The US Internal Revenue Service (“IRS”) recently proposed new rules potentially affecting the classification of non-US insurance companies (including reinsurers and certain captives) as PFICs. In particular, these proposed rules raise three key issues for non-US insurance companies that hope to avoid PFIC status (and the application of onerous PFIC tax consequences to shareholders that are US taxpayers):
- A foreign insurer must confirm that it would be eligible under the Internal Revenue Code to file as an insurance company if it were a US corporation.
- A foreign insurer 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 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 consequences.
The IRS has requested public comment on the proposed rules. 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.
Non-US Insurance Companies Should Fulfill Subchapter L Requirements to Avoid PFIC Classification
The Internal Revenue Code (the “Code”) prescribes special rules applicable to foreign corporations that are passive foreign investment companies (“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. The rules relating to the taxation of shareholders of a PFIC are complex, but in general, a PFIC’s US 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) are subject to additional tax reporting requirements.
Specifically excluded from passive income is income derived from the “active conduct” of an insurance business by a corporation which is “predominantly engaged” in an insurance business.1 A chorus of concerns has 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 US Department of Treasury and the IRS to link the PFIC exemption for active non-US insurance companies to certain requirements of Subchapter L of the Code (governing the US federal income taxation of US 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.” Although the proposed regulations do not define what it means to be “predominantly engaged” in an insurance business, the preamble to the proposed regulations notes that any company taxable under Subchapter L of the Code as an insurance company is necessarily predominantly engaged in an insurance business.
Active Conduct of an Insurance Business
The proposed regulations require that income be derived from the active conduct of an insurance business.2 “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 employees of the insurance company may be problematic for non-US insurance companies 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 administrative services arrangements betwee insurers and their affiliates, is unclear.
1 The term “insurance company” is defined in Code section 816(a) as an entity “any more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.” US case law and IRS guidance further define the term “insurance” as generally involving the transfer of risk, distribution of risk, and meeting several other non-exclusive factors common to an insurance arrangement.
2 An “insurance business” is the business of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies, together with ancillary administrative services and investment activities that are required to support or are substantially related to insurance, to the extent that income from the activities is earned from assets held by the foreign corporation to meet obligations under the contracts. Prop. Reg. § 1.1297-4(b)(2).