Traditionally, there have been many benefits to organizing reinsurance companies outside of the US, Bermuda, Ireland and Puerto Rico being preferred locations. If such reinsurance companies followed certain operating guidelines, they were not treated as engaged in the US trade or business and were not subject to tax in the US (federal or state) on a net income basis. If such companies managed to avoid being treated as passive foreign investment companies (PFICs) or controlled foreign corporations (CFCs), their shareholders would not have current income inclusions either. Thus, because an insurance company's yield is largely based on investment of the reserves (reduced by payment of claims), investment advisors could offer US investors deferral of tax and exit from their interests at favorable capital gain rates.

In general, a non-US corporation will be a PFIC during a given year if 75 percent or more of its gross income constitutes "passive income" or 50 percent or more of its assets produce (or are held for the production of) passive income. In an insurance context, the issue is whether the reserves are investment or trade or business assets. A CFC is a foreign corporation more than 50 percent of the vote or value of the stock of which is owned by "United States Shareholders." A United States Shareholder is generally a shareholder of a foreign corporation that owns 10 percent or more of the vote or value of the stock of the foreign corporation, determined by taking into account complicated constructive ownership rules. In order to secure the deferral and capital gain tax benefits, the company needs to have a sufficient lack of US person concentrated ownership not to be a CFC, which is generally doable.

Summary of new regulations

On July 10, 2019, the US Internal Revenue Service and Department of the Treasury released proposed regulations relating to certain PFIC issues that replace a set of proposed regulations issued in April 2015. Among other changes, proposed regulations provide guidance relating to changes in the PFIC regime made by the 2017 Tax Cuts and Jobs Act (TCJA), including proposed rules for determining whether a foreign insurance company is a "qualifying insurance corporation"; (QIC) and new rules relating to the determination of the "active conduct" test.

General requirements for PFIC insurance income exception

PFIC rules, as modified by the TCJA, contain an exception to the definition of passive income for income derived by a QIC in the "active conduct" of an "insurance business." Generally, Section 1297(f) of the Internal Revenue Code of 1986, as amended (the "Code") provides that a QIC is a foreign corporation that (1) would be subject to tax under subchapter L if it were a domestic corporation and (2) has applicable insurance liabilities that constitute more than 25 percent of its total assets (the "25 Percent Test").

Proposed regulations define foreign corporations eligible for QIC status by reference to Code Section 816(a), which restricts QICs to only those foreign corporations more than half of the business of which during the taxable year is the issuing of insurance, annuity contracts, or the reinsuring of risks underwritten by insurance companies.

25 Percent Test and the Alternative Test

To qualify as a QIC, a foreign corporation also must meet the 25 Percent Test, which requires that the company's applicable insurance liabilities must exceed 25 percent of its total assets.

Under the proposed regulations, the determination is made based on the assets and liabilities as reported in the applicable financial statement for the last year ending with or within the taxable year, and the amount of applicable insurance liabilities may not exceed the lesser of (1) the amount shown on the most recent applicable financial statement; (2) the minimum amount required by applicable law or regulation of the jurisdiction of the applicable insurance regulatory body; and (3) the amount shown on the most recent financial statement made on the basis of US GAAP or IFRS if such financial statement was not prepared for financial reporting purposes.

If a foreign insurance company fails to meet the 25 Percent Test, it may qualify for the alternative test, which requires that a foreign corporation be "predominantly engaged in insurance business," and its applicable liabilities constitute 10 percent or more of its total assets. To be eligible for the alternative test, a foreign corporation must show that the failure to meet the 25 Percent Test was solely due to runoff-related or rating-related circumstances involving its insurance business. In order to utilize the exception, however, an election must be made by the US person who would be subject to the PFIC consequences and who owns stock in the insurance company.

Definition of insurance business

Proposed regulations §1.1297-5(c)(2) defines an insurance business as the business of issuing insurance and annuity contracts or reinsuring risks underwritten by other insurance companies (or both). Under the proposed regulations, an insurance business also includes the investment activities and administrative services required to support (or that are substantially related to) those insurance, annuity, or reinsurance contracts issued or entered into by the QIC.

Definition of active conduct of insurance business

The proposed regulations provide that the determination of whether a foreign corporation is engaged in "active conduct" of insurance business should be based on all of the facts and circumstances. In general, a QIC actively conducts an insurance business only if the officers and employees of the QIC carry out substantial managerial and operational activities, but for this purpose such persons include officers and employees of another entity in the same control group as the QIC.

Control for this purpose requires either (1) direct or indirect ownership by the QIC of more than 50 percent by vote and by value of the entity whose officers and employees provide the services; or (2) more than 80 percent direct or indirect ownership (by vote and value) by a common parent of both the QIC and the entity whose officers and employees provide the services.

In addition, the QIC must exercise regular oversight and supervision over the services and pay the compensation of the officers and employees providing the services, reimburse the service-providing entity for such compensation, or otherwise pay arm's length compensation for such services.

Further, the expenses related to the payment of the officers and employees providing the substantial managerial and operational activity (and that are related to the production or acquisition of premiums and investment income on assets held to meet obligations under the insurance, annuity, or reinsurance contracts issued or entered into by the QIC ("production or acquisition expenses")) must equal or exceed 50 percent of all production or acquisition expenses for the taxable year (not taking into account ceding commissions) (the "Active Conduct Percentage Test").

If a QIC meets the Active Conduct Percentage Test, all of its passive income will be eligible for the PFIC insurance income exception. However, if a company fails to meet the Active Conduct Percentage Test, all of its income is treated as passive income. Thus, the proposed regulations provide a bright-line test for determining whether a QIC is engaged in an active conduct of insurance business. In practice, companies with a large book of business heavily relying on the services of independent investment advisors might find it difficult to meet the Active Conduct Percentage Test.

Applicability dates

Generally, the proposed regulations will apply on or after the date of publication of the final regulations. However, until finalization, United States persons that are shareholders in certain foreign corporations may apply the rules of §§1.1297-4 (defining QIC) and 1.1297-5 (describing PFIC insurance income exception) for taxable years beginning after December 31, 2017, provided those United States persons consistently apply the rules of §§1.1297-4 and 1.1297-5 as if they were final regulations. In addition, taxpayers may continue to rely on Notice 88-22 until these regulations are finalized.


Even though the new proposed regulations may present additional compliance issues for foreign reinsurance companies, there are planning opportunities that should be explored. In general, foreign reinsurance companies should review their operations to confirm they meet the new standards of being engaged in the active conduct of insurance business and implement the changes that would allow them to continue using the insurance income exception to PFIC passive income rules.