Proposed Regulations Targeting Hedge Fund Reinsurance Arrangements May Impact Traditional Insurance Companies

In April 24, 2015, Treasury and the Internal Revenue Service (IRS) published proposed regulations (REG-108214-15) that provide guidance regarding when a foreign insurance company’s income is excluded from the definition of passive income under Section 1297(b)(2)(B). As described in the preamble, the proposed regulations are directed at hedge funds that purport to establish a foreign reinsurance company in an effort to avoid treatment as a passive foreign investment company (PFIC). The issuance of the proposed regulations met a 90-day deadline for additional guidance on this issue that IRS Commissioner John Koskinen agreed to early this year during questioning by Senator Ron Wyden (D-OR).2 It is unclear when final regulations might be issued, but the issue addressed by the proposed regulations is of great interest to Senator Wyden who will presumably continue to prod Treasury and the IRS to act to curtail use of the PFIC insurance exception by hedge funds. The insurance industry is well advised to monitor developments in this area and provide input to prevent government actions that could have unintended consequences.

BACKGROUND

The PFIC rules are an anti-deferral regime intended to ensure that U.S. persons cannot avoid current U.S. income tax on their share of passive or highly mobile income by investing through a foreign corporation. If a U.S. person is a shareholder in a PFIC, that person is subject to U.S. tax on its share of the PFIC’s income under one of three alternative regimes: (1) an interest-charge regime; (2) an elective full-inclusion regime; or (3) an elective mark-to-market regime.

A foreign corporation is a PFIC if either 75 percent or more of its gross income for the taxable year is passive income (passive income test), or an average of 50 percent or more of its assets produce passive income or are held for the production of passive income (passive asset test). For purposes of applying the passive income test, Section 1297 provides that the term “passive income” does not include any income that is derived in the active conduct of an insurance business by a corporation that is predominantly engaged in an insurance business and that would be subject to tax under subchapter L as an insurance company if the corporation were a domestic corporation.

In 2003, the IRS issued Notice 2003-34 to address certain arrangements in which taxpayers were deferring recognition of ordinary income or characterizing ordinary income as capital gain as a result of an investment in a foreign company that was a purported insurance company. The foreign company would invest in hedge funds or investments in which hedge funds typically invest. The IRS noted that to qualify as an insurance company for federal tax purposes, a taxpayer must issue insurance contracts and must use its capital and efforts primarily in earning income from issuing such contracts. The IRS stated that it would scrutinize the types of arrangements de- scribed in the Notice and apply the PFIC rules in those cases in which the IRS determines the foreign company is not an insurance company for federal tax purposes.