After an initial period of almost 30 years without significant regulatory guidance addressing the statutory exception for foreign insurance companies under the passive foreign investment company (PFIC) regime, the U.S. Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) continued the recent trend of fundamental change in this area with the issuance of a new set of proposed regulations. Published on July 10, 2019, the new proposed regulations withdraw the prior relevant proposed regulations that were issued in 2015 and provide the basis for determining whether the modified statutory exception put in place in 2017 applies to foreign insurance companies.
The 2015 proposed regulations had evoked concern in the insurance industry by proposing an artificially narrow definition of what it means for a corporation to conduct an active insurance business – a definition that would have ignored for this purpose the services provided by affiliates. Although the new proposed regulations may provide relief when compared with the prior proposed regulations for certain foreign corporations, they introduce significant additional complexity for all foreign insurance companies, and they do not fully alleviate the concerns of insurance company groups.
In general, a foreign corporation is a PFIC if (1) 75 percent or more of its gross income in a taxable year is passive income or (2) 50 percent or more of its assets produce (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. However, the PFIC provisions include an exception to the definition of passive income for income derived by a qualifying insurance corporation (QIC) in the “active conduct” of an “insurance business.”
A QIC is a foreign corporation that (1) “would be subject to tax under subchapter L if such corporation were a domestic corporation,” and (2) either (a) has “applicable insurance liabilities that constitute more than 25 percent of its total assets” (the 25% Test) or (b) meets an alternative test dependent in part on it having applicable insurance liabilities constituting at least 10 percent of its total assets (the Alternative 10% Test). The Alternative 10% Test is available only where the foreign corporation fails the 25% Test solely due to runoff-related or rating-related circumstances involving its insurance business.
The proposed regulations include a number of technical changes that generally affect each of the requirements imposed by the insurance income exception, including each prong of the QIC test. In particular, the proposed regulations identify those foreign corporations that would be subject to subchapter L if they were domestic corporations by reference to section 816(a) of the Internal Revenue Code of 1986, as amended (the Code), which restricts QICs to only those foreign corporations “more than half of the business of which during the taxable year is the issuing of insurance of annuity contracts or the reinsuring of risks underwritten by insurance companies.”
The proposed regulations also limit the amount of applicable insurance liabilities considered under the 25% Test and the Alternative 10% Test to the lesser of (1) that shown on the most recent applicable financial statement of the foreign corporation, (2) the minimum amount required by applicable law or regulation of the jurisdiction of the applicable insurance regulatory body, and (3) the amount shown on the most recent financial statement made on the basis of U.S. generally accepted accounting principles or international financial reporting standards if such financial statement was not prepared for financial reporting purposes. And the Alternative 10% Test will be available only to the extent that a U.S. person who is a shareholder of the foreign insurance company elects to have that test apply on a Form 8621 attached to the shareholder’s federal income tax return for the year to which the election relates.
Consistent with the 2015 proposed regulations, the new 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 that are substantially related to) those insurance, annuity, or reinsurance contracts issued or entered into by the QIC.”
Although the Treasury and the IRS assert that the determination of “active conduct” is still intended to be interpreted consistently with the relevant Treasury Regulations under Code section 367, the proposed regulations expand the definition beyond the 2015 proposed regulations in two important ways:
- First, the proposed regulations provide that the determination is based on “all facts and circumstances” and not just those enumerated in the Treasury Regulations under Code section 367.
- Second, although the proposed regulations provide that a QIC will generally be treated as actively conducting an insurance business only if “the officers and employees of the QIC carry out substantial managerial and operational activities,” the actions of officers and employees of other entities also will be considered (Specified Related Entities), so long as certain control tests are met and the QIC exercises “regular oversight and supervision” over and pays certain expenses with respect to such individuals.
Even where a foreign corporation is treated as a QIC that derives income in the active conduct of an insurance business, the insurance income exception will apply only to such income if the QIC’s “active conduct percentage” for a taxable year is at least 50 percent. A QIC’s active conduct percentage is generally equal to the percentage of its overall expenses for a taxable year “related to the production or acquisition of premiums and investment income on assets held to meet its obligations under the insurance, annuity, or reinsurance contracts issued or entered into by the QIC” that are incurred for services of the officers and employees of the QIC (and Specified Related Entities).
The proposed regulations include a substantial number of technical clarifications and material changes to the rules governing the insurance income exception specifically and the general PFIC income and asset tests more generally. Although the additional guidance provided by the proposed regulations may in certain cases be welcome, it also adds significant complexity to each of these determinations and creates new potential traps for the unwary.
A foreign corporation’s particular concerns will generally depend on its specific facts and circumstances. However, the requirement that a QIC have an active conduct percentage of at least 50 percent in a taxable year in order for any of its income to qualify for the insurance income exception could cause unexpected and unintended issues, particularly in a taxable year where a QIC incurs extraordinary expenses. The preamble to the proposed regulations requests comments regarding whether this threshold should represent the only test in this regard, or whether it would better serve as a safe harbor in the context of a larger facts and circumstances test.
Moreover, the expansion of the definition of the active conduct of an insurance business to take into account activities performed by employees of affiliates of the insurance company being tested still may create issues for insurance company groups that rely on a service company within the group to provide services for multiple insurance companies in the group. The requirement in the proposed regulations that each such insurance company exercise “regular oversight and supervision” over the services provided by the service company may be problematic if the management and operation of the group is centralized and individual insurance companies in the group do not even have any separate employees.
Although the proposed regulations will not become effective until finalized, taxpayers may generally choose to rely on them for taxable years beginning after December 31, 2017, so long as the taxpayers apply the rules consistently. Any comments or requests for a hearing on the proposed regulations must be made on or before September 9, 2019.