IRS proposal redraws tax lines for sovereign investors
The IRS has proposed changes that would narrow a long-standing tax exemption for foreign sovereign investors.
The proposal targets §892 of the Internal Revenue Code, which shields sovereign wealth funds and certain public pension funds from US tax on investment income.
The IRS would expand the definition of taxable commercial activity. The change matters now because sovereign funds are large providers of private capital in US markets.
The Law in Play
§892 exempts foreign governments and their controlled entities from US tax on passive investment income. The exemption does not apply to income from commercial activities.
The core legal question is where investment ends and commercial activity begins.
The IRS argues that modern sovereign investing often looks operational rather than passive. Sovereign investors argue that active oversight is standard risk management, not commercial business.
Timeline
December 2025: The IRS released proposed regulations that revise the §892 definitions.
December 2025 to January 2026: Market participants and advisors began assessing exposure.
February 13, 2026: Public comment period closes.
Present: Rules are proposed only—no final regulations issued.
The Larger Story
Sovereign wealth funds have moved steadily into private equity and private credit. Those strategies rely on direct lending, co-investments, and negotiated investor rights. The tax code they depend on was written for a more passive era of sovereign investing.
The proposal reflects a broader US policy shift under President Donald Trump toward taxing and reshaping inbound capital. Tariffs, industrial policy, and tax rules are all being used to influence where and how foreign capital participates in the US economy.
What It Means in Practice
Direct lending by sovereign funds may be treated as taxable commercial activity.
Active involvement in restructurings could trigger US tax even on legacy investments.
Minority stakes in private companies may no longer be safe if paired with standard investor rights.
Blocker structures used in co-investments could lose effectiveness if deemed to exercise control.
Some funds may shift toward fund-level investing rather than direct deals.
Next Steps
The IRS will review public comments after February 13. Any final regulations would likely include transition guidance, but the proposal suggests potential retroactive effects. Sovereign investors and their advisors are assessing portfolio structures and considering whether to submit formal comments.
One More Thing
The proposal does not eliminate §892, but it redraws its boundaries in favor of passive capital over hands-on sovereign investing.