Under the Code, a non-U.S. corporation is a PFIC 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 as an insurance company if the non-U.S. corporation were a U.S. corporation. As described in more detail in our prior Sidley Tax Update on this topic,1 discussions between Senator Wyden and the Treasury led the Treasury and the Internal Revenue Service (the IRS) to issue the Proposed Regulations on April 23, 2015. The Wyden Bill is the next step in this ongoing debate. The Wyden Bill proposes to amend the Insurance Exception by adding a new definition of a “qualifying insurance corporation.”
A “qualifying insurance corporation” is any foreign corporation but only if (a) it would be subject to subchapter L of the Code if it were a domestic corporation (i.e., the U.S. federal income tax rules applicable to domestic insurance and reinsurance corporations) and (b) the applicable insurance liabilities of the company constitute more than 25 percent of its total assets, determined on the basis of the liabilities and assets reported on the corporation’s applicable financial statement for its previous tax year. For this purpose, the term “applicable insurance liabilities” means, with respect to any life or property and casualty insurance business, (a) loss and loss adjustment expenses and (b) reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance claims with respect to contracts providing coverage for mortality or morbidity risks. Importantly, the amount of such relevant “applicable insurance liabilities” is capped at the lesser of (a) the amount of such liabilities as reported to the applicable insurance regulatory body in the applicable financial statement (e.g., the Bermuda insurance regulatory authority) or (b) the amount determined under U.S. Treasury regulations that are yet to be promulgated. In addition, for purposes of the “qualifying insurance corporation” definition, the term “applicable financial statement” means a statement for financial reporting purposes that (a) is made on the basis of U.S. GAAP, (b) is made on the basis of international accounting standards (IAS) but only if no U.S. GAAP statement is available, or (c) except as otherwise provided by new Treasury regulations, the annual statement that is required to be filed with the applicable insurance regulatory body, but only if there is no statement in accordance with U.S. GAAP or IAS.
If a foreign corporation fails to satisfy the requirements of a “qualifying insurance corporation” as described above, the Wyden Bill provides for an alternative test for such corporations. Specifically, if a foreign corporation fails to qualify as a qualifying insurance corporation solely because the ratio of insurance liabilities to total assets is less than 25 percent, a U.S. person that owns stock in such a foreign corporation may elect to treat the stock as stock of a qualifying insurance corporation if (a) the ratio is at least 10 percent, and (b) under new Treasury regulations, based on all the facts and circumstances (x) the foreign corporation is predominantly engaged in an insurance business and (y) such failure is due solely to temporary circumstances involving such insurance business.
Our initial observations on the Wyden Bill, particularly in the context of 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. The Wyden Bill does not automatically exclude a non-U.S. corporation from the Insurance Exception if it uses alternative investment strategies to a significant extent. That is consistent with the approach taken in the Proposed Regulations.
- Active Conduct. The main focus of the Proposed Regulations is the “active conduct” prong of the Insurance Exception. The Wyden Bill neither removes this requirement from the Code nor provides any additional guidance as to how to interpret this requirement. Accordingly, it appears that Senator Wyden may generally agree with the approach taken by the Treasury in the Proposed Regulations or is willing to have the Treasury and the IRS address what constitutes “active conduct.” As described in our prior Tax Update, we expect a significant amount of commentary on this issue.
- Annual Ratio Test. The Proposed Regulations do not provide any mechanical tests or ratios for purposes of the Passive Asset Test. Instead, the Treasury and the IRS asked for comments in this regard. The Wyden Bill provides such a commentary by proposing a bright line, annual ratio test.
- The annual insurance liabilities versus total asset test is in line with possible ratio tests previously discussed in the industry. This is a single annual ratio test (as opposed to a test taking into account a longer testing period such as three years or multiple annual ratios, some or all of which must satisfy the test). One advantage of this balance sheet-based single annual ratio test is that it focuses on “total assets” which makes it unnecessary to distinguish between “good” insurance-related assets and “bad” excess assets. The Wyden Bill provides a clear hierarchy of financial statements for measuring insurance liabilities, but it would not be surprising if this rule proved to be problematic in certain cases (e.g., if liabilities required to be reflected on regulatory balance sheets were not similarly reflected in a GAAP statement).
- The interaction of the new “qualifying insurance corporation” definition with the Passive Asset Test is not entirely clear.
- The definition of insurance liabilities seems to be narrower than necessary. For example, this definition appears to exclude “annuity reserves.” Moreover, it is unclear how modified coinsurance arrangements would be addressed, as reinsurers under such arrangements require capital to support the reinsured business but reserves relating to the business are not shown as insurance liabilities of the reinsurer.
- The 25 percent requirement appears to be at the high end of the range of percentages that have been discussed, even though it is lower than the percentage proposed in the previous Camp tax reform bill. This percentage would apply to all insurance companies irrespective of their relevant line or lines of business (e.g., life, property and casualty or health insurance).
- Unfortunately, the Wyden Bill does not supplement its single ratio test with a facts and circumstances test as a fallback. Instead, it merely permits very limited relief from the strict application of the annual ratio test if a failure of the ratio test is due to special circumstances. While it is very helpful that the Wyden Bill acknowledges the significance of such special situations, it is questionable whether this limited relief approach would be workable in practice.
- It does not appear that the Wyden Bill grants the Treasury and the IRS the authority to adopt alternative ratio tests that could be used when a particular insurance company would not be able to satisfy the 25 percent test in a given year.
- No Rating Requirement. Like the Proposed Regulations, the Wyden Bill does not condition the access to the Insurance Exception on the receipt of a rating.
- Implications Beyond “Hedge Fund/Re” Structures. Like the Proposed Regulations, the Wyden Bill is not limited to “hedge fund/Re” structures, even though those structures seem to be the apparent focus of Senator Wyden’s attention. Accordingly, the Wyden Bill would affect other insurance structures, such as reinsurance companies owned or accessed by insurance-linked securities funds.
If you have any questions regarding this Sidley Update, please contact the Sidley lawyer with whom you usually work, or
R. Lee Christie
1 See “Treasury Issues Proposed Regulations Concerning the Application of the PFIC Rules to Non-U.S. Reinsurance Companies,” Sidley Tax Update, dated April 24, 2015, available at http://www.sidley.com/en/news/04-24-2015-tax-update.
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