Proposed regulations issued under Internal Revenue Code section 892, on November 2, 2011, address some of the most criticized rules under temporary regulations issued more than 20 years ago. Under the controlled commercial entity (CCE) regulations, engaging in even a de minimis amount of commercial activity can result in characterization of non-integral controlled entities as CCEs (the so-called “all or nothing” rule). As described in more detail below, the proposed regulations would liberalize this rule by not classifying an entity as a CCE if its commercial activity is determined to be “inadvertent.” If certain other conditions are met, a new safe harbor rule excludes commercial activities as long as 5% or less of the controlled entity’s assets and income are from commercial activities, but corrective action is required to eliminate the commercial activity once discovered. Another significant change eliminates the partnership attribution rules in the context of limited partnerships, thereby allowing foreign governments and sovereign wealth funds (SWFs) to invest in limited partnerships as a limited partner without being classified as CCEs regardless of whether or not the partnership engages in commercial activities.

Although the proposed regulations provide much advocated change to the temporary regulations concerning the scope of activities that constitute commercial activities, the proposed regulations do not alter the scope of the section 892 tax exemption. Thus, although a controlled entity may not be characterized as a CCE under the more lenient proposed CCE regulations, it remains taxable on all income from commercial activities, including the deemed disposition of a direct interest in U.S. real property. In the limited partnership context, this may result in foreign governments being taxable on their distributive shares of income from commercial activities or the dispositions of U.S. real property, while retaining their section 892 exemption on all other eligible income.

The key points of the proposed regulations are as follows...