The United States wants to tax global sovereign wealth funds.

U.S. tax authorities are advancing a tax reform that could reshape the global investment landscape for sovereign wealth funds.

According to a report by the Financial Times on the 16th, the Internal Revenue Service proposed an amendment to section 892 of the tax code last December. This change could subject sovereign wealth funds and some public pension funds to tax obligations for their investments in the U.S., directly impacting one of the largest sources of capital in the private equity market.

Under current regulations, foreign governments and their controlled entities—including sovereign wealth funds and certain public pension funds—are exempt from U.S. taxes on their investment activities. But the new proposal would significantly broaden the definition of "commercial activities," reclassifying certain activities that were previously regarded as investments as taxable commercial activities. This means common practices such as direct lending and private equity co-investments by sovereign funds may lose their tax exemptions.

This policy shock comes as the Trump administration pursues more aggressive economic measures in its second term. According to consulting firm Global SWF, global state-owned investors will hold $550 billion in private credit investments in 2025, and last year their direct private equity investments in the U.S. exceeded $73 billion—more than triple the previous year's total. If implemented, the new regulations may force these funds to adjust their strategies or shift investments to other markets.

The proposal's comment period ended on February 13, but whether the final rules will take effect remains uncertain. Given the Trump family's close ties with multiple sovereign funds, the outlook for a proposal that could effectively "tax allies" is highly uncertain.

Direct Lending Business Faces Redefinition

The core of the IRS proposal is redrawing the boundary between investment and commercial activity. Under the new rules, sovereign funds participating in direct corporate loans or actively in debt restructurings would be classified as commercial activity, thus losing their tax-exempt status.

International law firm Cleary Gottlieb points out that under the proposal, if a sovereign fund investor proactively offers debt financing to a borrower—instead of passively accepting an investment opportunity—and takes part in structuring and negotiating loan terms, even a single loan could be considered a commercial activity. The IRS has removed “lending” from the list of investments not considered commercial activity.

The proposal includes "safe harbor" provisions for some debt investments, such as publicly issued debt instruments purchased from non-affiliated underwriters, and debt traded in mature securities markets. This means government and corporate bonds may be unaffected, but directly issued private credit will come under strict scrutiny.

More severely, even if a sovereign fund bought a company's bond years ago at a normal price, once the company becomes distressed and the fund joins a creditors committee to recover funds, that action would be considered commercial activity. Kristin Gallagher, Head of KPMG’s International Tax and U.S. Sovereign Wealth and Pension Fund Services, said: "Assuming all debt acquisitions are commercial activity represents a profound shift that requires immediate attention."

Private Equity Investment Structures Impacted

The new rules are also far-reaching for private equity investments. Sovereign funds have long relied on special purpose vehicles—known as "blocker entities"—to hold co-investments and direct equity investments, isolating tax liability. These structures allow funds to pay corporate income tax and then use section 892 to exempt dividend distributions from the 30% withholding tax.

But the proposal expands the definition of "actual control." Currently, sovereign funds avoid being regarded as having actual control by ensuring no single investor holds more than 50% of voting shares or rights. Under the new rules, holding certain investor rights—such as consultation on exit—even without economic or voting control, could be regarded as actual control.

Law firm Eversheds Sutherland notes that the Treasury and IRS clearly view governance influence as a proxy for control. The new rules indicate that even if a foreign government holds no shares in an entity, if it can influence or direct key decisions through economic or regulatory pressure, it could constitute actual control.

This has limited impact on passive investors, but poses challenges for sovereign funds involved in co-investments or direct investments. Global SWF data shows that last year, sovereign funds and public pension funds accounted for two-thirds of U.S. private equity transactions via co-investments.

Tax Exemption Could Be All-or-Nothing

For sovereign funds classified as "controlled entities" rather than "integral parts," the new rules would have even greater impact. Jeffrey Koppele, tax partner at Squire Patton Boggs, points out the "all or nothing" rule still applies: if a sovereign fund, as a controlled entity, engages in any amount of commercial activity—whether in the U.S. or abroad—it may lose its section 892 exemption for all U.S. income.

This means a sovereign fund with a U.S. investment portfolio worth hundreds of billions of dollars could theoretically lose all its U.S. tax exemptions if, for example, its European subsidiary made a direct loan of €10 million to a French company.

Koppele also warns if the proposal is finalized as currently written, it could apply to investments already made by sovereign funds, making the new rule retroactive and impacting existing portfolios.

However, the actual impact of losing section 892 status depends on the legal structure of each fund, and investors can still rely on other exemptions. Some public pension funds do not depend on section 892, instead using portfolio debt exemption for foreign investors or exemptions for foreign pension funds.

Market Impact and Policy Outlook

According to Global SWF, excluding U.S. domestic funds, the world's top 100 sovereign wealth funds manage about $15 trillion in assets, and combined with the top 100 public pension funds, the total is $27 trillion. About 40% is invested domestically, with the remaining $8.4 trillion invested internationally.

Diego López, Managing Director at the consulting firm Global SWF, said about a quarter of state-owned entities' private credit assets are direct investments rather than through private market asset management firm funds. The new rules may prompt sovereign funds and some public pension funds to abandon direct investment models in favor of more passive structures, such as investing through private capital funds.

The ultimate fate of the proposal remains uncertain. Last year, a proposed amendment to section 899 of the tax code raised market concerns about disruption in the Treasury bond market, but it was not passed. The comment period for the current proposal ended February 13, but given the Trump family's close relationships with many sovereign fund heads—including at least one that invested billions in the family's stablecoin project—imposing new taxes on these new allies and business partners seems uncharacteristic of Trump's style.

Yet this fits with the current administration's broader strategy to stimulate the U.S. economy with aggressive measures like tariffs and equity investment. Sovereign funds and public pension funds are closely monitoring the proposal and assessing their portfolio risk exposures.

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