Australia Amending Tax Treatment for SWFs

As I discuss in my forthcoming article Sovereign Wealth Funds and Corporate Governance: Evidence and Policy, the US affords favorable tax treatment to SOEs and SWFs, provided they play by certain rules:

Under Section 892 of the Internal Revenue Code, income earned by foreign governments on investments in the United States in stocks, bonds, or other domestic securities, financial instruments held in the execution of governmental financial or monetary policy, or interest on deposits in banks in the United States, is exempt from taxation.[1] The exemption provided under § 892 does not apply to commercial activity, however, with the justification that as an extension of the doctrine of sovereign immunity, § 892’s exemption should be limited to activities that are related to sovereign activities of the government.[2] The definition of commercial activity under § 892 turns on whether income was received from a controlled commercial entity, a term defined to mean

“any entity engaged in commercial activities (whether within or outside the United States) if the government (i) holds (directly or indirectly) any interest in such entity which (by value or voting interest) is 50 percent or more of the total of such interests in such entity, or (ii) holds (directly or indirectly) any other interest in such entity which provides the foreign government with effective control of such entity.”[3]

Because “effective control” may come at shareholdings significantly below 50%, SWFs have a tax incentive to avoid making investments that might trigger tax liability under § 892.

[1] I.R.C. § 892 (2006).

[2] This explicit distinction was codified by the Foreign Sovereign Immunities Act of 1976, 28 U.S.C. § 1602 (2006); for a discussion of the development of the Foreign Sovereign Immunities Act and § 892, see N.Y. State Bar Ass’n Tax Section, Report on the Tax Exemption for Foreign Sovereigns under Section 892 of the Internal Revenue Code 14–16 (June 2008), .

[3] I.R.C. § 892(a)(2)(B).

Some (including politicians) have argued that the US should not give favorable tax treatment  to SWFs because they are purportedly engaged in commercial activity, rather than “sovereign” activity.  This is what we call putting out the “unwelcome” mat.  Contrast this with the position of Australia, as reported on Lexology:

In keeping with its goal of encouraging more foreign investment into Australia, the Federal Government will change existing laws to ensure foreign pension and sovereign wealth funds can access the Managed Investment Trust (MIT) withholding tax regime.

In summary, the regime allows a MIT to make payments to non-residents at concessional withholding tax rates, offering an attractive Australian investment option for foreign funds where they and their members are ultimately based overseas.

Popularity of MITs in Australia

The use of MITs in Australia is growing rapidly.  In the superannuation industry alone, the value of savings under management has exploded from $183 billion in 1993 to $1.5 trillion today.

As at 1 January 2010, 17.6% of all inflows to Australian MITs came from foreign pension and sovereign wealth funds.  By 31 December 2011, this figure had grown to 26%.

B1G Fundraising, 2012

Compiled from a recent report from the Council for Aid to Education, here are the B1G schools ranked by funds raised in 2012.  I’m not surprised to see Ohio State high on the list (go Bucks!), but the #1 school surprised me:

Indiana University


Ohio State University


University of Wisconsin-Madison


University of Michigan


Northwestern University


University of Illinois


Penn State University


University of Nebraska


Purdue University


Michigan State University


University of Iowa


University of Minnesota

n/A (didn’t respond)

My JD-granting alma mater, UCLA, received $344,201,149, almost exactly the same amount as Ohio State.  The big winner, with far more than any other school (including Harvard and Yale): Stanford, with $1,034,848,797.  Wow . . .

New Research: "Sovereign Investing and Corporate Governance: Evidence and Policy"

I have posted to SSRN a draft of a new paper entitled “Sovereign Investing and Corporate Governance: Evidence and Policy.” Here is the paper’s abstract:

Discussions of corporate governance often focus solely on the attractiveness of firms to investors, but it is also true that firms seek out preferred investors. What, then, are the characteristics of an attractive investor? With nearly $6 trillion in assets, sovereign wealth funds (SWFs) are increasingly important players in equity markets in the United States and abroad, and possess characteristics that firms prize: deep pockets, long-term (and for some, theoretically infinite) investment horizons, and potential network benefits that many other shareholders cannot offer. However, despite their economic power, their reach, and their general desirability as investors, SWFs are almost entirely disengaged from corporate governance matters in U.S. firms. Indeed, with the exception of Norway’s Government Pension Fund-Global, SWFs are notable primarily just for their passivity as shareholders.

Given the domestic and external political and regulatory factors that discourage SWF engagement in corporate governance in the United States, how can SWFs provide appropriate stewardship over their equity investments? The article answers this question by describing how SWFs and regulators can create the crucial “space” necessary for SWF engagement in corporate governance. The analysis proceeds in three substantive sections. Part I lays out a definition of SWFs and describes SWF investment patterns. Part II reviews empirical evidence on SWF investment behavior and the effects that the investment has on firm values, and then examines evidence on SWF activities in corporate governance. Part III discusses the key factors that limit SWF involvement in corporate governance activities. Part IV describes how, given these limitations, SWFs may engage in governance without triggering regulatory reprisals, and how regulators can encourage SWF investment and engagement.

