Most investment funds are structured as flow-through vehicles (i.e., regulated investment companies or investment partnerships), including most hedge funds. Accordingly, investors are taxed on the funds’ income regardless of whether that income is distributed to the investors. In the late 1990s and early 2000s, certain asset managers formed non-U.S. reinsurance companies (typically located in the Cayman Islands or Bermuda) through which investors would make investments in the funds of that asset manager. Those structures became commonly known as “hedge fund/Re” structures. One alleged motivation for the creation of this structure was the beneficial tax treatment for investors (when compared with a direct investment in a fund), based on the reinsurance company not being a PFIC. The asset managers generally have taken the position that the reinsurance company would fall within the scope of the “active insurance business” exception of the PFIC rules.
The Internal Revenue Service (the IRS) has, in certain circumstances, questioned this treatment. In particular, the IRS announced in IRS Notice 2003-34 that it intended to scrutinize the activities of purported insurance companies organized outside of the United States, including insurance companies that invest a significant portion of their assets in alternative investment strategies, and that it would apply the PFIC rules where it determines that a non-U.S. corporation is not an insurance company for U.S. federal income tax purposes. In February 2014, U.S. House Ways and Means Committee Chairman, Dave Camp, published the proposed Tax Reform Act of 2014 and an accompanying technical explanation written by the staff of the Joint Committee on Taxation which, among other matters, discussed certain proposed changes to the PFIC exception for insurance companies. Most recently, in a June 12, 2014 letter, Senate Finance Committee Chairman, Ron Wyden, asked the Treasury and the IRS for information about their efforts to challenge the PFIC status of certain non-U.S. reinsurance companies. The Treasury, in an August 9, 2014 letter, responded to Chairman Wyden’s letter stating that it was concerned about certain of those arrangements and was actively working to identify possible legislative or administrative options for addressing these structures. Senator Wyden responded in a September 11, 2014 letter, recommending that action should be taken and asking for Treasury’s view on legislative and administrative options to address his concerns. The Proposed Regulations are the result of these events.
Under the Code, a non-U.S. corporation is a PFIC only if either 75 percent or more of its gross income for the tax year is “passive income” (the Passive Income Test) or, on average, 50 percent or more of its assets for the tax year produce passive income or are held for the production of “passive income” (the Passive Asset Test). For purposes of applying the Passive Income Test, Section 1297(b)(2)(B) of the Code provides that, except as provided in regulations, the term “passive income” does not include any income that is derived in the active 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 (relating to the taxation of U.S. insurance companies) as an insurance company if the non-U.S. corporation were a U.S. corporation (the Insurance Exception). Prior to the Proposed Regulations, there was no guidance as to the proper interpretation of the Insurance Exception. The Proposed Regulations provide some, but not all, of the sought-after guidance.
- Active Conduct. The Proposed Regulations, by referring to Treasury Regulation § 1.367(a)-2T(b)(3), provide that an insurance business will generally be considered to be “active” if the officers and employees of the corporation carry out substantial managerial and operational functions. However, the activities of independent contractors and the activities of officers and employees of related entities are not taken into account.
- Insurance Business. The Proposed Regulations provide that the term “insurance business” means the business activities of issuing insurance and annuity contracts and reinsuring of risks underwritten by insurance companies, together with investment activities and administrative services that are required to support or are substantially related to the insurance contracts issued or reinsured by the non-U.S. insurance company.
- Investment Activities are any activities that produce income of a kind that would be “subpart F income” within the meaning of Section 954(c) (i.e., interest, dividends, capital gains from bonds and stocks, etc.).
- Support or Substantially Related. Investment activities will “support” or be “substantially related” to the insurance business only to the extent that income from such investment activities is earned from investment assets held by the non-U.S. corporation to meet its obligations under the insurance or reinsurance contracts. However, the Proposed Regulations do not set forth any method as to how to determine what portion of investment assets is held to meet obligations under insurance contracts. Instead, comments are requested regarding appropriate methodologies for making that determination.
