On April 23, 2015, the Treasury Department (Treasury) and Internal Revenue Service (IRS) issued proposed regulations on the application of the passive foreign investment company (PFIC) rules of Internal Revenue Code Section 1297 to foreign companies engaged in insurance activities. Specifically, the guidance addresses whether a foreign company's income is income derived in the active conduct of an insurance business under an exception in Code Section 1297(b)(2)(B) (the PFIC active insurance exception). Income that is derived from the active conduct of an insurance business is not considered passive income for purposes of determining if the company is a PFIC. To qualify for the PFIC active insurance exception, the proposed regulations require that passive income from investment activities be earned from assets held to meet obligations under insurance or annuity contracts issued or reinsured by the foreign corporation. However, the guidance does not yet address the controversial question of how to determine whether assets are held to meet obligations under insurance and annuity contracts. IRS and Treasury have requested comments on appropriate methodologies. The proposed regulations (Prop. Reg. § 1.1297-4) will be effective on the date they are published as final regulations.
Under Code Section 1297, a foreign corporation is a PFIC for the taxable year (subjecting U.S. shareholders in the corporation to current taxation, or its economic equivalent, on their share of the company's passive income) if either 75 percent or more of the foreign corporation's gross income for the taxable year is passive income or on average 50 percent or more of its assets produce passive income or are held for the production of passive income. Passive income is income of a kind that would be "foreign personal holding company income" under Code Section 954(c), including dividends, interest, and capital gain. Assets that generate both passive and non-passive income during the year are treated as partly passive and partly non-passive, in proportion to the relative amounts of income generated by those assets in that year.
Code Section 1297(b)(2)(B) provides that, except as provided in regulations, the term passive income does not include any income that is derived in the active conduct of an insurance business by a corporation which is (1) predominantly engaged in an insurance business and (2) would be subject to tax under subchapter L as an insurance company if the corporation were a domestic corporation. The current test for taxation as an insurance company under subchapter L requires that more than half of the company's business during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. See Code Sections 816(a) and 831(c). The test is a facts and circumstances test that takes into consideration a number of factors, including the relative number of employees assigned to, the amount of space allocated to, and the net income derived from, the various business activities of the company.
Scrutiny by IRS and Congress
Over a decade ago, the IRS alerted taxpayers in Notice 2003-34 that some foreign corporations purporting to be insurance companies will not qualify for the PFIC active insurance exception because they either would not constitute insurance companies for federal tax purposes or their income would not be considered to be derived in the active conduct of an insurance business. The notice specifically addressed foreign corporations organized to invest in hedge funds or in investments that are invested in by hedge funds seeking to avoid PFIC status. The IRS expressed concern that a foreign corporation with insignificant insurance activities compared to investment activities may not be an insurance company because the primary use of such corporation's capital and efforts is in investing, rather than in the insurance business.
In the last few years, tax reform proposals by former Senate Finance Committee Chairman Max Baucus and Former House Ways and Means Committee Chairman Dave Camp both included changes to the active insurance exception that would narrow the application of the PFIC active insurance exception. Additionally, Ranking Member Ron Wyden called on the IRS and Treasury, including in a June 2014 letter and February 2015 Senate Finance Committee hearing, to issue regulations to prevent hedge funds from exploiting the PFIC active insurance exception.
Proposed Regulations and Observations
The proposed regulations provide that passive income does not include income earned by a foreign corporation that would be subject to tax under subchapter L if it were a domestic corporation, but only to the extent the income is derived in the active conduct of an insurance business. See Prop. Reg. § 1.1297-4(a).
The proposed regulations do not include a reference to the requirement in Code Section 1297(b)(2)(B) that a corporation also be "predominantly engaged" in an insurance business to avail itself of the PFIC active insurance exception. The Preamble to the proposed regulations explains that because the current subchapter L rules require that more than half of a company's business activities be insurance activities, a company that would be subject to tax under subchapter L will necessarily be "predominantly engaged" in an insurance business for purposes of Code Section 1297(b)(2)(B). This clarification is helpful.
