US tax implications for sovereign wealth funds of financial derivative investments

www.pwc.com/us/assetmanagement
US tax implications for
sovereign wealth funds
of financial derivative
investments
Philip Sutton
John Mattos
Rebecca Lee
Robert Saltzman
December 2010
Traditionally, sovereign
wealth funds (“SWFs”)
have made investments
directly in US stocks,
bonds, private equity
funds, or real estate.
Today, the activities of
SWFs have expanded in
a number of ways.
SWFs have begun hedging the foreign
currency and interest rate exposures on
their investments with financial
derivatives. Further, SWFs have also
begun to utilize financial derivatives to
achieve the fundamental economic
exposure that their fund managers may
be seeking. SWFs are key investors in
many onshore and offshore fund
complexes. Fund managers for these fund
complexes also have expanded their
investment parameters in similar ways to
achieve the returns they are seeking.
Why is this significant? Because the US
tax treatment of these financial
derivatives is not entirely clear for SWFs.
The current rules that exempt SWFs from
taxation in the United States are outdated
and do not reflect these modern financial
realities. Based on these outdated rules, it
is not clear whether SWFs are eligible to
claim an exemption from US taxation on
income from investments in derivatives
and other financial transactions. In
situations in which the SWF invests in a
fund that is treated as a partnership for
US tax purposes, the SWF is treated as
deriving its allocable share of the
partnership’s activities and income.
Therefore, SWFs, and the fund managers
of the funds in which they invest, must be
sensitive to the investment choices that
can limit the nature of their investments.
It is important that fund managers
appreciate the concerns that SWFs can
face when taking positions with respect to
foreign currency.
December 2010
The term “derivative” can mean different
things to different investors. For purposes
of this discussion, we use the term
“derivative” broadly, to mean forward,
futures, option and swap contracts, each
of which is a bilateral executory contract
which “derives” its value from an
underlying asset, index, interest rate or
currency. Short sales (the borrowing of
stock or other property to sell to establish
a “short” position in the underlying
property) raise slightly different tax issues
and are discussed separately herein.
When the differences between these
transactions are relevant from a US tax
perspective, each is separately addressed.
A SWF investing (directly or indirectly) in
derivatives has two primary concerns:
(1) whether the income qualifies for
exclusion from tax in the US (the “Section
892 Exemption”) where the SWF invests
directly and earns US source income; and
(2) whether the income, deduction, gain
or loss from derivatives arise from a
“commercial activity” which could cause
all of the income earned by an entity
controlled by the SWF to be treated as not
eligible for the Section 892 Exemption
and therefore possibly taxable in the US.
US tax implications for sovereign wealth funds of financial derivative investments
1
Background
In general, foreign governments are not
subject to US tax on US source investment
income earned directly by the foreign
government or earned by a SWF or a
SWF-controlled entity that does not
engage in commercial activities. Outdated
Treasury regulations attempt to draw
lines between commercial and
“investment-type” activities, but these
regulations do not address derivatives
and other modern transactions,
except indirectly in the context of the
execution of governmental financial or
monetary policy.
To the extent a SWF receives income that
is not eligible for the Section 892
Exemption, the SWF is subject to US tax
in the same manner as a foreign
corporation, unless an exemption under
an income tax treaty applies. A foreign
person (i.e., a non-resident alien or
foreign corporation) is taxable in the US
only on (i) US source income and limited
sources of foreign source income
“effectively connected with a US trade or
business” and (ii) other US source income
that is fixed or determinable annual or
periodic (“FDAP”) income. Therefore,
income of a SWF that is not exempt under
section 892 is subject to US income tax in
the same manner, and to the same extent,
as that income would be if it had been
earned by a foreign corporation.
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US tax implications for sovereign wealth funds of financial derivative investments
Exempt income
In general, income that a SWF receives
from the following investments in the
United States is exempt from US tax:
1. Stocks, bonds, or other
domestic securities;
2. Financial instruments held in the
execution of governmental financial or
monetary policy; and
3. Interest on deposits in banks in the
United States of moneys belonging to
such foreign governments.
