Ending tax breaks for massive sovereign wealth funds? Practical observations about the Wyden bill

On July 26, 2023, Senate Finance Chairman Ron Wyden introduced a bill, the Ending Tax Breaks for Massive Sovereign Wealth Funds Act. As its title suggests, the Bill would deny the benefits of Section 892 of the Internal Revenue Code of 1986, as amended, to certain foreign governments with large sovereign wealth funds, many of which are active investors in United States private markets.

Background

Section 892 generally exempts foreign governments (and their sovereign wealth funds and other affiliates) from United States federal income tax on certain types of income, including certain income from stocks, bonds, and other securities. Based on the principle of sovereign immunity, Section 892 serves to encourage significant investment in the United States and is frequently relied on by foreign governments, in particular those that do not have an income tax treaty with the United States.

Bill summary

If passed, the Bill would remove the exemption provided by Section 892 for (i) any foreign government that directly or indirectly holds more than USD$100 billion of assets for investment or the production of income, and (ii) either (A) does not have an income tax treaty or free trade agreement in effect with the United States or (B) is North Korea, China, Russia, or Iran. Under the Bill, no later than December 31, 2024, the Treasury shall publish a list of such foreign governments that would no longer be entitled to the exemption provided by Section 892. The Bill would generally apply beginning in 2024 but contains certain provisions that would delay its full application until 2026.

Practical observations

Sovereign wealth funds have become a critically important source of direct investment into the United States economy. Foreign governments without free trade agreements or income tax treaties in effect with the United States include, among others, the governments of countries with some of the largest sovereign wealth funds, most notably Saudi Arabia, the United Arab Emirates, Kuwait, and Qatar. Sovereign wealth funds from these countries have trillions of dollars in assets and have invested substantial capital in a multitude of businesses located in the United States in reliance on the exemption provided by Section 892.

If the Section 892 exemption is eliminated for these sovereign wealth funds, they will need to contend with United States federal income taxes on many investments that could previously be structured in a tax-efficient manner. As a result, the Bill will make it more challenging for private fund sponsors focused on United States investments to raise capital from a category of investors that previously made significant fund commitments and, in many cases, anchored such funds. The Bill could also encourage accelerated exits of existing investments prior to its full application in 2026.

Given that sovereign wealth funds are some of the largest investors in real estate located in the United States, the Bill may have a particularly negative effect on United States real estate markets. Sovereign wealth funds have utilized various exemptions to invest in real estate located in the United States in a tax-efficient manner, including Section 892 and, when Section 892 is unavailable for a particular investment, the exemption provided for sales of domestically controlled REITs. Less than a year ago, the Treasury Department and the IRS issued proposed regulations targeting some of the domestically controlled REIT structures commonly used by sovereign wealth funds (for more information, see our prior alert.). By removing the benefits of Section 892, the Bill would remove one of the last strategies available to the sovereign wealth funds covered by the Bill to invest in equity positions in United States real estate without becoming fully subject to United States federal income tax.

Though perhaps small consolation, the Bill affects only Section 892 and thus does not remove all tax exemptions available to the covered sovereign wealth funds. For example, the portfolio interest exemption for debt investments is unaffected by the Bill and will continue to present these sovereign wealth funds with numerous opportunities to invest in United States debt markets.

Conclusion

If enacted, the Bill would effect a landmark change in available tax strategies for many of the world’s largest sovereign wealth funds. It could encourage these sovereign wealth funds to make debt investments instead of equity investments in the United States. The Bill could also encourage sovereign wealth funds to invest in countries other than the United States that continue to provide benefits analogous to Section 892 under their local tax laws, negatively affecting the domestic marketplace for capital.

It remains to be seen how serious Congress is about enacting this or a similar Bill. Other countries have flirted with the idea of curtailing tax exemptions available to foreign governments (for more information, see our prior alert on a similar proposal in the United Kingdom) but these proposals were ultimately dropped. We will continue to monitor the developments of this important Bill. To learn more, please contact any of the authors listed above.