PFIC Proposed Regulations - The Insurance Company Exception

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The original Passive Foreign Investment Company (PFIC) rules were enacted in 1986 as an additional weapon in Congress’ attempt to thwart deferral of tax on income earned by foreign entities with certain elements of U.S. ownership. Included in the rules collectively known as anti-deferral legislation, the then new PFIC rules joined the already existing Subpart F regime in targeting U.S. owners of foreign corporations with primarily passive income or assets.

The PFIC rules are more broadly based than the rules contained in Subpart F as they aim to eliminate the economic benefit of tax deferral with respect to all U.S. investors in a PFIC, not just those with significant ownership. The PFIC rules are complex and have created compliance burdens for affected taxpayers, discouraging U.S. taxpayers from investing in PFICs. Identification of a foreign corporation as a PFIC in the first instance can be difficult. When the foreign corporation conducts an insurance business, certain industry and operational issues further complicate the analysis. For example, almost all foreign insurance companies could be considered PFICs based on the quantum of passive assets they hold to meet their reserve requirements. As such, an exception to PFIC classification for bona-fide foreign insurance companies was developed.

On July 10, 2019, the U.S. Department of the Treasury (the Treasury) and the Internal Revenue Service (IRS) issued a set of proposed regulations that clarify certain rules with respect to the PFIC regime, including the so-called insurance company exception. The exception to the PFIC rules for insurance companies, as modified by the 2017 Tax Cuts and Jobs Act (TCJA) provisions, requires that an insurance company be characterized as a qualifying insurance corporation (QIC) and that its income be derived in the active conduct of an insurance business for the entity to avoid classification as a PFIC.

Qualifying Insurance Company Defined

A QIC for a tax year must meet the following requirements: (i) the corporation would be subject to tax under subchapter L if it was a U.S. domestic corporation, and (ii) its applicable insurance liabilities as reported on the corporation’s applicable financial statements constitute more than 25 percent of its total assets.

For certain entities that fail to qualify as a QIC solely because of the aforementioned 25 percent test, an alternative facts and circumstances test/election is available. If an entity that is predominantly engaged in an insurance business fails the 25 percent test solely due to (i) run-off related circumstances, or (ii) rating related circumstances, it may elect to apply the alternate facts and circumstances test if it reports an amount of applicable insurance liabilities that is at least 10 percent of the amount of total assets on its applicable financial statement. In practice, it is expected that this 10 percent option will be limited to entities that have entered a run-off/un-wind of existing business or are merely meeting regulatory requirements to maintain the minimum credit rating required for the foreign corporation to be classified as secure to write new insurance business. It is hoped that the final regulations will clarify application of rating related circumstances to start-up foreign insurance entities, i.e. a “start-up” exception.

Applicable Insurance Liabilities

For these purposes, applicable insurance liabilities include loss and loss adjustment expenses and reserves (other than deficiency, contingency or unearned premium reserves) for life and health insurance risks. In applying the 25 percent and 10 percent tests described above, the proposed regulations provide a cap on the amount of an insurance company’s applicable insurance liabilities. The amount of the applicable insurance liabilities may not exceed the lesser of (i) the amount reported on a generally accepted accounting principles (GAAP) or international financial reporting standards (IFRS) statement (whether or not prepared for financial reporting), or (ii) the minimum amount required by applicable law in the company’s regulatory jurisdiction. If GAAP or IFRS are not used to prepare a company’s financial statements, and the method used does not discount unpaid losses on an economically reasonable basis, the amount of such company’s applicable insurance liabilities will be limited to an amount reduced by a discounting standard commensurate with such standard applied in the context of GAAP or IFRS.

Financial Statements

The proposed regulations also provide guidance on financial statements. Applicable financial statements are defined as the financial statements that are used by the foreign corporation for financial reporting purposes and are characteristic of the following:

  1. Made on the basis of GAAP;
  2. Made on the basis of IFRS if there is no statement made on a GAAP basis; or
  3. The annual statement required to be filed with the applicable insurance regulatory body if there is no statement made on either a GAAP or IFRS basis.

There is a prohibition against moving from a GAAP or IFRS financial reporting standard to another reporting standard unless a non-tax business reason is present. For the purposes of the QIC test, total assets are those assets shown on the end of period applicable financial statement for the last accounting period ending with or within the taxable year.

Other Information

Insurance operations have traditionally been a difficult area for the Treasury to create a bright-line set of rules that address the operational and regulatory requirements of the industry, particularly with respect to the PFIC rules.

In 2015, the Treasury and IRS issued proposed regulations on the then existing insurance exception to the PFIC rules, which were substantially the same (active conduct concept) as the new TCJA exception without a QIC requirement. The industry submitted comments to the Treasury with respect to the definition of an active insurance business in order to provide operational information on how typical foreign insurance companies were managed. The 2015 proposed regulations required that an insurance company’s officers and employees conduct the operations and management of the company in order to be considered in the active conduct of an insurance business, thus not considered a PFIC.

From an operational perspective, industry comments highlighted that management companies were commonly used throughout the industry. The comments concluded that it was inappropriate to require an insurance company’s business to be conducted by its own officers and employees in order to meet the active business requirement.

Responding to this operational paradigm, the 2019 proposed regulations modify the definition of active conduct of an insurance business providing that active conduct is now based on a facts and circumstances analysis. The proposed regulations go on to state that active conduct of an insurance business requires the officers and employees of the QIC to carry out substantial managerial and operational activities. In determining whether officers and employees of the QIC carry out substantial managerial and operational activities, the activities of independent contractors are disregarded.

In further deference to comments received to the 2015 proposed regulations, the 2019 rules allow that managerial and operational roles may be performed by persons (officers and employees) of another entity within the same control group as the QIC.

Control for this purpose requires either (i) direct or indirect ownership by the QIC of more than 50 percent by vote and by value of the entity whose officers and employees provide the services, or (ii) more than 80 percent direct or indirect ownership by vote and value by a common parent of both the QIC and the entity whose officers and employees provide the services. Further, the QIC must exercise regular oversight and supervision over such services and must pay the compensation of the officers and employees providing the services, or reimburse the service providing entity for such compensation.

Additionally, in order for the QIC’s income to be characterized as derived in the active conduct of an insurance business, expenses related to the payment to the persons providing substantial managerial and operational activity (and that are related to the production or acquisition of premiums and investment income on assets held to meet obligations under the insurance, annuity, or reinsurance contracts issued or entered into by the QIC) must equal or exceed 50 percent of all expenses. This does not take into account ceding commissions, paid by the QIC to any person for the production or acquisition of premiums and investment income on assets held to meet obligations under the insurance, annuity or reinsurance contracts issued or entered into by the QIC.

Finally, the new proposed regulations withdraw the proposed regulations that were issued in 2015. The new proposed regulations would be effective once finalized, but taxpayers may choose to apply the proposed rules as if they were final regarding whether a foreign corporation is a QIC, as well as the exception from the definition of passive income for active insurance income to taxable years beginning after December 31, 2017. This is under the assumption that the rules are applied consistently.

In summary, the proposed regulations attempt to address the unique operational and managerial issues faced by foreign domiciled insurance companies while giving taxpayers a more definitive set of standards to apply in their efforts to avoid PFIC status.