Note that the term “other domestic
securities” does not include partnership
interests (with the exception of publiclytraded partnerships), trust interests or
certain commodity derivatives.
December 2010
Commercial activities
The Section 892 Exemption specifically
does not apply to income earned by a
foreign government or its integral parts
that is 1) derived from conducting any
commercial activity (whether within or
without the United States), 2) received
by or from (directly or indirectly) a
controlled commercial entity (“CCE”) or
3) derived from the disposition of any
interest in a CCE. A “CCE” means “any
entity engaged in commercial activities
(whether within or without the United
States) if the 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 practical
control of the entity.”
If the SWF is an “integral part” of the
foreign government and directly invests in
a commercial activity, only the income
earned from such disqualified commercial
activities will lose its Section 892
Exemption. Income from commercial
activities anywhere in the world (no
matter how trivial) earned by a controlled
entity (including a SWF that is not an
“integral part” of the foreign government)
causes the SWF or other controlled entity
to be treated as a CCE, causing all of the
income of the CCE to be tainted and
ineligible for the Section 892 Exemption.
This definition does not include passive
investment in specified assets including
stocks, bonds and securities; loans;
investments in financial instruments held
in the execution of governmental
financial and monetary policy and the
holding of net leases on real property or
land which is not producing income.
Transferring securities pursuant to a
securities lending arrangement (discussed
in more detail below) is specifically
described as an investment activity. The
term “commercial activities” does not
include certain trading activities,
including effecting transactions in stock,
securities, or commodities for a foreign
government’s own account regardless of
whether such activities constitute a trade
or business under section 162 or a US
trade or business for purposes of section
864. An activity may be considered a
commercial activity, however, even if such
activity does not constitute the conduct of
a trade or business in the United States
under the section 864(b) safe harbors
applicable to other foreign taxpayers.
It should be noted that once a controlled
entity is “tainted,” the entity generally is
deprived of its Section 892 Exemption
only on its US source income. The foreign
source income earned by the tainted
controlled entity would generally not be
subject to US tax regardless of the
applicability of section 892 (except for
certain kinds of foreign source income
treated as “effectively connected income”
under section 864(c)(4)).
The term “commercial activities” includes
all activities ordinarily conducted “with a
view towards the current or future
production of income or gain.”
December 2010
US tax implications for sovereign wealth funds of financial derivative investments
3
Key points to consider
There are a number of key points for a
SWF to consider before entering into
derivatives, including:
(1) Sourcing of income and gain
on derivatives
(B) Swaps entered into by US resident
partnerships. Under existing regulations,
payments received by a US partnership
(which is treated as a US “qualified
business unit” under the applicable
sourcing regulations) are treated as US
source payments. SWFs investing in
swaps through US partnerships may
receive US source periodic payments on
such swaps. In many cases, a SWF may
not be fully aware of the nature of the
investments entered into by funds in
which it invests.
When the SWF invests in derivatives
directly (or through a controlled entity
without the specter of “commercial
activity” (described below)), only income
that is US source results in US taxation.
Generally, the gain on derivatives that are
treated as dispositions of property, such
as forward contracts (binding bilateral
contracts for the sale of property with
future delivery), futures contracts
(exchange-traded forwards) and option
contracts (bilateral contracts providing
the right, but not the obligation, to
purchase property at a fixed price), are
sourced by reference to the residence of
the seller.
Swaps (a.k.a. “notional principal
contracts”) are generally sourced by
reference to the residence of the recipient
of the payment. Two critical exceptions to
note:
(A) Swaps over US equities. Under the
new FATCA legislation, the gross amount
of periodic payments received with
respect to certain swaps over US equities
are treated as US source payments. These
provisions also affect the source of certain
payments on sale-repurchase (“repo”)
transactions and “in lieu of” dividend
payments received from lending securities
(an activity otherwise protected under
section 892).
