Firm Proposes PFIC Guidance on Qualifying Insurance Corporation

September 5, 2018

Douglas L. Poms
International Tax Counsel
Office of Tax Policy
U.S. Department of Treasury
1500 Pennsylvania Avenue, N.W.
Washington D.C. 20220

Brett York
Associate International Tax Counsel
Office of Tax Policy
U.S. Department of Treasury
1500 Pennsylvania Avenue, N.W.
Washington D.C. 20220

Edith Brashares
Dir. International and Business Taxation
Office of Tax Analysis
Office of Tax Policy
U.S. Department of the Treasury
Main Treasury, Room 4221
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Josephine H. Firehock
Internal Revenue Service
Office of Associate Chief Counsel (International)
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Dave Brazell
Financial Economist
Office of Tax Analysis
Office of Tax Policy
U.S. Department of the Treasury Main Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Re: Passive Foreign Investment Company Rules — Definition of Qualifying Insurance Corporation

Dear Mr. Poms, Ms. Brashares, Mr. Brazell, Mr. York, and Ms. Firehock:

Thank you again for taking the time to meet with us, and for your continuing interest in and effort toward providing timely and appropriate guidance regarding the new qualifying insurance corporation (“QIC”) test for application of the insurance company exception to passive foreign investment company (“PFIC”) status. We appreciate your commitment to issuing regulations clarifying the QIC test before the end of 2018. As we previously explained, guidance is needed as soon as possible in 2018 to provide affected companies sufficient time to make adequately informed structural and capital allocation decisions to address the new PFIC requirements.

During our meeting we discussed guidance on the following topics: (i) clarifying that passive income does not include income of a domestic corporation subject to tax under subchapter L; (ii) the methodology for electing to use the alternative facts and circumstances test in the following situations (a) an automatic election by public shareholders and small shareholders provided the group parent publicly indicates certain information, and (b) the ability to make the election at the group parent company level for relevant insurance subsidiaries in the group, provided the group parent publicly indicates certain information; (iii) the circumstances in which the alternative facts and circumstances test would be available; and (iv) the definition of loss. We have attached proposed regulatory language addressing these issues to assist you.

We have specifically addressed the question you raised regarding how to define that an insurance company's failure to meet the 25% threshold is solely due to rating-related circumstance. As we discussed, rating agencies generally do not provide insurance companies with any documentation of the capital the agency requires for a particular rating. Accordingly, in the absence of documentation we have proposed a reasonable methodology that will illustrate that the failure to meet the 25% threshold is solely due to rating-related circumstances.

Another question raised during our meeting related to whether defining losses as loss reserves plus paid losses for a particular year would adequately capture legitimate insurance companies that write lines of business that involve as a business necessity multi-year contracts, once the insurance company passed an initial start-up phase and reached a “steady state.” While determining losses based on reserves plus paid losses for a particular year would be adequate for insurance companies that write most lines of business, legitimate insurance companies that write certain types of business still would not meet the 25% threshold if only losses in a single year are considered. For lines of business, such as title, residual value, financial guaranty, and extended warranties for vehicles or consumer products, that must be written on a multi-year policy basis due to the nature of the business, focusing on losses in a single year will not adequately reflect the true loss profiles of the companies that write those lines of business.

Many multi-year coverages involve short tail lines of business that generally do not result in large loss reserves because losses are paid very quickly after they are reported. Moreover, these types of coverages often do not have risk that is spread evenly over the life of the policy. Thus, the insurance companies that write such coverage have years with few loss payments and other years in which loss payments are higher. Moreover, because insurance regulators require such companies to hold assets in respect of the losses that they are contractually obligated to pay in future years as well as premiums that will be earned over the lives of their multi-year policies, an end of year snapshot look at the ratio of reserves plus paid losses to assets reflects a distorted view of the loss profiles of such companies.

For example, in one year a company could write a large block of five-year policies that result in the company being required to hold assets to cover losses that will be paid and the premiums that will be earned over those five years. If years one and two are low loss years and years three, four, and five are high loss years, it may seem in year one that the insurance company is carrying excess assets, but because a significant portion of the assets held in year one with respect to the policies written in year one ultimately will be used to pay losses under the policies, the company is not carrying excess assets. This example demonstrates why, for insurance companies that write multi-year coverage due to business exigencies, the appropriate measure of the ratio of losses to assets should take into account losses over the lives of its policies.

Insurance companies that write annual policies with low frequency, high severity losses have a similar problem to writers of multi-year policies. Because of the volatility of such business, such insurance companies need to carry sufficient capital and surplus to be able to pay losses in a high loss year where the company's loss ratio may be well over 100%. In low loss years, the level of assets they carry may seem excessive, but because the losses are unpredictable, those assets are needed in case a substantial loss event occurs. The attached language proposes an alternative measurement of losses for companies that write specific lines of business involving multi-year policies or low frequency, high severity coverages. The measurement would take into account average loss ratios over a specified period of time to more accurately reflect the level of losses as compared to assets.

