Internal Revenue Bulletin No. 2026–3

## Executive Summary: Foreign Sovereigns and Administrative Updates

This edition of the Internal Revenue Bulletin (IRB) 2026-3, dated January 12, 2026, focuses predominantly on clarifying the tax treatment of foreign governments' investments within the United States, particularly under Section 892, which provides a conditional exemption for certain investment income of foreign governments. T.D. 10042 finalizes regulations providing guidance on determining when a foreign government is engaged in commercial activity and when an entity is a controlled commercial entity, shaping the contours of the "commercial activity" exception to the Section 892 exemption. Complementing this, REG-101952-24 proposes further regulations related to the taxation of income of foreign governments, with a specific emphasis on debt acquisition by foreign governments and the determination of effective control of entities engaged in commercial activities. These rules build on the final regulations issued in 2025.

Beyond the foreign government focus, this IRB includes administrative updates. Rev. Rul. 2026-2 provides the Applicable Federal Rates (AFR) for January 2026, which are crucial for various Code sections, including Section 1274 (determination of issue price where there is inadequate stated interest) and Section 7872 (treatment of certain loans with below-market interest rates). REG-110519-25 outlines proposed updates to points of contact within the Department of Justice (DOJ) and the IRS, reflecting the recent reorganization of the DOJ Tax Division, where tax enforcement functions are now bifurcated between the Civil Division (Tax Litigation Branch) and the Criminal Division (Tax Section). Finally, the IRB announces the withdrawal of REG-134219-08 and REG-132251-11, two notices of proposed rulemaking concerning innocent spouse relief under Section 6015, which provides avenues for a spouse to avoid liability for tax deficiencies attributable to the other spouse.

## T.D. 10042: Finalizing the 'Commercial Activity' Definition for Sovereigns

This section analyzes Treasury Decision (T.D.) 10042, which finalizes regulations under Section 892, concerning the taxation of income derived by foreign governments from investments within the United States. These final regulations provide crucial guidance on determining when a foreign government engages in "commercial activity" and when an entity qualifies as a "controlled commercial entity" (CCE). These definitions are central to whether the income is exempt from U.S. taxation.

### The Rule: Defining Commercial Activity and Controlled Commercial Entities
The final regulations under T.D. 10042 address the core issue of what constitutes "commercial activity" for foreign governments under Section 892. Section 892 generally exempts certain investment income of foreign governments from U.S. income tax. However, this exemption does not extend to income derived from commercial activities, income received by a CCE, or income derived from disposing of an interest in a CCE.

The regulations retain the general approach of the 2011 and 2022 proposed regulations, defining commercial activities broadly as *all* activities ordinarily conducted for the current or future production of income or gain, whether inside or outside the United States (§ 1.892-4(b)). The regulations clarify that it is the *nature* of the activity, not the intent behind it, that determines its commercial character. Activities that constitute a trade or business for purposes of Section 162, which allows deductions for ordinary business expenses, or constitute a trade or business in the U.S. under Section 864(b), which defines effectively connected income, are commercial activities unless explicitly excepted. Specifically, Section 864(b) defines "trade or business within the United States" to generally include the performance of personal services in the US, although it includes a de minimis exception and trading safe harbors. *YA Global Investments, LP v. Commissioner* (2023) serves as a reminder that agency attribution can cause a non-US entity to be engaged in a US trade or business under Section 864(b) if its US-based manager's activities go beyond mere investing.

A CCE, defined under Section 892(a)(2)(B), is any entity engaged in commercial activities where a foreign government holds a significant interest, generally 50% or more by value or voting power, or any interest granting the foreign government effective control (§ 1.892-5(a)(1)(iii)). The definition of "entity" includes corporations, partnerships, trusts, and estates, aligning with prior regulations (§ 1.892-5(a)(1)(ii)).

### The Context: Investment, Politics, and Legislative History
The evolution of these regulations reflects ongoing efforts to balance the U.S.'s desire to attract foreign investment from sovereign wealth funds (SWFs) and foreign governments with the need to prevent tax avoidance through commercial activities disguised as passive investments. The regulations respond to changes introduced by the Tax Reform Act of 1986 and subsequent amendments, particularly the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), which clarified that income from the disposition of interests in CCEs does not qualify for the Section 892 exemption.

The modifications to the USRPHC rules specifically address concerns raised by foreign governments about the potential for inadvertently triggering CCE status. By limiting the per se rule to domestic corporations, the Treasury Department and the IRS are attempting to align the regulations more closely with Congressional intent while mitigating unintended consequences for foreign investors. The retention of the minority interest exception, despite the change in the USRPHC per se rule, is a direct response to comments and a recognition that foreign government investors have relied on it. The definition of USRPHC is located in Section 897(c)(1)(A)(i), part of the Foreign Investment in Real Property Tax Act (FIRPTA). FIRPTA stipulates that gain from the disposition of a USRPI is treated as effectively connected income (ECI) subject to US tax.

