By Jonathan D. Grossberg, Stephen D. D. Hamilton, John W. Weber, Jr.
A mere 28 years after Congress enacted the tax rules governing passive foreign investment companies (“PFICs”), the Treasury Department and Internal Revenue Service have for the first time issued proposed regulations that address the statutory exception for foreign insurance companies under the PFIC regime. The proposed regulations, published April 24, 2015, are aimed at a perceived abuse of that exception by hedge funds that set up foreign insurance companies that engage in minimal insurance activities and are primarily used to defer taxation and convert income from ordinary income to capital gains. Yet, the proposed regulations, if not modified, could have a much broader effect.
In general, a foreign corporation is a PFIC if 75 percent or more of its gross income in a taxable year is passive income or 50 percent or more of its assets produce passive income or are held for the production of passive income. Passive income generally includes dividends, interest, royalties, rents, annuities and gains on assets that generate such income. The PFIC provisions include an exception to the definition of passive income for “income derived in the conduct of an insurance business by a corporation which is predominantly engaged in an insurance business and which would be subject to tax under subchapter L if it were a domestic corporation.”
The proposed regulations elaborate on the scope of the exception by providing definitions for the words “active conduct” and “insurance business.” The regulations define “active conduct” by reference to the already existing Treasury Regulations under a different Internal Revenue Code provision, section 367, which specify that active conduct of a trade or business requires a group of activities that constitute an independent enterprise carried on for profit, and must include every operation that forms a part of the profit-making process, including the collection of income and the payment of expenses.
The Treasury Regulations under section 367 require that substantial operational and managerial activities must be carried on by the officers and employees of the corporation, but the activities of officers and employees of affiliates, if supervised and paid for by the foreign corporation, may be included in determining whether the foreign corporation is actively conducting a trade or business. The proposed regulations, however, exclude the activities of officers and employees of affiliates from the determination of whether a foreign insurance company is engaged in the active conduct of an insurance business. Evidently, this exclusion was aimed at preventing a hedge fund formed insurance company that has no employees of its own from qualifying for the PFIC insurance company exception.
The proposed regulations define insurance business as “the business of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies, together with those investment activities and administrative services that are required to support or are substantially related to insurance and annuity contracts issued or reinsured by the foreign corporation.”
One serious problem with the proposed regulations is that they ignore basic aspects of the conduct of the global insurance business, both in the United States and abroad. Many insurance companies are widespread multinational organizations that have many subsidiaries that do not themselves have any officers or employees, and whose activities are carried on by officers and employees of the parent corporation or affiliated service companies within the group. This kind of structure is also typical of many domestic insurance companies. The proposed regulations, as drafted, could be read to imply that income and assets of insurance company subsidiaries in a holding company structure could fail the insurance company exception for PFIC purposes simply because the insurance company subsidiaries are run by employees of another member of the group.
The proposed regulations also state that investment activities are treated as sufficiently related to insurance or annuity contracts to the extent that the income is earned from assets held to meet obligations under the contracts. The Notice requests comments on methodologies for determining which assets are held to meet those obligations.
These proposed regulations are not currently effective and will not become effective until finalized. Any comments or requests for a hearing on the proposed regulations are requested to be made on or before July 23, 2015. We expect that there will be substantial comments from insurance industry representatives asking for significant modifications of the proposed regulations.