Section 892 of the United States Internal Revenue Code is a powerful and essential tax exemption for Canadian public pension plans and sovereign wealth entities investing in the U.S.
This section provides a critical exemption from U.S. income tax on income earned by foreign governments and their controlled entities in the country provided they meet certain criteria—but recent regulatory updates mean this exemption must be actively safeguarded.
The proposed and final regulations sharpen section 892’s focus on commercial activity, control and governance, which requires greater discipline in structuring and oversight.
With careful planning and continuous monitoring, Canadian pension plans and sovereign wealth entities that meet the key regulatory criteria can continue to benefit from section 892 while managing the heightened compliance expectations introduced by the revised regulatory framework.
Why this matters for Canadian entities
Section 892’s tax exemption for certain categories of passive investment income influences how Canadian pension plans and sovereign wealth entities structure and manage their U.S. investments. It can significantly reduce or eliminate U.S. tax on portfolio income, including interest, dividends and capital gains from U.S. securities.
In many cases, section 892 offers broader and more reliable relief than that under the Canada-United States Tax Treaty as it does not depend on a beneficial ownership analysis or limitation on benefits provisions.
If section 892 is unavailable for all or part of an investment structure, Canadian pension plans may become subject to U.S. taxation on income that would otherwise be treated as passive. Since most Canadian pension plans are exempt from federal income tax, foreign taxes paid are often not recoverable as a foreign tax credit, which results in a permanent reduction in after tax returns.
Section 892 also affects Canadian sovereign wealth entities like Crown corporations and government-owned investment vehicles. These entities are generally structured as controlled entities of a foreign government under the U.S. regulations and, as such, are eligible for the section 892 exemption on certain U.S. source investment income.
They are subject to the same compliance requirements and face the same risks as pension plans such as the loss of exemption if the entity is found to be engaged in commercial activities, whether within or outside the U.S.
Legal framework of section 892
Section 892 subsection (a)(1) provides that income of foreign governments from investments in U.S. stocks, bonds, other domestic securities, interest on deposits in United States banks, and certain financial instruments held in the execution of governmental financial or monetary policy is exempt from U.S. income tax.
This statutory relief provides that, to the extent a Canadian government is involved, Canadian pension plans can participate in the U.S. capital markets in a tax-efficient manner.
Section 892 subsection (a)(2) sets out important exclusions; the exemption does not apply to income derived from commercial activities, income received by or from a controlled commercial entity or income from the disposition of an interest in a controlled commercial entity.
An entity will be treated as a controlled commercial entity if it is engaged in commercial activities and the foreign government holds at least 50 per cent of its value or voting power, or otherwise exercises effective control.
Under the previous rules, effective control—or “effective practical control—was determined by a facts-and-circumstances test where control could arise from a combination of minority ownership and other relationships such as creditor, contractual or regulatory relationships that enabled a foreign government to influence an entity’s key decisions.
The proposed regulations clarify the existing framework and specify that effective control can result from any combination of interests, such as equity, debt, voting rights or contractual arrangements that confer authority over operational or managerial decisions.
Section 892 subsection (c) authorizes the U.S. Treasury Department to issue regulations defining these concepts, and recent guidance reflects a clear policy emphasis on commercial activity and control.
Key elements of the new regulations
Here is a look at the major updates to section 892 as Canadian entities evaluate their current structures:
Commercial activity
The final regulations adopt a broader definition of commercial activity. Any activity ordinarily conducted to produce income or gain may constitute commercial activity, even if it does not rise to the level of a U.S. trade or business under section 162 or 864.
Canadian pension plans or sovereign wealth entities previously could structure their U.S. investments such that equity investments were treated as passive, while certain debt and credit investments did not necessarily give rise to commercial activity.
The new guidance narrows this distinction—meaning activities that generate economic profit, including certain debt origination and structured credit roles, may fall outside the investment exception unless carefully structured.
Partnerships and qualified partnership interests
Partnerships remain a central focus of the section 892 regime. While holding or trading a partnership interest is not inherently commercial, partners are generally attributed the commercial activities of the partnership.
The final regulations provide relief through the qualified partnership interest framework, under which a passive partner without control or management rights is not treated as engaged in commercial activity solely by reason of its partnership interest.
For Canadian pension plans and sovereign wealth entities—which commonly invest through partnerships in private equity, infrastructure, real estate and credit funds—the specific rights granted under partnership agreements are now critical in determining eligibility for the exemption.
Controlled commercial entities
An entity engaged in commercial activity may be treated as a controlled commercial entity if it is either owned or effectively controlled by a foreign government or its integral parts.
Income earned by or derived from such an entity is excluded from the section 892 exemption, even if the income would otherwise be considered passive in nature.
Debt acquisitions under the proposed regulations
The proposed regulations address when the acquisition of debt constitutes commercial activity.
Debt investments may be treated as commercial unless they fall within defined safe harbours or satisfy a facts-and-circumstances investment standard.
This guidance is particularly relevant for direct lending and private credit strategies that have become increasingly significant for Canadian pension plans and sovereign wealth entities.
Practical implications for Canadian pension plans
Partnership structures are present across pension portfolios. Under the revised framework, it is no longer sufficient to hold a pure economic interest in a partnership. Governance rights, ownership thresholds and consent powers must be reviewed to ensure compliance with the qualified partnership interest requirements.
Private credit and direct lending activities warrant particular attention. Active loan origination, negotiation or structuring may jeopardize the exemption. Canadian pension plans may need to segregate these activities into taxable entities or rely on third-party managers to mitigate attribution of commercial activity.
Operating platforms also present risk. U.S. operating subsidiaries or platforms controlled by a pension plan can taint broader structures unless properly ring-fenced.
Controlled commercial entity status must be assessed on an annual basis, rather than assumed to be static.
Timing and absence of exceptions for existing structures
The final regulations apply to tax years beginning on or after Dec. 15, 2025, and may be applied to earlier open years at the taxpayer’s election.
Since there are no broad exceptions for existing structures, Canadian pension plans and sovereign wealth entities should treat the regulations as effectively binding for current and future years.
