The Unjustified Subsidy: Sovereign Wealth Funds and the Foreign Sovereign Tax Exemption
Bird-Pollan, Jennifer, Fordham Journal of Corporate & Financial Law
The taxation of Sovereign Wealth Funds in the United States is outmoded and due for reconsideration. Offering a tax exemption to the billion dollar investment funds owned by foreign governments is both unfair and ineffective. Founded in the principles of sovereign immunity, the foreign sovereign tax exemption, codified in I.R.C. § 892, fails to satisfy the Congressional goals that motivated its creation. This Article explains the current taxation of foreign sovereigns and, by extension, Sovereign Wealth Funds. It then illustrates that the current exemption is simultaneously too broad, providing a tax exemption for activities that are clearly non-governmental activities, and therefore outside of the realm of sovereign immunity, and too narrow, failing to provide a tax exemption for activities that clearly are governmental activities. Finally, this Article explains that any exemption provided to foreign sovereigns should be offered only as a treaty matter, reserving the privilege as a negotiation tool, and thereby ensuring that the United States receives similar benefits.
Investment in the United States by Sovereign Wealth Funds ("SWFs") has grown significantly in recent years.1 Several high profile deals have brought this activity into the headlines and have started conversations about just what SWFs should or should not be permitted to do.2 However, despite this evolving attitude toward investment in the United States by foreign governments and the growing presence of SWFs in the U.S. economy, the taxation of SWFs and the related policy rationales are sorely outdated. Section 892 of the Internal Revenue Code (the section that provides a tax exemption to foreign governments, and, by extension, to SWFs) has remained substantially unchanged since it was written in 1917.3 Now is the time to re-examine the U.S. tax treatment of foreign governments and SWFs to ensure that our tax law reflects and encourages the general U.S. policy towards investment by foreign governments and SWFs in particular.4
In this Article, I demonstrate that the current statutory structure offers SWFs a tax exemption that is both unfair (because it allows foreign governments to earn investment income in the United States without paying tax on that income while not offering a similar exemption to other similarly situated taxpayers) and incomplete (because currently the statute does not provide a complete exemption for income connected with the sovereign activities of foreign governments, which is the rationale for providing the exemption in the first place). I will reevaluate historical justifications for offering a tax exemption to foreign governments to show that those justifications are not served by the current form of the exemption. I begin by carefully outlining the current tax treatment of SWFs. I then demonstrate why this statutory framework fails to promote good U.S. tax policy. Finally, I identify an alternative statutory model that more adequately satisfies U.S. tax and foreign policy goals.
Good tax policy might justify offering foreign governments a lower rate of tax than foreign private investors.5 What I point to in this Article, however, is that preferential rates for foreign governments and their investing SWFs should be offered, if at all, only after careful consideration by Congress, or by tax treaty negotiators. The current model is an historical accident and both over-taxes and under-taxes foreign governments earning income in the United States.
Based on the justification of sovereign immunity, the model adopted by the U.S. tax Code offers a tax exemption to foreign governments who earn income in their governmental capacity, but taxes income earned from any so-called "commercial activity."6 However, despite the intention of taxing foreign governments in this way, the actual language of the Code exempts income earned from certain activities that ought to be treated as commercial,7 while simultaneously taxing income earned by a foreign government engaging in activities that are central to its sovereign role. …