U.S. INVESTMENT INCOME OF U.K. SUPERANNUATION FUNDS IS EXEMPT FROM WITHHOLDING.

Rev. Rul. 88-7

ISSUE

Is income received by local governmental authorities of England, Wales, and Scotland from certain United States investments allocable to their superannuation funds exempt from Federal income taxation under section 892 of the Internal Revenue Code of 1986, and therefore not subject to withholding under sections 1441 or 1442 of the Code?

FACTS

The United Kingdom Superannuation Act of 1972 permits local governmental authorities in England, Wales, and Scotland to establish investment reserves in the form of superannuation funds ("Funds") to provide retirement and other benefits to government employees and certain other employees within their jurisdiction. In England and Wales, such Funds have been established by three types of local governmental authorities:

1. the non-metropolitan county councils established by the Local Government Act 1972;

2. the residuary bodies and district councils that, under sections 60 and 66 of the Local Government Act 1985, assumed responsibility for Funds previously established by the former metropolitan county councils and the Greater London Council; and

3. the inner and outer London Borough Councils established by the Local Government Act 1963.

In Scotland, Funds have been established by the regional councils, the Orkney Islands Council, and the Shetland Islands Council.

The county councils, district councils, residuary bodies, inner and outer borough councils, regional councils, and island councils ("Councils") were established by an act of Parliament. They provide governmental services to inhabitants within their jurisdiction. Upon dissolution, no assets of the Councils vest in any private person. Rather, such assets vest in a successor body designated by Parliament, or in Parliament itself. None of the Councils engages in commercial activities within or outside the United States.

Each Council may provide pension benefits from its Fund or otherwise to its own employees, employees of other United Kingdom governmental bodies, employees of certain educational institutions in the local jurisdictions, and eligible employees of certain bodies that are admitted into the Fund ("admitted bodies"). Admitted bodies are institutions that perform governmental or social services, such as associations for the blind, schools for the deaf, social centers for the elderly, port and harbor commissions, and library systems.

A Council establishes a Fund simply by allocating to a separate account specific assets that thereafter are held for Fund purposes. Each Council is responsible for the administration, collection, and investment of Fund assets and is directly responsible to pensioners for payment of their pensions. Each Council is required to maintain a separate record of all receipts, payments, and earnings allocable to its Fund. The money and assets allocated to a Fund are the property of the Council and may be used as security for the Council's external borrowings. The right to collect contributions from employers and employees, the duty to pay pension benefits, and the obligation to invest or lend surplus moneys allocable to the Fund are rights, duties, and obligations enforceable by and against the Council and not the Fund.

Each Council invests a portion of the assets allocable to its Fund in stocks and securities of United States corporations and receives dividend and interest income with respect to such investments. None of these investments represents an investment in a controlled commercial entity as defined by section 892(a)(1)(B) of the Code, and no amounts are received as rents, royalties, or similar payments. These investments in United States stocks and securities are the sole activities of the Councils in the United States.

LAW AND ANALYSIS

Section 892(a)(1) of the Code excludes from gross income and exempts from income taxation the income of foreign governments received from investments in the United States in stocks, bonds, or other domestic securities owned by such foreign governments; income received from financial instruments held in the execution of governmental financial or monetary policy; and interest on deposits in banks in the United States of moneys belonging to such foreign governments. Section 892(a)(2)(A) provides that this exclusion does not apply to income derived from the conduct of any commercial activity, whether within or outside the United States, or to income received from or by a controlled commercial entity. Sections 1441 and 1442 provide for withholding of tax on payments made to nonresident aliens and foreign corporations that are subject to tax under sections 871(a) and 881(a). Income exempt under section 892 is not subject to withholding under sections 1441 and 1442.

For purposes of section 892 of the Code, a foreign government consists only of integral parts or controlled entities of a foreign sovereign. Section 1.892-1(b)(2) of the Income Tax Regulations provides that an integral part of a foreign sovereign is any person, body of persons, organization, agency, bureau, fund, instrumentality, or other body, however designated, that constitutes a governing authority of a foreign country. Section 1.891-1(b)(5) of the regulations provides that the rules that apply to a foreign sovereign apply to political subdivisions of a foreign country. Under these rules, the Councils are a governing authority of a foreign country for purposes of section 892.

Section 1.892-1(b)(2) of the regulations requires that the net earnings of the governing authority must be credited to its own account or to other accounts of the foreign sovereign, with no portion inuring to the benefit of any private person. The earnings of the Funds are used to provide benefits to both governmental and non- governmental employees. Earnings used to provide retirement benefits to the governmental employees are not considered to inure to the benefit of private persons; see Rev. Rul. 72-183, 1972-1 C.B. 213, which provides that income earned by a retirement fund for employees of the Organization for Economic Cooperation and Development is exempt from tax under section 892 of the Code.

Earnings used to provide retirement benefits to the non- governmental employees -- persons employed by certain local educational institutions and by the admitted bodies -- likewise do not inure to the benefit of private persons. Although the employing entities are not themselves integral parts of the foreign government, their activities are not conducted with a view towards the production of income and are therefore not commercial in nature. Cf. section 1.892-1(c)(1) of the regulations. Therefore, no part of any Fund earnings inures to the benefit of private persons, and income described in section 892(a) of the Code used by the Councils to provide retirement benefits to governmental employees, employees of certain educational institutions, and employees of admitted bodies is exempt under section 892.

The treatment of the Funds differs from that of an independent pension trust for purposes of section 892 of the Code. A pension trust is a separate juridical entity and must qualify as a controlled entity in order for its income to be potentially exempt under section 892. A pension trust will qualify as a controlled entity only if it is established exclusively for employees or former employees of a foreign government. See Rev. Rul. 84-28, 1984-1 C.B. 177.

The Funds established by the Councils provide pension benefits to some non-governmental employees. However, Funds are simply assets of the Councils and are not separate pension trusts. Therefore, the restrictions imposed on pension trusts do not apply.

HOLDING

Income received from investments allocable to the Funds maintained by the Councils is considered to be received by a foreign government within the meaning of section 892 of the Code. Therefore, income described in section 892(a) that is received by the Councils from investments allocable to the Funds is exempt from Federal income taxation under section 892 and is not subject to withholding under sections 1441 or 1442.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 72-183 is amplified. Rev. Rul. 84-28 is distinguished.

DRAFTING INFORMATION

The principal author of this revenue ruling is Phyllis Marcus of the office of the Associate Chief Counsel (International). For further information about the ruling, call Ms. Marcus at (202) 566- 6645 (not a toll-free call).