### The Implication: Navigating Investment Structures and Derivatives
These final regulations have several key implications for tax practitioners advising foreign governments and SWFs:

1.  **Investment vs. Commercial Activity:** Foreign governments must carefully evaluate their activities in the U.S. to ensure they are structured as passive investments rather than commercial activities. Investments in stocks, bonds, and certain financial instruments are generally considered non-commercial.

2.  **Financial Instruments (Derivatives):** The regulations clarify that trading and investing in derivatives within the scope of proposed regulations under Section 864(b) are not commercial activities (§ 1.892-3(a)(4)(i)). This provision is crucial for SWFs that use derivatives for hedging or portfolio management. However, if a financial instrument results in beneficial ownership of a reference asset, the determination of commercial activity is based on the asset itself, not the derivative.

3.  **Partnerships:** The regulations clarify that merely holding or trading partnership equity interests is not commercial activity *per se* (§ 1.892-4(c)(1)(i) and (c)(2)). However, a foreign government’s distributive share of partnership income attributable to commercial activities remains taxable. SWFs investing in U.S. partnerships must analyze the partnership's activities to determine if those activities are attributed to them. Furthermore, SWFs now have increased flexibility in structuring foreign holding companies without automatically triggering CCE status due to the USRPHC rules.

4.  **USRPHCs:** Foreign governments investing in U.S. real estate through domestic corporations need to be acutely aware of the USRPHC rules. While the per se rule now applies only to domestic USRPHCs, income from the direct disposition of a U.S. real property interest, as defined in Section 897(c)(1)(A)(i) – generally, interests in U.S. real estate – remains ineligible for the Section 892 exemption (§ 1.892-4(c)(3)). Section 897(c)(1)(A)(i) defines a USRPI as an interest in real property located in the United States. Note that under Section 897, gain or loss from the disposition of a USRPI by a nonresident alien or foreign corporation is treated as effectively connected income (ECI) with a US trade or business.

## REG-101952-24: New Scrutiny on Sovereign Debt Acquisition & Control

The Internal Revenue Service (IRS) is proposing new regulations under Section 892, which addresses the tax treatment of income earned by foreign governments, specifically concerning the acquisition of debt and the determination of effective control over entities. This supplements the finalized regulations in T.D. 10042 by providing more granular rules.

**1. The Rule:**

The proposed regulations (REG-101952-24) introduce a new framework for determining when a foreign government's acquisition of debt is considered a 'commercial activity' (taxable) versus a passive 'investment' (exempt under Section 892(a)(1), which generally exempts income of foreign governments received from investments in the U.S. in stocks, bonds, or other domestic securities, financial instruments held in the execution of governmental financial/monetary policy, or interest on bank deposits). These regulations affect foreign governments deriving income from sources within the United States. This framework is designed to provide clarity on how lending activities undertaken by sovereign entities will be classified for tax purposes.

The general rule is that *all* acquisitions of debt are treated as commercial activity *unless* the acquisition qualifies as an investment under either of two safe harbors or a facts-and-circumstances test. "Debt," for this purpose, means any obligation treated as debt for Federal tax purposes. Dealer activity, as defined in § 1.864-2(c)(2)(iv)(a), will always be treated as commercial activity, regardless of the safe harbors or facts-and-circumstances test. The proposed regulations create the *exclusive* framework for determining whether acquiring debt, including at original issuance, is treated as investment, unless otherwise provided, determined *without* regard to whether the debt acquisition is treated as a trade or business for Federal tax purposes.

Two safe harbors are proposed. The *first* safe harbor treats acquisitions of bonds or other debt securities acquired in an offering registered under the Securities Act of 1933 (15 U.S.C. 77a, et seq.), as investment, provided that the underwriters of the offering are *not* related to the acquirer within the meaning of Section 267(b) (which defines related parties to include certain family members, corporations, partnerships, and fiduciaries) and Section 707(b) (related parties are defined as a partnership and a person who owns more than 50% of the capital or profits interest in the partnership).

The *second* safe harbor treats a qualified secondary market acquisition of debt as investment. This generally includes acquisitions of debt traded on an established securities market, within the meaning of § 1.7704-1(b) (defining what constitutes an established securities market), provided that the acquirer is *not* purchasing from the issuer or participating in the negotiation of the terms or issuance of the debt, and the acquisition is not from a person that is under common management or control with the acquirer, unless that person acquired the debt as investment.

