After years of inaction, the Internal Revenue Service (IRS) is throwing up obstacles to enjoying the tax advantages of hedge fund-backed reinsurance. On April 24, 2015, the IRS issued a notice of proposed rulemaking titled “Exception From Passive Income for Certain Foreign Insurance Companies” (REG-108214-15). The proposed rules seek to separate truly “active” reinsurance companies from those that allegedly serve merely as vehicles for U.S. hedge fund investors to shelter investment income from taxation.

Normally, an investor in a U.S. hedge fund faces taxation on his or her share of the fund’s gains. These gains can be either short-term (39.6 percent) or long-term (20 percent). Investors might try to set up their hedge funds in a low-tax or no-tax offshore jurisdiction to defer and change the character of taxes on these gains. The tax code makes this strategy unpalatable, however, by treating such foreign vehicles as Passive Foreign Investment Companies (“PFICs”) and taxing their owners’ income accordingly. Taxation of PFIC income is so harsh as to be punitive.

What is a hedge fund investor to do? The tax code contains a carve-out for foreign entities that would otherwise be deemed PFICs if their income is “derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business.” In other words, in spite of the fact that insurance companies earn a great deal of their income from investments, foreign insurers are exempt from being taxed as foreign investment companies.

Seizing on this, since at least 1999, U.S. hedge fund investors have been setting up reinsurance in low-tax and no-tax offshore jurisdictions. These offshore reinsurance companies typically hold unusually large reserves relative to the amount of risk of loss that they reinsure. As a result, their income from investing their reserves dwarfs the income that they earn from premiums. Where do they invest their reserves? In the U.S. hedge funds whose investors set them up. This allows Americans to invest in U.S. hedge funds while enjoying the benefits of offshore operation, including substantial tax advantages.

This arrangement has attracted the IRS’s attention since at least 2001. In that year, the IRS announced that it planned to define “active conduct of an insurance business” more precisely. It failed to do so. In 2003, the IRS again announced that it planned to take action to address hedge fund-backed reinsurance. It did not. For the next decade-plus, the IRS appeared to take no further action until a member of the Senate Finance Committee wrote a letter to the IRS commissioner demanding action. On February 3, 2015, during a budget hearing, the IRS commissioner told senators that the IRS would try to issue guidance on hedge fund-backed reinsurance within 90 days.

True to the commissioner’s word, on April 24, 2015, the IRS issued the previously-mentioned notice of proposed rulemaking titled “Exception From Passive Income for Certain Foreign Insurance Companies” (REG-108214-15). The notice starts by announcing that the Treasury Department and the IRS “are aware of situations in which a hedge fund establishes a purported foreign reinsurance company in order to defer and reduce the tax that otherwise would be due with respect to investment income.”

In the notice, the IRS acknowledges that the tax code exempts from PFIC treatment foreign entities that would otherwise be deemed PFICs if their income is “derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business.” The terms ‘‘active conduct,’’ ‘‘insurance business,” and “predominantly engaged” all have the potential to create challenges for hedge fund-backed reinsurance companies.

First, the proposed regulations borrow the definition of “active conduct” from existing regulations, which provide that “a corporation actively conducts a trade or business only if the officers and employees of the corporation carry out substantial managerial and operational activities.” A hedge fund-backed reinsurer’s officers and employees presumably already carry out these activities. The proposed regulations add a crucial and potentially challenging requirement, namely that a reinsurer cannot count the officers and employees of related entities (e.g., the hedge fund). This suggests that the reinsurer must have dedicated officers and employees who carry out substantial managerial and operational activities. Reinsurers who borrow officers and employees from related entities will have to change their practices.

Second, the proposed regulations define ‘‘insurance business’’ as “the business activity of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies, together with investment activities and administrative services that are required to support or are substantially related to insurance contracts issued or reinsured by the foreign insurance company.” Hedge fund-backed reinsurance companies clearly engage in the business activity of reinsuring risks underwritten by insurance companies. The nub of the matter is whether hedge fund-backed reinsurers’ large investment reserves are “substantially related to insurance contracts” that the company reinsures. In other words, reinsurers can avoid devastating PFIC treatment only if their income is “earned from assets held by the [reinsurer] to meet obligations under the [reinsurance] contracts.” The proposed regulations do not yet provide a means for determining whether reinsurance companies’ assets are truly held to meet reinsurance obligations or are merely held to generate investment income from investing in U.S. hedge funds.

Third, the proposed regulations do not define “predominantly engaged,” but the explanatory preface to the proposed regulations states that the IRS will fall back on the existing definition of “insurance company” in the tax code for guidance. For a company to be treated as an insurance company under the existing definition, “more than half of its business during the taxable year is required to be the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.” The preface states that the more-than-half standard is “stricter and more precise” than the predominantly engaged standard, meaning that any company that qualifies as an insurance company under existing regulations necessarily satisfies the predominantly engaged standard.

The question is whether a hedge fund-backed reinsurance company whose investment income dwarfs its premium income is even an insurance company. If 90 percent of its income comes from investing in a hedge fund, is more than half of its business the reinsuring of risks underwritten by insurance companies? If the investment income is derived from reserves that are substantially related to insurance contracts, perhaps the answer is yes.

Hedge fund investors who have set up or are considering setting up offshore reinsurance companies would do well to monitor these developments. The deadline for comments to the proposed regulations is July 23, 2015.