New Research: "The Management of Public Natural Resource Wealth"

I have posted to SSRN a draft of my paper “The Management of Public Natural Resource Wealth“, which expands on and revises an earlier draft on “American Sovereign Wealth.”  Here is the paper’s abstract:

As improved but often more environmentally-obtrusive technologies such as hydraulic fracturing facilitate the extraction of billions of dollars in natural resource wealth, more states are now faced with a welcome but exceedingly complex set of problems: Who should benefit from natural resources extracted from public lands? If the state retains much of this wealth in the form of tax receipts, how should these funds be spent? What do states owe to the communities from which these resources were extracted? What do states owe to future generations? While these are questions of first impression for a few, fortunate states, a number of states have been trying to address these issues for decades, and have enacted a variety of responses that have crucial implications for the states, their citizens, and their natural environments.

This article proceeds by providing in Part I historical background on the crucial legal developments which allowed state public natural resource funds to develop. In Part II, the article turns to the first of the two central questions by introducing the principal policy justifications of state public natural resource funds through a review of the stated objectives of the funds, the funds’ governance and distributions mechanisms, the role the funds play in state policy making and budgeting, and the aspects of federalism implicated by the state funds. Part III then analyzes the operations of the funds in light of the policy justifications identified in the article. The article concludes by showing how governance weaknesses often limit the effectiveness of funds in achieving their policy goals, and suggests ways in which states can create appropriate legal and governance structures to enhance their funds’ effectiveness.

Comments are welcome.

Governance and SWF Branding

A colleague is going to speak to several SWFs in the coming weeks and asked for a few thoughts on governance issues that he could pass along to the SWFs.  Here are a few things that came to mind: 

  • Transparency is key.  I know SWFs hear this all the time, but regulators want to know what funds are up to (with full acknowledgement of the problems that “bottom-line” transparency can bring, as Dixon and Monk have noted).  This doesn’t require funds to  disclose short-term performance, or to reveal all of their positions and interests (although if they invest more than $100 million in public equities in the US they should disclose these equity investments per SEC rules),  but I think it does require them to be very deliberate and careful in disclosing their general strategies and policies, including how they exercise their shareholder rights.  Funds don’t want to give an excuse to politically-motivated regulators or legislators to raise their lack of transparency as a sign that they are engaged in something nefarious.
  • Related to that, I think funds have to very transparent and precise in how they use funds for domestic purposes.  Whether a fund should be used for domestic purposes is a political and economic issue that is largely beyond my analysis, but I do think that academic observers and regulators have looked at economic development funds in countries that also have SWFs, or at SWFs that are used both for domestic and international investment, and have raised concerns about “political” uses of SWFs based on domestic investments; in other words, the SWF’s international investments are more heavily scrutinized because of domestic “political” uses.  A number of countries have both types of funds, and I think it is prudent to keep them separate and clearly defined.  I like to think of SWFs as in need of positive branding, and to protect the brand as a “non-political, passive investor”, countries should be very transparent and diligent about using their SWF only as an international, non-political, passive investment vehicle.  Even regional investments may draw suspicion as political investments.  Again, I see this as a branding issue, and sponsors should be very careful about protecting their SWF’s brand.  CIC is trying conscientiously to develop such a brand, it seems to me, even as other Chinese funds engage in arguably “political” activities.
  • Finally, domestic funds have a number of governance risks that in some cases are less likely to arise in the international investment context, namely, the danger of corruption.  Strong conflicts-of-interest and anti-bribery rules and compliance efforts are very helpful in protecting against corruption (and the likely decreased returns that flow from it). 

More on Sovereign Investing in Real Estate

From Bloomberg (HT: Ashby Monk):

Sovereign wealth funds from China to Azerbaijan, which pushed their real estate deal making to a record last year, are set to extend their buying spree as they seek alternatives to low-yielding bonds and volatile stocks.

The funds made 38 property investments valued at almost $10 billion in 2012, according to the Sovereign Investment Lab at Bocconi University in Milan, which has data going back to 1985. While lower than the $13 billion spent on real estate the year before, such deals were 21 percent of all sovereign fund investments last year, the highest percentage on record and topping the 2011 high of 16 percent.

“Given the very low yields in the bond markets and the volatility in the equity markets, real estate is an attractive play at the moment, especially for long-term investors,” said Andrew Rozanov, head of sovereign advisory at London-based Permal Investment Management Services Ltd. who coined the term “sovereign wealth fund” in a 2005 article. Real estate investments “typically include protection against inflation and portfolio diversification,” he said.

The article goes on to list some of the investment hotspots, including prime locations in large U.S. and European cities.  A couple of advantages to real estate investment not mentioned in the article: no corporate governance concerns that come with equity investment and, related to this, fewer host country national security concerns that might impede a deal.


Pensions and SWFs: New Allocation Stategies

Ron D’Vari, one of my co-affiliates at the Sovereign Wealth Fund Initiative, has some interesting insights on SWF and pension funds’ continuing shift away from traditional bond holdings to other asset classes:

Pensions and sovereign wealth funds are rapidly re-evaluating their substantial allocations to bonds and are considering commercial real estate, private equity, emerging markets equities and alternative assets. Recent announcements by entities such as Japan’s Government Pension Investment Fund (“GPIF”), Norway Sovereign Wealth Fund, and CIC are just the tip of the iceberg in a move out of bonds to other assets with more attractive risk-reward profiles.

Sizable allocations to bonds before and during the crisis has been critical to the shoring up of returns of most pension and sovereign wealth funds. With economic prospects reverting to steady, but relatively modest growth, many large pension and wealth funds are questioning their overweight to bonds and are gradually considering to reverse them. Given low yields in sovereign bonds and other fixed income assets, institutional funds are seeking diversification, current income, yield, inflation/principal protection in the more conservative US and global commercial real estates.