On July 11, 2019, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued comprehensive proposed regulations on passive foreign investment companies (PFICs) that include guidance on the recently revised insurance exception to the PFIC rules. The proposed regulations specifically request comments on many of the provisions, and comments are due by September 9, 2019.
Notably, with respect to insurance companies, the proposed regulations provide:
An updated definition of active conduct;
Treatment of US insurance company income and assets as non-passive, in most cases;
A limiting definition of the statutory term “losses” and the use of new undefined terminology, i.e., occurred losses;
Limited guidance on the use of the alternative facts and circumstances test for “qualifying insurance corporations;”
Coordination rules for sections 1297(c) and 1298(b)(7) of the Code1; and
Different treatment for active banking income under Code section 954(h) and for active insurance income under Code section 954(i) for purposes of determining passive income.
PFIC Definition and the Insurance Exception
In general, a non-US corporation will be a PFIC during a given year if: (1) 75% or more of its gross income constitutes “passive income;” or (2) 50% or more of its assets produce (or are held for the production of) passive income. For the above purposes, passive income is income characterized as foreign personal holding company income as defined under Code section 954(c), which generally includes interest, dividends, annuities, certain royalties and rents, and other investment income. Under this definition, almost all non-US insurance companies would be characterized as PFICs absent an exception.
The exception to the PFIC rules for insurance companies as modified by the 2017 tax reform provisions, commonly referred to as the Tax Cuts and Jobs Act, requires that an insurance company be characterized as a qualifying insurance corporation and that its income be derived in the active conduct of an insurance business.
In order to be a qualifying insurance corporation (QIC) for a taxable year, the following requirements must be met: (1) the corporation would be subject to tax under subchapter L if it were a US domestic corporation; and (2) its “applicable insurance liabilities” as reported on the corporation’s “applicable financial statements” constitute more than 25% of its total assets (or meet an alternative facts and circumstances test). For these purposes, “applicable insurance liabilities” include: loss and loss adjustment expenses and reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance risks.
The alternate facts and circumstances test allows a corporation that does not meet the 25%-test to otherwise qualify for the exception if: (1) the corporation is predominantly engaged in an insurance business; (2) at least 10% of its total assets comprise “applicable insurance liabilities;” and (3) the reason for the failure to meet the 25%-test is solely due to run-off or ratings-related circumstances. 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.
The 2015 Proposed Regulations and Active Conduct
In 2015, Treasury issued proposed regulations on the then existing insurance exception to the PFIC rules, which was substantially the same as the new exception, but did not include the QIC requirement. The industry submitted numerous comments to Treasury with respect to these proposed regulations, including with respect to the definition of “an active insurance business.”
The 2015 proposed regulations required that an insurance company’s officers and employees conduct the operations and management of the company in order to be considered in the active conduct of an insurance business and not be considered a PFIC. The industry commented that management companies were typically used throughout the industry and that, accordingly, it was inappropriate to require an insurance company’s business to be conducted by its own officers and employees in order to meet the “active” requirement.
Highlights of the 2019 Proposed Regulations and the Insurance Company Exception
The proposed regulations section 1.1297-5(c)(3) modifies the definition of active conduct of an insurance business from the definition provided in the 2015 proposed regulations and provide that active conduct is based on a facts and circumstances analysis. However, the proposed regulations further require that a QIC’s officers and employees carry out substantial managerial and operational activity, 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% by vote and by value of the entity whose officers and employees provide the services; or (2) more than 80% 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 or reimburse the service-providing entity for such compensation.
Further, in order for the QIC’s income to be characterized as derived in the active conduct of an insurance business, 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% of all production or acquisition expenses for the taxable year (not taking into account ceding commissions).
Eversheds Sutherland Observation: For a company with a large book of business and a corresponding large pool of assets that utilizes the services of investment advisors, among others, it may be difficult to meet this 50% requirement.
US Domestic Insurance Companies
The proposed regulations section 1.1297-5(b) and (d) generally provide that the income and assets of a US domestic insurance company subject to tax under subchapter L will be treated as non-passive for purposes of the PFIC rules. There is, however, an exception to this treatment for purposes of Code section 1298(a)(2) (which is the rule that applies to determine if a US person is deemed to own shares in a lower tier PFIC).
Applicable Insurance Liabilities
The proposed regulations provide that “applicable insurance liabilities” for P&C companies include only occurred losses and unpaid expenses of investigating and adjusting unpaid losses. In contrast, the relevant statutory provisions provide that “applicable insurance liabilities” include loss and loss adjustment expenses. The proposed regulations do not provide reasoning for the limiting language or a definition of the new language.
Occurred losses are described as those losses for which a company “has become liable but has not paid” by the end of the accounting period, and include unpaid claims for death benefits, annuity contracts, and health insurance benefits. This inclusion appears duplicative of the provision that allows for “[t]he aggregate amount of reserves (excluding deficiency, contingency, or unearned premium reserves) held for future, unaccrued health insurance claims and claims with respect to contracts providing coverage for mortality or morbidity risks, including annuity benefits” to be characterized as applicable insurance liabilities. The relevant statutory provisions require a company’s applicable insurance liabilities to be as stated on the company’s applicable financial statements and also provide limitations on the amount of applicable insurance liabilities to the lesser of what is reported on such financial statements or is required by law. Presumably, this provision was included to simplify any information gathering required to determine QIC status; the adoption of a rule that requires review beyond the face of a company’s financial statements appears at odds with this statutory goal.
