By amendment to long-standing regulations, the Treasury Department has revoked “look-through” treatment under IRC Section 817(h) for investment funds operated as nonregistered partnerships that are not “insurance dedicated.” Consequently, in order for a variable insurance product supported by a nonregistered partnership to have its intended tax deferral attributes, it is now generally necessary for all owners of beneficial interests in the partnership to be either insurance company separate accounts or other entities specified in the regulations (including insurance company general accounts, fund managers, and certain qualified pension or retirement plans).
This change is particularly relevant for hedge funds that support variable insurance products, because most such hedge funds are operated in the form of nonregistered partnerships.
The regulations also provide that, if an insurance company general account or a fund manager owns a beneficial interest in an insurance dedicated partnership, Section 817(h) look-through treatment will be available only if the return on such interests is computed in the same manner as the return on an interest held by an insurance company separate account. Thus, the manner in which the general account’s or the fund manager’s return is computed must be carefully scrutinized to ensure compliance with this requirement. Also, even if none of the interests in the partnership is held by an insurance company general account or by a fund manager, there is a risk that the partnership may still fail to qualify for “look-through” treatment if the partnership credits different returns with respect to different separate account investors. This potential problem arises because the language of the regulations could be read to assume that there will be only one rate of return for any partnership that will qualify for Section 817(h) look-through treatment.