Debt acquisitions that do not satisfy the safe harbors may still qualify as an investment based on all relevant facts and circumstances. Factors considered include: (1) whether the acquirer solicited prospective borrowers; (2) whether the acquirer materially participated in negotiating or structuring the terms of the debt; (3) whether the acquirer is entitled to compensation (other than interest) for Federal tax purposes; (4) the form of the debt and the issuance process; (5) the percentage of the debt issuance acquired by the acquirer; (6) the percentage of equity in the debt issuer held or to be held by the acquirer; (7) the value of that equity relative to the amount of the debt acquired; and (8) If debt is deemed to be acquired in a debt-for-debt exchange as a result of a significant modification under § 1.1001-3 (which defines "significant modification" of a debt instrument), whether there was, at the time of acquisition of the original unmodified debt, a reasonable expectation, based on objective evidence, that the original unmodified debt would default.

The proposed regulations also revise § 1.892-5T(c)(2) to provide further guidance on what constitutes 'effective control' under Section 892(a)(2)(B)(ii), which states that a Controlled Commercial Entity (CCE) includes an entity in which the foreign government holds any interest providing it with effective control of the entity. The proposed regulations define the terms “other interest” and “effective control” broadly to include circumstances in which a foreign government would have control over either the operational, managerial, board-level, or investor-level decisions of an entity. Effective control is achieved by any interest in the entity that, either separately or in combination, results in control over these decisions. Interests may include equity interests, voting power, debt interests, contractual rights, business relationships, regulatory authority, or any other arrangement or relationship that provides influence over the entity’s decisions. A managing partner or managing member of an entity is deemed to have effective control, but the mere right to be consulted with respect to operational, managerial, board-level, or investor-level decisions of an entity will not alone give rise to effective control.

**2. The Context:**

This proposed regulation addresses a growing trend: foreign governments, particularly sovereign wealth funds, are increasingly engaging in direct lending and debt acquisition activities in the United States and globally. It is crucial for the IRS to distinguish between passive investment, which is generally tax-exempt under Section 892, and active lending, which is considered a commercial activity and therefore taxable. The IRS is responding to comments received on the 2011 proposed regulations, where stakeholders expressed uncertainty about the circumstances in which loan origination is considered commercial activity. The proposed regulations seek to provide clarity and prevent the erosion of the U.S. tax base. These proposed regulations complement the 2025 final regulations and follow up on promises made within them to give more guidance on the circumstances in which loan origination is considered a commercial activity. They take into consideration that the prior regulations provided that loans and investments in stocks, bonds, and other securities are not commercial activities, but did not give sufficient guidance as to the characterization of loan origination.

**3. The Implication:**

For tax practitioners, these proposed regulations represent a significant shift in how debt acquisitions by foreign governments are analyzed. The safe harbors provide clear guidelines for certain transactions, but many debt acquisitions will require a detailed facts-and-circumstances analysis. Practitioners must carefully document the nature of the debt, the acquisition process, and the foreign government's relationship with the issuer to determine whether the acquisition qualifies as an investment.

The proposed regulations on 'effective control' also demand a deeper understanding of the relationships between foreign governments and the entities in which they invest. Minority interests coupled with contractual rights, business relationships, or regulatory authority can now trigger CCE status, even without a controlling equity stake. Practitioners must analyze all aspects of the relationship to assess whether the foreign government has the ability to control the entity's operational, managerial, board-level, or investor-level decisions. The failure to carefully navigate these rules could result in unexpected U.S. tax liabilities for foreign governments and their controlled entities.

## Rev. Rul. 2026-2: January 2026 Applicable Federal Rates

Following the finalization of the "commercial activity" definition for sovereigns, the IRS also released its routine update on applicable federal rates. Revenue Ruling 2026-2 provides the various prescribed rates for federal income tax purposes for January 2026. These rates are crucial for calculations involving several areas of tax law, most notably debt instruments and certain tax credits.

Table 1 of the ruling contains the short-term, mid-term, and long-term applicable federal rates (AFR) for January 2026, as determined under Section 1274(d). Section 1274 governs the determination of the issue price for certain debt instruments issued for property, ensuring that an adequate amount of interest is stated. The short-term AFR is 3.63%, the mid-term AFR is 3.81%, and the long-term AFR is 4.63%, each assuming annual compounding. Higher rates are provided for instruments at 110%, 120%, and 130% of the AFR. If the stated interest is below the AFR, Section 1274(b) stipulates that the issue price becomes the "imputed principal amount," calculated by discounting payments at the AFR.