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US tax implications for sovereign wealth funds of financial derivative investments
There are separate rules regarding the
sourcing of foreign currency gains and
losses from derivatives. These rules are
generally consistent with the rules
discussed above for forwards, futures,
options and swaps. One notable
exception: the foreign currency rules
contain an explicit exception that in the
case of a foreign partner of a US
partnership that is not engaged in a US
trade or business, income from foreign
currency derivatives is sourced by
reference to the residence of the foreign
partner (i.e., as foreign source income).
December 2010
(2) CCEs and derivatives – commercial
activity risk
The stakes for a SWF investing in
derivatives are different where the SWF
enters into derivative through a
controlled entity, rather than directly.
Instead of risking US tax on US source
income, the SWF risks that all of the
income of the controlled entity would be
“tainted” and not eligible for exclusion
from tax under the Section 892
Exemption.
The Section 892 Exemption has a
definition of “commercial activity” that
may be viewed as at odds with the
colloquial meaning of of “commercial
activity.” The regulations have specific
definitions of “investment activities,” and
state that all other activities engaged in
for profit and not explicitly excluded
represent “commercial activities.”
Investments in financial assets directly
(stocks, bonds, etc.) clearly represent
investment activities.
Financial instruments used in the
execution of governmental financial or
monetary policy
The treatment of investments in
derivatives is less clear. The regulations
clearly contemplate that investments in
financial instruments held in execution of
governmental or monetary policy do not
represent “commercial activities.” The
boundaries of what constitutes the
furtherance of governmental financial or
monetary policy are not clear. For
example, the derivatives (financial
instruments) activities of a central bank
that are essential to a country’s monetary
reserve policy are clearly in execution of
monetary policy. Where an SWF is an
entity or owns an interest in an entity
whose purpose or authority extends
beyond a principal purpose of
effectuating its government’s financial or
monetary policy, for example, investing a
government’s excess foreign currency
reserves accumulated as a result of high
global commodity prices, it may be more
difficult to conclude that such activities
are not commercial activities. Factors
relevant for this determination may
include whether the transactions are
“hedging” or managing governmental
risk, whether the stated purpose of the
activities is to earn a yield or merely
provide systematic stability and the
amount of discretion granted to nongovernmental investment managers to
determine the objectives and methods of
investment. It may be more difficult to
satisfy this standard in situations in which
the SWF is directed in a fund complex
employing its own fund managers.
December 2010
Other financial instruments
(aka derivatives)
Assuming that the investments by an
entity are not in furtherance of
governmental financial or monetary
policy, these transactions may still not rise
to the level of commercial activities.
Under prior guidance, an activity
represented a “commercial activity” only
if it were treated as such for other
purposes of the Internal Revenue Code.
Under this prior standard, a wide variety
of investment and derivatives trading
activities may not be viewed as
“commercial activities.” These
regulations, changed in 1988 as a result
of legislative changes under the Tax
Reform Act of 1986, now provide that an
activity may be considered a “commercial
activity” regardless of whether it is
treated as a trade or business activity for
other purposes, including the section 864
rules regarding US trade or business
activities. This change, coupled with the
express regulatory language that
addresses investments in “financial
instruments” in the course of
governmental financial or monetary
policy, suggests that the IRS and Treasury
could have explicitly exempted
investment in derivatives from
“commercial activity,” but chose not to.
Having said that, the legislative history
behind the 1986 legislation indicates that
Congress intended that “the principles
distinguishing income taxed on a net basis
and income taxed on a gross basis for
private foreign persons apply to foreign
governments also.”
US tax implications for sovereign wealth funds of financial derivative investments
5
The regulations outlining the definition of
“commercial activities” rely heavily (but,
as discussed above, not completely) on
the section 864(b) standards for
determining whether a foreign person is
engaged in a US trade or business. For
example, so long as trading in physical
securities satisfies the section 864(b) safe
harbor for trading activities, these
activities do not rise to the level of
commercial activities for purposes of the
Section 892 Exemption.
