The Internal Revenue Service late last week issued proposed regulations addressing what constitutes the “active conduct of an insurance business” for purposes of the passive foreign investment company (“PFIC”) rules. These regulations were issued in part in response to the perceived problem of hedge funds using offshore reinsurance companies to defer U.S. taxation of investment income earned on hedge fund investments. 

U.S. shareholders in a PFIC generally are currently taxable on the “passive income” it earns, regardless of whether such income is distributed (unless they opt to pay an interest charge penalty). Passive income for this purpose, however, generally does not include income derived from the “active conduct of an insurance business.” Existing authorities and guidance do not provide a precise definition of the active conduct of an insurance business for this purpose. 

Reliance on this “active conduct” exception by hedge funds and other taxpayers has attracted significant attention recently. In a typical transaction, a hedge fund (or hedge fund investors) establishes an offshore reinsurance company which invests in the fund. Investment earnings of the reinsurer attributable to its investment in the fund are treated as earned in the active conduct of the reinsurer’s insurance business, and thus as exempt from the PFIC rules. 

The proposed regulations contain two definitions which are intended to ensure that this active conduct exception is limited to appropriate circumstances: (1) the meaning of the “active conduct” of an insurance business, and (2) the meaning of the term “insurance business.” Generally, the regulations require the insurer or reinsurer to have its own officers and employees carrying out substantial managerial and operational activities. The regulations also limit the “active conduct” exception to income earned on assets held to meet insurance obligations (thus potentially eliminating the benefit of this treatment for excessive investment assets), although they reserve on determining how to best quantify this, instead requesting comments on this issue. 

Although the proposed regulations will not be effective until the date they are finalized, offshore insurers and reinsurers with U.S. shareholders that rely on the “active conduct” exception to the application of the PFIC rules should evaluate their business operations to ensure they can comply with the standard set forth in the regulations.