Table 2 provides the adjusted AFR rates for January 2026, crucial for calculations under Section 1288(b). Section 1288 concerns the treatment of discount on short-term obligations. These adjusted rates reflect inflation adjustments. The short-term adjusted AFR is 2.75%, the mid-term adjusted AFR is 2.88%, and the long-term adjusted AFR is 3.51%, assuming annual compounding.

Table 3 sets forth rates related to ownership changes under Section 382(f). Section 382 addresses the limitation on net operating loss carryforwards and certain built-in losses following an ownership change. The adjusted federal long-term rate for January 2026 is 3.51%. The long-term tax-exempt rate for ownership changes during the same month is also 3.51%, representing the highest of the adjusted federal long-term rates for the current month and the prior two months.

Table 4 details the appropriate percentages for the low-income housing credit under Section 42(b)(1). Section 42 provides a tax credit for investments in low-income housing. The appropriate percentage for the 70% present value low-income housing credit is 7.98%, while the percentage for the 30% present value credit is 3.42%. The ruling reiterates the caveat that under Section 42(b)(2), the applicable percentage for non-federally subsidized new buildings placed in service after July 30, 2008, shall not be less than 9%.

Table 5 contains the rate used to determine the present value of annuities, life estates, remainders, and reversionary interests under Section 7520. Section 7520 governs the valuation of such interests. The applicable federal rate for January 2026 is 4.6%.

Table 6 provides the deemed rate of return for transfers made during calendar year 2026 to pooled income funds described in Section 642(c)(5) that have been in existence for less than 3 taxable years. Section 642 addresses special rules for credits and deductions for estates and trusts. The deemed rate of return is 4.0%.

Finally, Table 7 presents the average of the applicable federal mid-term rates (based on annual compounding) for the 60-month period ending December 31, 2025, used for purposes of Section 7702(f)(11). Section 7702 defines life insurance contracts. The average rate is 3.19%, rounded to 3%.

## REG-110519-25: Updating Procedures for DOJ Tax Division Reorg

Following the detailed analysis of the January 2026 Applicable Federal Rates in Revenue Ruling 2026-2, this section will address proposed regulations, specifically REG-110519-25, which concerns updates to points of contact within the Department of Justice (DOJ) and the IRS.

### 1. The Rule (What is the IRS updating?)

The proposed regulations seek to update references in 26 CFR Part 301, the Procedure and Administration Regulations, and 27 CFR Part 70, which governs taxpayer claims for credit or refund to the Alcohol and Tobacco Tax and Trade Bureau (TTB). These changes are necessary to reflect a reorganization within the DOJ and changes within the IRS. Specifically, the proposed regulations address two key areas: (1) updating DOJ points of contact to reflect the division of responsibilities between the Civil Division and the Criminal Division and (2) updating IRS points of contact for administrative claim submissions from taxpayers seeking civil damages for certain unauthorized collection actions or awards of administrative costs with respect to certain administrative proceedings.

### 2. The Context (Politics/Industry/History)

Historically, the Tax Division of the DOJ handled both civil and criminal litigation related to internal revenue laws. However, the DOJ has reorganized its structure, dissolving the former Tax Division in November 2025. The Civil Division now houses a dedicated **Tax Litigation Branch**, responsible for civil tax suits, refund claims, and lien enforcement. The Criminal Division now manages the **Tax Section**, handling all criminal proceedings and investigations arising under internal revenue laws. This move, tied to Executive Order 14210, necessitates updating regulatory references to ensure that administrative claims and refund checks are directed to the correct Assistant Attorney General.

Additionally, the IRS has undergone internal restructuring. The IRS Restructuring and Reform Act of 1998 (RRA 98) mandated a fundamental reorganization, shifting from a geographically focused system to one focused on specific taxpayer categories. This shift has led to changes in the offices responsible for processing certain claims, particularly those related to unauthorized collection actions under Section 7433, which allows taxpayers to sue the United States in District Court if an IRS officer recklessly, intentionally, or negligently disregards the Code or regulations "in connection with any collection of Federal tax." The proposed regulations aim to reflect the current roles of the Field Insolvency (FI) and Centralized Insolvency Operation (CIO) within the IRS.

### 3. The Implication (What do practitioners need to know?)

Tax practitioners need to be aware of the following changes to ensure proper handling of administrative claims and communication with the DOJ and IRS:

*   **DOJ Contact Updates:** Claims and checks related to civil tax matters should now be directed to the Assistant Attorney General for the Civil Division of the Department of Justice. For criminal tax matters, communication and disclosures should be directed to the Assistant Attorney General for the Criminal Division of the Department of Justice. These changes affect 26 CFR 301.6103(h)(2)-1, which regulates disclosures of returns and return information to the DOJ in grand jury proceedings; 26 CFR 301.6402-2, which regulates claims for credit or refund; and 27 CFR 70.123, which governs claims for credit or refund to the TTB.