The inconsistency between the regulatory
language under section 892 and the
policy goals of the Section 892 Exemption
causes unnecessary confusion for SWFs.
On one hand, the current broad definition
of “commercial activities” under the
current regulations coupled with the lack
of a specific carve-out for derivative
activities as well as the absence of a
definition for what activities constitute
the execution of governmental financial
or monetary policy suggests that any
derivatives transaction may represent a
“commercial activity.” On the other hand,
the policy behind the “commercial
activity” rules is to prevent SWFs from
deriving a benefit from a US tax
perspective by not being taxed on income
from other active trades or businesses.
Typically, entering into derivatives – in
the capacity of a true investor – does not
rise to the level of a trade or business. The
activities are often identical to a direct
investment in stocks, bonds or currencies
– investments that would generally
produce income eligible for the Section
892 Exemption. Further, the section
864(b) safe harbors for trading activity
were extended to explicitly cover trading
activities in derivatives. Although these
derivatives trading regulations may be
helpful by analogy to the Section 892
Exemption, the fact that the IRS and
Treasury Department believed regulations
were necessary might suggest that
derivatives activities must be separately
evaluated for “commercial activity” status.
6
(3) Special considerations for foreign
currency transactions
Hedging transactions – derivatives used
to manage risk with respect to an
investment portfolio (market risk, interest
rate risk or foreign currency risk) – might
not even be entered into “with a view
towards the current or future production
of income or gain.” These transactions
may be entered into with a view to
mitigate risk, rather than strictly to
produce income or gain. Based on
this intent test, these transactions
arguably may not rise to the level of
commercial activity.
All of this uncertainty has been the
subject of much debate by commentators
and the IRS. In light of this uncertainty,
SWFs need practical solutions that make
sense from an investment management
perspective, in order to allow the SWF to
protect itself from characterization of
these transactions as commercial
activities. A simple approach for those
SWFs that are not themselves controlled
entities of a foreign government is to
isolate the derivatives activity (and any
assets that it hedges) in a separate
controlled entity. This approach limits the
potential “taint” (if any) of the income
from these entities as potentially
ineligible for the Section 892 Exemption
to only those assets in the particular
corporate entity. Because the “tainting”
risk affects all of the assets of the
particular entity, narrowly tailoring the
assets in a particular controlled entity, or
investing via an “integral part” of the
SWF, may limit this risk. Note that
business purpose and economic substance
are fundamental considerations when
evaluating all transactions, including the
formation of a corporation.
SWFs that are controlled entities of a
foreign government should consider
investing in derivatives in a subsidiary
controlled entity; because commercial
activities of a subsidiary controlled entity
are not attributed to it parent, should the
investments in derivatives be viewed as
commercial activity, such activity would
not taint the parent controlled entity.
US tax implications for sovereign wealth funds of financial derivative investments
A foreign currency investment may
involve the actual sale or purchase of
foreign currency, the purchase of foreign
currency denominated debt instruments
or the sale and purchase of a derivative
based on changes in value of foreign
currency. The discussion above is equally
applicable to foreign currency derivatives.
One subtlety to note: The definition of
“financial instrument” (for purposes of
the governmental and monetary policy
rule) includes an investment in physical
non-functional currency. In addition to
the discussion above, SWF should
carefully consider transactions directly in
non-functional currency in light of this
fairly over-inclusive rule.
These transactions warrant special note
because investment managers may not
view foreign currency derivative
investments as representing a separate
investment strategy. For example, a SWF
that invests in funds that conduct
business in currencies other than the
SWF’s functional currency may hedge the
foreign currency risk associated with the
fund investment through a foreign
currency derivative. The SWF’s
investment manager might view the
foreign currency derivative as merely
preserving the value of a permissible
investment. As discussed above, so-called
“hedging” transactions certainly present a
more sympathetic case for the application
of the Section 892 Exemption than an
active foreign currency trading operation.
