Senator Ron Wyden (D-OR) has released legislation, the Offshore Reinsurance Tax Fairness Act (ORTFA), which aims to close what he perceives to be a loophole used to exploit an exception to the passive foreign investment company or PFIC tax rules.
The PFIC rules are intended to eliminate the deferral benefit of earning passive income through offshore vehicles by taxing any gain on the sale of share in such entity at the highest ordinary income tax rates and imposing an interest charge on any deferred tax liabilities. The ORTFA seeks to clarify and limit the definition of what qualifies as an insurance or reinsurance vehicle for purposes of the PFIC exception that is afforded to such companies, which otherwise allows an active insurance or reinsurance entity to classify its income as active for purposes of the PFIC income and asset tests.
The ORTFA, if enacted in its current form, would have a material impact on fund-sponsored insurance entities, and would also likely ensnare many non-fund sponsored vehicles. There have been a number of similar proposals in the international tax area the last few years and to date none have been enacted. It is impossible to predict whether this (or, indeed, any other tax-oriented legislation) will be enacted and what a potential effective date would be. But it is prudent to be aware of this development and the larger implications of the trend for PFICs.
A foreign corporation is a PFIC if either 75 percent or more of its gross income for the taxable year is passive income (the passive income test), or, on average, 50 percent or more of its assets produce passive income or are held for the production of passive income (the passive asset test). However, passive income does not include any income that is derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business and which would be subject to tax as an insurance company under US federal tax law if the corporation were a domestic corporation.
Previously, Senator Wyden noted that the Treasury and the IRS had done little to enforce the 2003 Notice against individuals using investments in purported offshore insurance companies to defer recognition of ordinary income or convert the character to capital gain. On April 23, 2015, the IRS and Treasury Department released proposed Treasury Regulations (providing, among other things, that a foreign insurance company is generally not engaged in the “active conduct” of an insurance business − which includes both underwriting and investment activities − unless it conducts substantial managerial and operational functions through its own employees and not through employees of independent contractors, or even employees of affiliates.) The proposed regulations also provide that investment income is not earned in an “insurance business” unless that income is earned from assets held by the foreign corporation to meet obligations under the insurance company’s insurance, annuity or reinsurance contracts, but do not specify further how such obligations may be quantified. These proposed regulations were released largely as a result of numerous requests by Senator Wyden to address this perceived abuse.
THE ORTFA generally limits the availability of the active insurance company exception to the PFIC rules to “qualifying insurance corporations.” A “qualifying insurance corporation” is any foreign corporation if (a) it would be subject to the US federal income tax rules applicable to domestic insurance and reinsurance companies and (b) the “applicable insurance liabilities” of the company constitute more than 25 percent of its total assets reported on the company’s applicable financial statement for its previous tax year.
- “Applicable insurance liabilities” are (a) loss and loss adjustment expenses and (b) reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance claims with respect to contracts providing coverage for mortality or morbidity risks. “Applicable insurance liabilities” are capped at the lesser of (x) the amount of such liabilities as reported to the applicable insurance regulatory body in the applicable financial statement or (y) the amount determined under applicable law or regulation.
- “Applicable financial statements” are statements for financial reporting purposes that (i) are based on US GAAP, (ii) are based on IFRS (if no US GAAP statement is available), or (iii) are required to be filed annually with the applicable insurance regulatory body, but only if no statement in (i) or (ii) is available.
If a foreign corporation fails to satisfy the 25 percent requirement above, a US person owning stock in such a foreign corporation may elect to treat the stock as stock of a qualifying insurance corporation if (a) the percentage is no less than 10 percent, and (b) based on all the facts and circumstances (i) the foreign corporation is predominantly engaged in an insurance business and (ii) such failure is due solely to temporary circumstances involving such insurance business. This facts and circumstances test would be further defined under new Treasury regulations, which have not been promulgated.
A company whose insurance liabilities constitute less than 10 percent of its assets will be ineligible for the PFIC exception and subject to the PFIC tax regime.
Should it be enacted, the ORTFA has an effective date of December 31, 2015.
Impact and open questions
If enacted in its current form, the ORTFA may hinder a fund’s existing plans to set up such offshore entities; for many investors in such entities, the deferral of income and tax rate conversion are considerations taken into account before making investment decisions. At a minimum, return projections would need to be modified to take account for potential loss of such deferral/rate benefits.
In addition, even for offshore insurers whose structure is not established primarily for the associated tax benefits, the bright-line tests imposed by ORTFA may be problematic; often, insurance liability build up may be slow and may not necessarily move as quickly as asset returns. Therefore, a company could fall below 25 percent easily in its first few years.
Furthermore, the timing for the applicability of these rules may pose problems for existing structures – the PFIC test is made annually, and while such legislation may not have a retroactive effect, an entity may nonetheless be treated as a PFIC in a later year if it does not satisfy applicable thresholds.
Several unanswered questions remain. For instance, it is not clear how the ORTFA would interact with the proposed regulations, if at all, and whether a separate Congressional grant of regulation-making authority would be required to promulgate any regulations under the facts and circumstances test described in the ORTFA. It is also not entirely clear how the PFIC look-through rules would apply to offshore holding companies that own 25 percent or greater interests in such offshore insurance/reinsurance entities (generally, for purposes of determining whether a company is a PFIC under either the income or asset tests, a 25 percent look-through rule applies and treats a foreign corporation as owning a pro rata interest in the income and assets of lower-tier potential PFIC entities in which it owns equity interests).
Given the current status of the proposed regulations and the ORTFA, it would be prudent for existing direct or indirect investors in offshore insurance and/or reinsurance companies to consider (1) making qualified electing fund (or QEF) elections with respect to their direct (or indirect) investments; such election effectively treats the reinsurer as a pass-through entity and any deferral is eliminated or (2) filing a “protective statement” in the first taxable year to which the statement will apply so that a holder is able to make a retroactive QEF election at later time.