*   **IRS Insolvency Claim Updates:** Administrative claims related to violations of the automatic stay under Section 362 of Title 11 of the United States Code (Bankruptcy Code) or the discharge provisions under Section 524 of the Bankruptcy Code should now be directed to the Centralized Insolvency Operation (CIO), rather than the Chief, Local Insolvency Unit. This change impacts 26 CFR 301.7430-1, regarding exhaustion of administrative remedies; 26 CFR 301.7430-2, describing procedures for recovery of reasonable administrative costs; and 26 CFR 301.7433-2, regarding the civil cause of action for violation of Section 362 or 524 of the Bankruptcy Code. Taxpayers should note that the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 significantly amended Section 362 regarding automatic stays. For example, for individual debtors, the stay in Tax Court now applies only to taxable periods ending before the order for relief. Further, under Section 362(b)(9), filing for bankruptcy does not stay an audit by a governmental unit to determine tax liability or prevent the issuance of a notice of tax deficiency. In *Cochran v. Commissioner* (2022), the Tax Court held that confirmation of a Chapter 11 plan alone does not terminate the automatic stay.

*   **IRS Unauthorized Collection Action Claim Updates:** Claims for damages due to unauthorized collection actions under Section 7433 should be sent to the Collection Advisory Group of the area in which the taxpayer currently resides, replacing the reference to "Area Director, Attn: Compliance Technical Support Manager." This change affects 26 CFR 301.7433-1. To succeed on a claim under Section 7433, the IRS's conduct must be part of an affirmative collection effort, as demonstrated in cases like *Manuel Lampon-Paz v. United States* (D.N.J. 2025).

*   **Bankruptcy Code Reference Updates:** The regulations also update references to Section 362(h) of the Bankruptcy Code to reflect the recodification under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). The updated reference is Section 362(k) of the Bankruptcy Code.

These proposed regulations are intended to be effective as of the date of publication of a Treasury decision adopting these rules as final. The IRS believes there is good cause to dispense with a delayed effective date, as the organizational changes at the DOJ and IRS are already in effect.

## Withdrawal of Innocent Spouse Relief Proposals

Following updates to the Bankruptcy Code, the IRS is addressing earlier regulatory proposals. Specifically, the IRS is withdrawing two notices of proposed rulemaking regarding relief from joint and several tax liability and relief from Federal income tax liability resulting from the operation of State community property laws, published in the Federal Register on August 13, 2013 (78 FR 49242) and November 20, 2015 (80 FR 72649).

**The Rule:** The IRS is withdrawing REG-132251-11 and REG-134219-08, which are 2013 and 2015 proposed regulations respectively. These concerned relief from joint and several liability under Section 6015 and relief from the operation of community property laws under Section 66. Section 6015, often called "Innocent Spouse Relief," provides avenues for a spouse to avoid liability for tax deficiencies attributable to the other spouse on a joint return. Section 66 addresses the treatment of community income when spouses are separated and treated as living apart.

**The Context:** These proposed regulations aimed to provide clarity on how taxpayers could seek relief from tax liabilities arising from actions of their spouses. The 2015 proposed regulations specifically reflected changes to Section 6015 made by the Tax Relief and Health Care Act of 2006, as well as changes arising from litigation. As seen in the recent case of _Zaheen v. Commissioner_ (T.C. Memo. 2026-7), courts actively adjudicate disputes over spousal tax liabilities, particularly using the equitable relief provision under Section 6015(f).

**The Implication:** The IRS cites the passage of time and resource allocation as the reasons for the withdrawal, indicating they do not intend to finalize these rules without providing additional notice and requesting public comments. For tax practitioners, this means that the specific guidance anticipated from these proposed regulations will not be forthcoming in their current form. While the IRS may propose new rules in the future, practitioners should consider the withdrawn regulations effectively defunct for now. The withdrawal does not affect existing statutory and regulatory requirements or the responsibility to administer the statutory requirements the proposed rules would have implemented if finalized. Taxpayers should be aware that under Section 6015(f), courts consider various factors for equitable relief, as highlighted in Revenue Procedure 2013-34, including marital status, economic hardship, and knowledge of the understatement. _Zaheen v. Commissioner_ (2026) recently emphasized that spousal abuse and financial control can mitigate the "reason to know" factor when evaluating equitable relief.