese too torturous to reproduce, the Treasury makes it crystal clear that the moment a SWF steps into a creditor committee, they are definitely, totally, unambiguously no longer the kind of investor who should be tax exempt. And for this it doesn’t look like it matters whether the debt is public or private, whether it was purchased years ago at par when the issuer had a spotless credit rating, or picked up for cents on the dollar in default. Trying to get your money back from a bad loan is going to be classified as commercial activity.
Moreover, for some SWFs who have organised themselves as so-called ‘controlled entities’ rather than ‘integral parts’, the cherry on this particular cake is that stuff the IRS reckons to be commercial activity doesn’t even need to occur in the US.
As Jeffrey Koppele, a tax partner at the law firm Squire Patton Boggs, patiently explained to Alphaville:
The “all or nothing” rule for controlled entities remains in effect under the new regulations. If an SWF that is a controlled entity engages in even a modest amount of commercial activity, whether inside or outside the US, it can still eliminate the entity’s section 892 exemption for all US income.
So if some hypothetical s892 ‘controlled entity’ investor with a hundred billion of US income-producing investments originates a puny little €10mn direct loan out of its Eurozone subsidiary to a little French widget-maker, it very much looks like it may no longer be able to claim 892 exemption on any of its US investment income.
We’d love to list which SWFs were controlled entities for US tax purposes, but the information just isn’t out there.
What it means for private equity
Owning a widget-making company directly has always been understood to be a commercial activity. And you’re going to pay 21 per cent US corporation tax on your share of the profits produced by the firm even if you’re a supposedly tax-exempt foreign government. But how do you stop your stake in said widget maker, accrued in the course of assembling a portfolio of co-investments hawked to you by your PE buddies, from destroying the tax exemption of your entire SWF? Hire an army of lawyers and accountants.
The lawyer/ accountant solution has been to create myriad special-purpose vehicles — called ‘blockers’ because they block the flow of tax liabilities to tax-exempt investors. SWFs and PPFs can use one or more blockers to hold all their LP interests, co-investments, and direct equity stakes.
And then, sure, a blocker will be liable for its share of any tax payable on the profits. But s892 exemption can be rolled out to dividend money out of the blocker without triggering a 30 per cent withholding tax on distributions.
And when the SWF sells its stake in the blocker, s892 comes to their rescue in preventing US capital gains from being chargeable. Given that the US taxes capital gains made by foreigners where assets are largely land, buildings and stuff nailed to the ground, this can be a big deal for their real estate and infrastructure holdings.
OK, so what might change? Well, right now SWFs can’t just own 100 per cent of a blocker and magic away the tax liability. Too easy. They need to make sure they don’t have ‘effective control’ of the blocker. And to do this, different SWFs have tended to pool together their interests in blockers so that they each individually own less than 50 per cent of a blocker by vote or value. No one has effective control. Problem solved; tax dodged.
But ‘effective’ and ‘control’ are just words; their meaning in the context of US tax mean what the IRS say they mean. And the meaning is changing. It’s hard to pin down a precise new definition, but the Treasury do set out a bunch of examples that illustrate the breadth of the new interpretation. Law firm Eversheds Sutherland describes the approach as follows:
Treasury and the IRS apparently view governance leverage as a proxy for effective control. The examples indicate that effective control can arise under any arrangement that allows a foreign government to influence or direct important decisions, including through economic and regulatory pressure, even if the foreign government owns no equity in the entity. The practical question, therefore, is where customary creditor protections end and control over key decisions begins.
We can see that this may not be a deal-breaker for SWFs or PPFs who take their private market exposures entirely passively — with no governance rights over things like making sure you’re consulted on exits, or approving strategic plans. But for those engaged in co-investment or direct investing it looks like a bigger deal.
And it’s not like co-investments and direct investments have been few and far between. Here’s a chart of the SWF/ PPF private equity deals in the US that fall outside the traditional LP channel over the past few years:
Moreover, beyond just the PE deals, there were all the real estate deals, infrastructure transactions, etc.
We don’t have a sense as to how many of these deals just wouldn’t have been done in a world where the effective tax rate on their profits was closer to 50 per cent than 20 per cent. But we imagine the number is greater than zero.
Maybe it won’t happen
Nobody Alphaville spoke to ventured a guess as to how much tax was being saved by SWFs using s892 exemptions, or even suggested a way by which a guess could even be hazarded. But let’s have a go.
We could say it’ll apply only to SWFs, because Alphaville suspects many public pension funds will not be organised as s892 investors. And if we focus just on the top 100 SWFs by AuM, we’re talking about maybe $15tn of global investments.
Of this $15tn, just over four-tenths are domestically invested. GlobalSWF estimates that Saudi Arabia’s Public Investment Fund, for example, has a mammoth $1.15tn assets under management, but that $920bn of these are invested locally. Totting up all the non-domestic assets of the top 100 SWFs gets us to $8.4tn of international investments.
If we stick our fingers in the air and reckon that maybe 60 per cent of this $8.4tn is invested in the US, and furthermore imagine that otherwise taxable US income on these assets accrues at perhaps 5 per cent, we can get to a figure of around $75bn of US tax avoided by SWFs using s892 exemptions.
This figure is clearly wrong. And even if it were right, this is not to say that SWF behaviour wouldn’t shift away from active direct investment that seems to be under the microscope towards more passive strategies that look less tricksy. Moreover, it’s probably a safe bet that lawyers and accountants will be able to upend current legal structures and spin new corporate webs in ways that might dodge the IRS dragnet. But we thought we’d throw you a figure.
We know what you’re thinking. There were lots of stories about a reform to some section of the US tax code last year. Section 899 — that threatened to cause major market disruption by screwing with the Treasury market — consumed brain-space and ultimately came to nothing. And it’s quite possible that this set of proposals meet the same fate. Nothing has been finalised; comments are open until February 13.
After all, the Trump family has built close ties to an increasing number of SWF principals, at least one of whom has ploughed billions into his family’s stablecoin. Handing his new friends and business partners a new tax they’ll have to cough up if they want to be anything but passive private market investors seems distinctly unTrumpian.
Hold on, what are we saying? This sounds entirely in keeping with the Administration.
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