- Predominantly Engaged. The preamble of the Proposed Regulations confirms that the term “predominantly engaged” is defined by reference to Section 831(c) (i.e., the definition of an insurance company) because the Insurance Exception requires that the non-U.S. corporation would be subject to Subchapter L if it were a U.S. corporation. Accordingly, in order to be “predominantly engaged” in an insurance business within the meaning of the Insurance Exception, more than half of a non-U.S. corporation’s business during a tax year must consist of the issuance of insurance or annuity contracts or the reinsuring of risk underwritten by insurance companies.
Our initial observations on the Proposed Regulations are as follows:
- Insurance Exception Remains Available Despite Use of Alternative Investment Strategies. Historically, insurance companies have invested most of their assets in liquid government securities and other investment grade securities. The investment of a significant portion of an insurance or reinsurance company’s assets in alternative investment strategies is a fairly recent development. Treasury and IRS do not adopt an approach in the Proposed Regulations pursuant to which a non-U.S. corporation would be automatically excluded from the Insurance Exception if it uses alternative investment strategies to a significant extent.
- Active Conduct. The main development provided by the Proposed Regulations is the clarification of the term “active conduct.”
- The regulations that the Proposed Regulations cross-reference for purposes of defining “active conduct” provide that the “the officers and employees of the corporation are considered to include the officers and employees of related entities who are made available to and supervised on a day-to-day basis by, and whose salaries are paid by (or reimbursed to the lending-related entity by), the transferee foreign corporation.” The Proposed Regulations specifically exclude the activities of the officers and employees of related entities.
- This is a potentially significant hurdle for “hedge fund/Re” structures because it requires that the non-U.S. insurance corporation hire its own officers and employees and they must be capable of running an insurance or reinsurance business (which often, but not always, requires a rating by a rating agency, such as A.M. Best or S&P).
- This rule would have adverse implications for all non-U.S. reinsurance companies that use affiliated insurance managers, regardless of whether the companies are “hedge fund/Re” companies. It may also affect the treatment of segregated cells that are treated as separate corporations for U.S. federal income tax purposes.
- It is not readily apparent which tax policy concern has caused Treasury and the IRS to turn off the “related entity” rule.
- The Proposed Regulations do not specify any minimum number of “employees” or whether certain employees, such as a general counsel, are required.
- No Mechanical Tests or Ratios for Passive Asset Test. Most of the discussion in the industry has been around whether there should be a bright-line ratio or other quantifiable test for purposes of the Passive Asset Test. Determining which assets are passive is critical to determining whether a non-U.S. corporation is more akin to a non-U.S. investment fund (i.e., mostly investment assets with an insurance business on the side) or more akin to an operating insurance business (i.e., investment assets needed to support the predominant insurance activities).
- Treasury and the IRS did not shed any light on this issue. Instead, they opted for pushing this issue into the “notice and comments” process prior to the issuance of final regulations.
- There is no suggestion in the preamble as to what Treasury and IRS are contemplating in this regard. For example, there is no reference to an approach in which a safe harbor test is combined with a general facts and circumstances test. There is also no discussion as to which ratios Treasury and IRS may regard as relevant, except they indicate that they are considering a ratio based on total assets to total insurance liabilities (without indicating the minimum percentage required).
- No Rating Requirement. The Proposed Regulations do not condition the access to the Insurance Exception on the receipt of a rating. Accordingly, both rated and unrated non-U.S. reinsurance companies have the potential to benefit from the Insurance Exception in the PFIC rules.
- Implications beyond “Hedge Fund/Re” Structures. The Proposed Regulations are not limited to “hedge fund/Re” structures. Accordingly, it is likely that the Proposed Regulations will affect other insurance structures, such as reinsurance companies owned or accessed by insurance-linked securities funds.
- Prospective Effective Date. The effective date of the Proposed Regulations is strictly prospective, which seems to indicate that Treasury and IRS do not view “hedge fund/Re” structures as akin to tax shelter transactions.
We will continue to monitor these developments closely.
If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or
|Laura M. Barzilai
| Christian Brause
| R. Lee Christie
| Tracy D. Williams
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This Tax update has been prepared by Sidley Austin LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this Tax update without seeking advice from professional advisers. Furthermore, this Tax update was not intended or written to be used, and cannot be used, by any person for the purpose of avoiding any U.S. federal, state or local tax penalties that may be imposed on such person.