The Internal Revenue Service (IRS) has set forth new regulatory proposals that aim to broaden the scope of taxable activities for foreign government investment entities operating within the United States. This includes sovereign wealth funds (SWFs) and some public pension funds, which traditionally benefit from tax exemptions on investment-related income under U.S. tax law.
At present, Section 892 of the U.S. Internal Revenue Code provides that foreign governments and entities controlled by them are generally exempt from U.S. federal income tax on their investment returns. This exemption applies to activities the IRS classifies as investment in nature. However, the IRS differentiates these from commercial activities, which remain taxable.
According to recent proposals, the IRS intends to expand its definition of what constitutes a commercial activity. This change would have specific implications for sovereign wealth funds that participate more actively in their investments—such as lending to companies or acquiring direct equity stakes in private firms, which historically may have been viewed as passive investment activities.
One key aspect of the proposed rule is the IRS’s stance on debt restructuring. The agency suggests that when a sovereign wealth fund engages in a company's debt restructuring process, it transforms this investor activity into a commercial one. This would apply even in cases where the sovereign wealth fund had acquired the bonds years prior, anticipating minimal risk of default.
The considerations surrounding these proposed tax changes are currently open for public comment, with a deadline set for February 13. Stakeholders within sovereign wealth funds, public pension funds, and affiliated parties are expected to analyze and respond to these proposals during the comment period.
Understanding the significance of sovereign wealth funds is essential in contextualizing these proposals. These state-owned investment entities typically amass their capital through sources such as commodity export revenues, foreign currency reserves, or governmental budget surpluses. Their investment portfolios are diversified, often covering assets including public equities, real estate ventures, infrastructure projects, and private credit markets.
As of 2025 data, sovereign wealth funds globally held approximately $550 billion in private credit investments. In the United States specifically, their direct holdings in private equity have seen substantial growth, tripling in size to reach $73 billion. Much of this investment has been structured through co-investment arrangements, reflecting a strategic approach to expanding their presence in the U.S. market.
These evolving tax regulations could present considerable shifts for sovereign wealth funds that have expanded their investment strategies beyond passive holdings. Should the IRS finalize these broadened definitions, the tax obligations for SWFs and similar public pension funds may increase, affecting their investment calculus and operational frameworks within the U.S.
Market observers and investment managers will be closely monitoring the development of these proposals, given their potential to influence capital flows and the management of sovereign wealth assets domestically. The comment period closes in February, after which the IRS may revise and implement these regulations.