Rev. Rul. 87-6

1987-1 C.B. 179, 1987-3 I.R.B. 5.

FOREIGN GOVERNMENTS AND CONTROLLED ENTITIES; EXEMPTION FROM INCOME TAX ON

CERTAIN U.S. INVESTMENTS

Published: January 20, 1987

Section 892.-Income of Foreign Governments and of International Organizations, 26 CFR 1.892-1: Income of foreign governments

  Foreign governments and controlled entities; exemption from income tax on certain U.S. investments. Three situations illustrate the taxation on U.S. source investment income of foreign governments and controlled entities.

ISSUE

  Whether income received by a controlled entity or an integral part of a foreign government on certain United States investments is exempt from taxation under section 892 of the Internal Revenue Code of 1986.

FACTS

  SITUATION 1: FX, a foreign corporation, is a 'controlled entity' of a foreign sovereign FC, within the meaning of section 1.892- 1(b)(3) of the Income Tax Regulations. FX does not engage in commercial activity anywhere in the world. FX makes investments in the United States in various publicly traded stocks, bonds, and other securities and interest-bearing bank deposits with regard to which FX receives dividend and interest income. One of FX's investments is 75 percent of the stock of Z, a United States corporation that operates a railroad located in the United States.

  SITUATION 2: Same facts as in SITUATION 1, except that FX is an airline engaged in commercial activity outside the United States. It does not fly to or from the United States and is not otherwise engaged in the conduct of a trade or business in the United States.

  SITUATION 3: Y is the Ministry of Tourism of foreign country, FC. Y is an  'integral part' of a foreign sovereign within the meaning of section 1.892- 1(b)(2) of the regulations. Y promotes tourism to FC on a worldwide basis through television, newspaper, and magazine advertising. Y maintains an office in FC's capital city which, in addition to providing tourist literature about FC, engages in commercial activity through sales of tee-shirts and various other items with slogans imprinted on them promoting FC. Y has investments, unrelated to its commercial activity in FC's capital city, in stocks and securities of certain United States corporations with regard to which Y receives dividend and interest income. One of Y's investments is 75 percent of the stock of Z, a United States corporation engaged in manufacturing.

LAW AND ANALYSIS

  Section 892(a)(1) of the Code provides, in general, that income of a foreign government received from investments in the United States in (i) stocks, bonds, or other domestic securities owned by such foreign government, or (ii) financial instruments held in the execution of governmental financial or monetary policy, and interest on deposits in banks in the United States of moneys belonging to such foreign government, shall not be included in gross income and shall be exempt from United States taxation.

  For purposes of section 892 of the Code, a foreign government consists only of integral parts or controlled entities of a foreign sovereign.

  Section 1.892-1(b)(2) of the Income Tax Regulations provides that 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. The net earnings of the governing authority must be credited to its own account or to other accounts of the foreign sovereign, with no portion inuring to the benefit of any private person. It does not include any individual who is a sovereign, official, or administrator acting in a private capacity.

  Section 1.892-1(b)(3) of the regulations provides that a controlled entity is an entity which is separate in form from a foreign sovereign or otherwise constitutes a separate juridical entity that satisfies the following requirements:

  (i) It is wholly owned and controlled by a foreign sovereign directly or indirectly through one or more controlled entities;

  (ii) It is organized under the laws of the foreign sovereign by which owned;

  (iii) Its net earnings are credited to its own account or to other accounts of the foreign sovereign, with no portion of its income inuring to the benefit of any private person; and

  (iv) Its assets vest in the foreign sovereign upon dissolution.

  Section 892(a)(2)(A) of the Code provides that income derived from the conduct of any commercial activity (whether within or outside the United States), or received from or by a 'controlled commercial entity' shall not be exempt from United States taxation under section 892. Section 892(a)(2)(B) of the Code provides that the term controlled commercial entity means any entity engaged in commercial activities (whether within or outside the United States) if the government: (i) holds (directly or indirectly) any interest in such entity which (by value or voting interest) is 50 percent or more of the total of such interests in such entity, or (ii) holds (directly or indirectly) any other interest in such entity which provides the foreign government with effective control of such entity.

  In SITUATION 1, FX is a controlled entity of a foreign government and is not engaged in commercial activity. FX, therefore, is not itself a controlled commercial entity as defined in section 892(a)(2)(B) of the Code. FX's investment income described in SITUATION l, with the exception of income from Z, is exempt from United States tax under section 892(a)(1). Income received from Z is not exempt from tax under section 892, since Z is a controlled commercial entity within the meaning of section 892(a)(2)(B). See section 892(a)(2)(A)(ii).

  In SITUATION 2, since FX is a controlled entity of a foreign government and is engaged in commercial activity, it is a controlled commercial entity within the meaning of section 892(a)(2)(B) of the Code. None of its income received from United States investments is exempt from United States tax under section 892. See section 892(a)(2)(A)(ii).

  In SITUATION 3, Y is an integral part, and not a controlled entity, of a foreign sovereign. Y, therefore, is not a controlled commercial entity within the meaning of section 892(a)(2)(B) of the Code. Y's income described in SITUATION 3 is therefore ineligible for exemption under section 892 only to the extent that it is derived from the conduct of any commercial activity or received from a controlled commercial entity. Y's dividend income from Z is received from a controlled commercial entity and is, therefore, not exempt under section 892. See section 892(a)(2)(A). Y's other income, all of which is described in section 892(a)(1), and none of which is derived in the conduct of a commercial activity by Y, is exempt from U.S. tax under section 892.

HOLDINGS

  In SITUATION 1, FX's investment income, other than from Z, a controlled commercial entity, is exempt from United States tax under section 892 of the Code.

  In SITUATION 2, none of FX's investment income is exempt from United States tax under section 892 of the Code.

  In SITUATION 3, Y's dividend and interest income, with the exception of income from its investment in Z, is exempt from United States tax under section 892 of the Code.