The U.S. Internal Revenue Service (IRS) and U.S. Department of Treasury (Treasury) recently proposed new rules potentially affecting the classification of non-U.S. insurance and reinsurance companies (including certain captive arrangements) as passive foreign investment companies (PFICs). Non-U.S. insurers and reinsurers that intend to avoid PFIC status (and the application of onerous PFIC tax consequences to shareholders that are U.S. taxpayers) should consider the following:
- Greater apparent focus by IRS and Treasury on the requirement that a non-U.S. insurer or reinsurer meet the test under the Internal Revenue Code to file as an insurance company if it were a U.S. corporation.
- A non-U.S. insurer or reinsurer that utilizes a service or management company, including an affiliated entity, to perform core management or operational functions may be required to reorganize such that some or all of these functions will be housed at the insurer or reinsurer level.
- Final rules may contain a bright line reserve-to-assets test or similar metric as a proxy for determining whether sufficient insurance (as opposed to investment) activities occur for purposes of avoiding PFIC classification.
The IRS has requested public comment on the proposed rules and the deadline for submitting comments is July 23, 2015. It is unclear as of the date of this alert whether the IRS will schedule a public hearing on the proposed regulations.
Foreign Insurers Must Meet Definition of "Insurance Company" Under Subchapter L Requirements to Avoid PFIC Classification1
The Internal Revenue Code (the Code) prescribes special rules applicable to foreign corporations that are PFICs. In general, with respect to each tax year, a foreign corporation is a PFIC if 75% or more of its income for such year is passive (e.g., investment income such as dividends, interest, and capital gains derived from a portfolio of stocks, debt securities, and derivatives) or 50% or more of the fair market value of its assets (based on a quarterly average) produce or are held for the production of passive income.2 The rules relating to the taxation of shareholders of a PFIC are complex, but in general, a PFIC’s U.S. shareholders are (i) not eligible for the reduced tax rate on qualified dividends, (ii) taxed at ordinary income rates rather than capital gains rates upon disposition of stock in the PFIC and may be subject to an interest charge, and (iii) subject to additional tax reporting requirements.
Specifically excluded as passive is income derived from the “active conduct” of an insurance business by a corporation that is “predominantly engaged” in an insurance business. Concerns have emerged in Congress in recent years that some licensed foreign insurers were acting predominantly as investment vehicles for hedge funds not actively engaged in the business of insurance underwriting. As a result, certain members of Congress pressured the IRS and Treasury to link the PFIC exemption for active foreign insurers to certain requirements of Subchapter L of the Code (governing the U.S. federal income taxation of U.S. insurance companies).
Responding to these concerns, the proposed PFIC regulations exclude from the definition of passive income “income earned by a foreign corporation that would be subject to tax under Subchapter L of the Code if it were a domestic corporation, but only to the extent the income is derived in the active conduct of an insurance business.”3 Although the proposed regulations do not define what it means to be “predominantly engaged” in an insurance business, the preamble to the proposed regulations clarifies that any company taxable under Subchapter L of the Code as an insurance company is necessarily predominantly engaged in an insurance business.4
Active Conduct of an Insurance Business
The proposed regulations require that income be derived from the active conduct of an insurance business.5“Active conduct” requires a facts-and-circumstances analysis, but as a necessary condition, officers and employees of the company (not those of an affiliate or third-party service or management company) must carry out substantial managerial and operational activities in connection with the insurance business.
The requirement that insurance business functions be carried out by officers and employees of the insurance company may be problematic for foreign insurers that use service or management companies to conduct management or operational functions. The potential impact of these proposed rules upon customary arrangements between insurers and investment managers that are authorized to manage the insurer’s investment portfolio, and upon administrative services arrangements between insurers and their affiliates, is unclear.
Bright-Line Rule and Open Questions
The proposed rules leave open for now the specific test or method to be used to determine the portion of a foreign insurer’s assets that are held to meet obligations under insurance and annuity contracts. The IRS has requested comments from the public on the ratio of reserves to assets that is appropriate for a foreign insurer’s assets to be considered as being held to meet obligations under insurance or annuity contracts issued or reinsured by the corporation.
In proposals anticipating the proposed regulations, several ratios have been suggested, from a high 35% minimum reserves-to-assets level suggested by a U.S. legislator, to the lower 15% suggested by an industry association.
The public comment period is open until July 23, 2015; this presents an opportunity for foreign insurers, and other interested stakeholders, to provide input on these proposed regulations. Foreign insurers also should be aware that they may need to update PFIC tax disclosures and risk factors in their future public filings and other offering documents, as well as the underlying analyses, to reflect the proposed regulations (and eventually the final guidance).