In either case, however, carefully
consideration is necessary to determine
whether the Section 892 Exemption ought
to be available for these transactions.
December 2010
(4) Special considerations for
short sales
A short sale is a distinct transaction with
different tax consequences than true
“derivatives” transactions. In a short sale
transaction, the investor borrows a
security (for example, shares of stock)
subject to an obligation to return an
identical security, and sells the security
into the market. The short seller “closes”
the short sale by returning the
substantially identical security to the
same party lending the securities (the
“securities lender”). By entering into a
short sale, the investor profits when the
shorted security declines in value. Short
sales could be used either as a hedge of a
particular asset or as part of a speculative
investment strategy.
A short sale involves the physical
purchase and sale of securities (rather
than a mere bilateral contract between
two parties). The short seller’s gain or loss
is determined in the same manner as
disposition of an asset – a comparison
between the seller’s adjusted basis in the
asset returned to the securities lender
compared to the amount realized on the
sale of the security into the market. (The
securities lender is protected from
realizing gain or loss on these
transactions under a specific Code
provision. A security lender’s gain or loss
from lending its securities is explicitly
included in the definition of “investment
income” for purposes of the Section
892 Exemption, and thus explicitly
excluded from the definition of
“commercial activity.”)
Although a short sale derives its value
from the shorted security, the form of a
short sale is the sale and purchase of
stock, rather than borrowing and selling
of shares. Thus, all of the income,
deduction, gain and loss resulting from a
short sale arises from the sale of
securities, rather than a derivative. There
is a very good argument that a short sale
falls squarely within the definition of an
investment activity for a SWF entering
into it directly, and outside of the
definition of a “commercial activity” for
an entity owned by a foreign government
or SWF. Consideration should be given to
whether a short sale could provide the
same economic exposure as certain other
short derivative positions entered into by
SWFs or its affiliates to avoid some of the
tainting issues outlined above. For
example, as part of an SWF’s investment
strategy, their investment advisor wants
short exposure to XYZ Corporation stock.
The SWF could enter into a derivative
(like a short total return swap or short
forward contract) in which the SWF
would profit if XYZ Corporation stock
declines in value. The SWF could achieve
the same economic exposure by entering
into a short sale (i.e., borrowing and
selling XYZ Corporation stock with an
obligation to return identical XYZ
Corporation stock). Each transaction (the
short total return swap, the short forward
and the short sale) may have different
commercial implications (for example,
required collateral amounts and rights in
bankruptcy). The difference in their tax
treatment, however, is a factor that a SWF
should consider in making investment
decisions.
December 2010
(5) Indirect Investments – traps for
the unwary
As highlighted above, a SWF that invests
in funds that are treated as partnerships
for US federal income tax purposes must
also be aware of the nature of the
partnership’s investments, because a SWF
is treated as if it owns those investments
directly. For example, a fund that the SWF
invests in might have exposures to
multiple foreign currencies. A lower-tier
fund might use foreign currency
derivatives to manage the foreign
currency risk on its investments back to
the fund’s functional currency. Although
the specific investments of the lower-tier
fund may not be transparent to the SWF,
the tax reporting from the fund (i.e., the
form K-1 received by the SWF or its
affiliate) will reflect whether any “section
988 gain or loss” (i.e., foreign currency
gains and losses) are allocable to the
SWF. Because the SWF is attributed its
proportionate share of all of the fund’s
underlying investments, the SWF needs to
understand whether partnerships in
which it invests enter into the derivatives
discussed above. This highlights that
investing through partnerships, although
perceived as efficient from a US tax
perspective, could pose additional
risks for a SWF investing directly into
the partnership.
US tax implications for sovereign wealth funds of financial derivative investments
7
Contacts
For more information, please contact:
Philip Sutton
Partner
[email protected]
John Mattos
Partner
[email protected]
Rebecca Lee
Principal
[email protected]
Robert Saltzman
Manager
[email protected]
www.pwc.com/us/assetmanagement
This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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