The proposed regulations define the term "active conduct" as having the same meaning as in Treas. Reg. § 1.367(a)-2T(b), with one modification. Treas. Reg. § 1.367(a)-2T(b) employs a facts and circumstances test to determine whether a foreign corporation is engaged in “the active conduct of a trade or business outside of the United States” for purposes of applying Code Section 367. Section 367(a)(1) denies the benefits of various corporate non-recognition rules when a U.S. person transfers property to a foreign corporation, but the transfer is usually exempted from Section 367(a)(1) if the property is to be used by the corporation in the active conduct of a trade or business outside the U.S. Treas. Reg. § 1.367(a)-2T(b) provides that the officers and employees of a corporation must carry out "substantial managerial and operational activities" for the corporation to be engaged in the active conduct of a trade or business. Incidental activities of the trade or business may be carried out on behalf of the corporation by independent contractors, but those activities are disregarded in determining whether the officers and employees carry out substantial managerial and operational activities. Treas. Reg. § 1.367(a)-2T(b) also provides that officers and employees of related entities are considered officers and employees of the foreign corporation being tested if certain requirements are met. Under the proposed PFIC regulations, however, officers and employees of related entities are not considered officers and employees of the foreign corporation being tested. The Preamble to the proposed regulation provides no explanation regarding why the term is defined by reference to the temporary regulations under Code Section 367, or why the test under those regulations has been modified to exclude the activities of related entities. This definition may adversely impact traditional insurance and reinsurance companies that rely on affiliated or third-party insurance or investment managers if adopted in final regulation.
The term "insurance business" is defined by the proposed regulations as the business of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies, together with those investment activities and administrative services that are required to support or are substantially related to insurance and annuity contracts issued or reinsured by the foreign corporation. For this purpose, investment activities are defined as any activity engaged in by the foreign corporation to produce income of a kind that would be foreign personal holding company income as defined in Code Section 954(c).
This definition of insurance business is consistent with the general understanding that investment activities are a central and integral part of an insurance business, but seeks to limit the extent to which investments activities are considered part of the insurance business. The proposed regulations clarify that investment activities are required to support or are substantially related to insurance and annuity contracts issued or reinsured by the foreign corporation to the extent that income from the activities is earned from assets held to meet obligations under the contracts. However, the proposed regulations do not address the controversial question of how to determine the extent to which assets are held to meet obligations under insurance and annuity contracts.
The Preamble describes one possible method for making this determination. The method would consider assets to be held to meet insurance obligations to the extent the corporation's assets in the calendar year do not exceed a specified percentage of the corporation's total insurance liabilities for the year. The Preamble suggests that the total insurance liabilities for the year could be determined by looking to the company's statutory reserves and other reserves required by law (established by reference to Code Sections 816(c) and 807(c)(3) through (6)). The Preamble requests comments regarding the appropriate percentage to use in applying such a test, as well as comments regarding whether other methods would be more appropriate to determine the portion of assets held to meet insurance obligations. As a point of reference, the legislative proposals from Camp and Baucus included tests comparing insurance liabilities to assets (e.g., the company's insurance liabilities, including reserves, must be greater than 35 percent of its total assets), as well as premiums-based tests (e.g., more than 50 percent of the company's gross receipts for the taxable year must consist of premiums).
Regarding the method suggested in the Preamble, a bright-line rule based on reserves could prove difficult to apply due to the varied requirements of local (i.e., foreign) law, as well as the lack of U.S. federal income tax return or reporting obligations for many of the foreign corporations claiming the benefits of the PFIC active insurance exception. Additionally, use of a bright-line rule based on reserves is potentially problematic because there are a multitude of reasons that reserve requirements in any given year may not provide the full picture of the capital needed to support insurance activities. For instance, ratings agencies may require additional capital to be held depending on the nature of the risks insured or the types of investment assets. Also, reserve requirements may not be in-line with capital needs if the company is starting up or winding down. Similarly, there are problems with a test based on annual gross receipts (as suggested in the Baucus and Camp proposals), since some insurance companies may need investments to support insurance contracts written in prior years, even if the current year premiums are low. As commentators have pointed out repeatedly over the last year, it is difficult to identify a bright-line rule that would prevent only the type of foreign corporations that have been the target of scrutiny by the IRS and Congress from availing themselves of the PFIC active insurance exception, without inadvertently penalizing legitimate insurance companies that should be permitted to qualify for the exception.
The proposed regulations seem poised to have broad application to offshore companies engaged in insurance and reinsurance activities. Stakeholders in these companies should be considering the effect the regulations could have on the characterization of insurance-related investment activities of offshore corporations under the PFIC rules and the PFIC status of those corporations.
Comments on the proposed regulations and requests for public hearing are due July 23, 2015.