Eversheds Sutherland Observation: The use of the terminology occurred losses raises a number of questions, including:
- Why are unpaid expenses related to paid losses excluded?
- Why did Treasury adopt new terminology not defined in the Code or in the proposed regulations?
- How does Treasury intend to handle that occurred losses are likely not reported as such on financial statements and are not required by law?
- What does “has become liable” mean?
As mentioned above, the proposed regulations provide a cap on the amount of an insurance company’s applicable insurance liabilities at the lesser of: (1) the amount reported on a GAAP or IFRS statement (whether prepared for financial reporting or not); or (2) the minimum amount required by applicable law in the company’s regulatory jurisdiction. If GAAP or IFRS is not used to prepare a company’s financial statements and the method used does not discount unpaid losses on an economically reasonable basis, the amount of such company’s applicable insurance liabilities will be limited to an amount reduced by a discounting standard commensurate with such standard applied in the context of GAAP or IFRS.
The proposed regulations also provide some guidance on financial statements. There is a prohibition on moving from a GAAP or IFRS financial reporting standard to another standard unless a non-tax business reason is present. For the purposes of the QIC test, total assets are those assets shown on the end of period applicable financial statement for the last accounting period ending with or within the taxable year.
Alternative Facts and Circumstances Test and Election
The proposed regulations section 1.1297-4(d) provides rules for the alternative facts and circumstances test and election. The industry had submitted numerous comments to Treasury with respect to this test and the election.
Comments included requests that: (1) the election be made by a US person with respect to the holding company of an insurance company group instead of with respect to each individual insurance company in the group; (2) an election be deemed made by small shareholders and public shareholders; (3) the election be available to a US person if the relevant insurance company provides certain public statements; and (4) rating related circumstances be interpreted broadly and be tied to an individual company’s rating.
The proposed regulations allow a US person with either direct or indirect ownership to make the election, but they do not allow the election to be made at the holding company level and require that the election be made for each QIC in a group. They also do not provide any special provision for small or public shareholders, unlike what is available in the context of a qualified electing fund (QEF) election, although they do ask for comments in this regard. The proposed regulations also permit the election to be made based on information made available publicly by an insurance company.
Rating Related Circumstances
With respect to rating related circumstances, the proposed regulations provide:
A foreign corporation fails to satisfy the 25-percent test solely due to rating-related circumstances only if--
(1) The 25-percent test is not met as a result of the specific requirements with respect to capital and surplus that a generally recognized credit rating agency imposes; and
(2) The foreign corporation complies with the requirements of the credit rating agency in order to maintain the minimum credit rating required for the foreign corporation to be classified as secure to write new insurance business for the current year.
The proposed regulations adopt a broad definition of credit rating agency (i.e., generally recognized credit rating agency), but are not very clear about: (1) the level of rating applicable to an individual company; (2) what is meant by “secure;” and (3) whether new business refers to any business or just the business that the company has written or wants to write.
With respect to the requirement for an insurance company that utilizes the alternative test to be predominantly engaged in an insurance business, the proposed regulations provide that:
A foreign corporation is predominantly engaged in an insurance business in any taxable year during which more than half of the business of the foreign corporation is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. This determination is made based on whether the particular facts and circumstances of the foreign corporation are comparable to commercial insurance arrangements providing similar lines of coverage to unrelated parties in arm’s length transactions.
The proposed regulations specify facts that indicate that an insurance company is/is not predominantly engaged in an insurance business. These facts generally follow the legislative history of the enactment of the QIC rules and include “a small overall number of insured risks with low likelihood but large potential costs” as a bad fact.
Coordination rules for sections 1297(c) and 1298(b)(7)
Proposed regulation section 1.1297-2(b)(2)(iii) provides that so long as the stock of a US domestic corporation is treated as a non-passive asset that produces non-passive income under Code section 1298(b)(7), the look through rule of Code section 1297(c) will not be applicable. This position is consistent with the position the IRS has taken in a few rulings that it has issued. In order for Code section 1298(b)(7) to apply, a non-US corporation must be subject to the accumulated earnings tax provisions under Code section 531.
Foreign Personal Holding Company Income
Proposed regulation section 1.1297-1(c) makes clear that passive income for purposes of determining whether a non-US corporation is a PFIC does not include income excepted from the definition of foreign personal holding company income under Code sections 954(c)(2)(A) (active rents and royalties), 954(c)(2)(B) (export financing), 954(c)(2)(C) (dealers), and 954(h) (active banking and, financing), but does include income excepted under Code sections 954(c)(3) (income from related persons) and 954(i) (active insurance). The preamble to the proposed regulations describes why these last two exceptions were treated differently and with respect to the related person exception points to specific legislative history. However, with respect to the Code section 954(i) exception, Treasury refers to the fact that the QIC rule was recently implemented and given this statutory change determined that Code section 95(i) should not apply. Treasury does not address the fact that the Code section 954(i) exception was already a more limited exception (requiring significant home country insurance) than that provided in the PFIC insurance income exception that was amended to include the QIC requirement.