On April 23, Treasury and the IRS issued proposed regulations interpreting the active insurance exception under the passive foreign investment company (PFIC) rules. Although the release of the proposed regulations did not come as a surprise given the recent media attention that has been focused on the PFIC active insurance exception, those regulations offer a few points that are worthy of further consideration, particularly with respect to the “active conduct” and “insurance business” aspects of the exception. With that in mind, we offer our thoughts on the proposed regulations below.
In order for a non-U.S. insurance company to avoid characterization as a PFIC under IRC § 1297(a), its income must be characterized as derived in the active conduct of an insurance business, and the non-U.S. company must bepredominantly engaged in an insurance business and subject to tax under Subchapter L if it were a U.S. domestic insurance company. See IRC § 1297(b)(2)(B) (commonly referred to as the PFIC active insurance exception).
The Proposed Regulations
The proposed regulations would add the requirements described below to the interpretation of what the “active conduct of an insurance business” means for purposes of the PFIC active insurance exception. Furthermore, the preamble to the proposed regulations discusses satisfaction of the “predominantly engaged” requirement under that exception.
Active Conduct Requirement. In order for the active conduct requirement to be satisfied, the proposed regulations require that a non-U.S. insurance company’sown officers and employees conduct substantial managerial and operational activities for the company. Similar to the active conduct requirement in the 1995 proposed regulations addressing the PFIC active banking exception, see Prop. Treas. Reg. § 1.1296-4(f)(1) (1995), this provision is implemented through a cross-reference to the IRC § 367 temporary regulations (specifically, Temp. Treas. Reg. § 1.367(a)-2T(b)(3)), with an important modification. The new proposed PFIC active insurance exception regulations differ from the 1995 proposed PFIC active banking exception regulations in that they would modify the application of the IRC § 367 temporary regulations to exclude officers and employees of related entities that conduct substantial managerial activity for the company for purposes of determining whether the active conduct requirement has been satisfied. Notably, the exclusion of officers and employees of related entities also differs from the definition provided for “active conduct” in the proposed regulations under IRC § 355 concerning the active trade or business requirement. See Prop. Treas. Reg. § 1.355-3(b)(2)(iii) (2007).
Definition of “Insurance Business.” The proposed regulations define “insurance business” as the issuing of insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies, together with the “administrative services” and “investment activities” of the non-U.S. company that are required to support, or are substantially related to, the insurance and annuity contracts issued or reinsured by the company (Insurance Obligations). Overall, this approach seems to give effect to language in the Joint Committee on Taxation’s Blue Book for the Tax Reform Act of 1986, which suggests that the PFIC active insurance exception effectively can cover only a portion of the company’s income. However, the approach that the proposed regulations take to limiting “insurance business” does not appear to account for things like assets held for growth of a company’s insurance / reinsurance business or a company’s receipt of fee income from the use of its investment management expertise as part of its overall business model, which is not an uncommon occurrence in the insurance industry today.
Satisfaction of Predominantly Engaged Requirement. The preamble to the proposed regulations also considers the predominantly engaged requirement and indicates that the current codified definition of “insurance company” in IRC §§ 816(a) and 831(c) is more strict than the predominantly engaged test and, thus, any company that would be taxable under Subchapter L also will satisfy the predominantly engaged requirement. Stated differently, the preamble to the proposed regulations recognizes that any company taxable under Subchapter L as an insurance company is necessarily predominantly engaged in an insurance business for purposes of the PFIC active insurance exception.
Effective Date. The proposed regulations will apply on the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.
Request for Comments. The proposed regulations provide for a 90-day comment period and specifically request comments with respect to appropriate methodologies to determine the extent to which assets are held to meet Insurance Obligations.