You also asked us to address how this alternative measurement of losses is different from taking into account unearned premiums, which are not included in the statutory definition of insurance liabilities. Our proposal to determine losses based on average loss ratios over a specified period is focused entirely on losses. It looks specifically at losses paid by the insurance company over a specified period of time. Nothing in the statutory language precludes a measurement of losses over time.

Unearned premiums are focused on revenue, not loss payment; and the concept of unearned premium in the Code is utilized as part of the measure of an insurance company's taxable income.¹ Although some portion of unearned premiums may be used to pay losses, they also are used to pay operating expenses and they generally incorporate a profit component. Unearned premiums and losses, even looked at over time, are simply two different things.

Moreover, we note that, although the legislative history to the 2017 tax act indicates that unearned premiums for property and casualty companies are excluded from insurance liabilities, the statutory language specifically excludes unearned premiums only for life insurance companies, not property and casualty companies. Notably, life insurance company unearned premiums do not generally include a loss component, as life insurance company reserves are calculated differently than property casualty company reserves, and already include the present value of future expected losses even though such losses have yet to be incurred. Accordingly, the mere fact losses paid by a property and casualty company over time may be paid out of what once were unearned premiums should not preclude those losses from being included in insurance liabilities.

We would be happy to answer any questions you have regarding the foregoing or the attached.

Very truly yours,

Saren Goldner

Kristan Rizzolo

Eversheds Sutherland LLP
New York, NY

---

(a) Treatment of domestic insurance corporations.

(1) For purposes of section 1297(b), passive income does not include any income derived by a domestic corporation that is subject to tax under subchapter L.

(b) Alternative facts and circumstances test election. —

(1) General rule. —

(i) Time for making a section 1297(f)(2) election. — For purposes of section 1297(f)(2), except as otherwise provided in this paragraph (b), a U.S. person must make an election to treat the stock it owns in a non-U.S. corporation as stock of a qualifying insurance corporation on or before the due date, as extended under section 6081 (election due date), for filing the shareholder's income tax return for each taxable year to which the election will apply. The section 1297(f)(2) election must be made in the original return for that year, or in an amended return, provided the amended return is filed on or before the election due date.

(ii) Manner of making a section 1297(f)(2) election. — Except as otherwise provided in this paragraph (b), A shareholder must make a section 1297(f)(2) election by —

(A) Completing Form [ ] in the manner required by that form and this section for making the section 1297(f)(2) election;

(B) Attaching Form [ ] to its Federal income tax return filed by the election due date for the shareholder's election year; and

(C) Receiving and reflecting in Form [ ] the information provided in the Qualifying Insurance Corporation Information Statement described in paragraph (b)(1)(iii) of this section.

(iii) Election requirements of the qualifying insurance corporation. —

(A) Qualifying Insurance Corporation Information Statement. — For each year of the qualifying insurance corporation ending in a taxable year of a shareholder, the qualifying insurance corporation must provide the shareholder with a Qualifying Insurance Corporation Information Statement. The Qualifying Insurance Corporation Information Statement is a statement of the qualifying insurance corporation, signed by the qualifying insurance corporation or an authorized representative of the qualifying insurance corporation, that contains the following information and representations —

(1) that the qualifying insurance corporation's failure to meet the requirements of section 1297(f)(1)(B) is solely because the percentage determined under section 1297(f)(1)(B) is 25 percent or less;

(2) the percentage determined under section 1297(f)(1) is at least 10 percent;

(3) the corporation is predominantly engaged in an insurance business; and

(4) the failure to meet the requirement of section 1297(f)(1)(B) is solely due to runoff related or rating-related circumstances involving the corporation's insurance business.

(2) Election for public and small shareholders. — For purposes of section 1297(f)(2), a U.S. person that is a qualified shareholder of a non-U.S. corporation parent, will be deemed to elect to treat the stock it directly or indirectly owns in that non-U.S. corporation parent, or in each of such non-U.S. corporation parent's direct or indirect subsidiaries which such corporation owns directly or indirectly more than 25% by value (the “group insurance corporations”), as stock of a qualifying insurance corporation, provided that the non-U. S. corporation parent whose stock the qualified shareholder directly or indirectly owns indicates in a public filing, disclosure statement or other notice provided to U.S. persons that are its direct or indirect shareholders, the information provided below.

(i) The information that must be provided by a non-U.S. corporation parent is:

(A) a list of the applicable group insurance companies;

(B) with respect to each group insurance corporation listed, that:

(1) such group insurance corporation's failure to meet the requirements of section 1297(f)(1)(B) is solely because the percentage determined under section 1297(f)(1)(B) is 25 percent or less;

(2) the percentage determined under section 1297(f)(1) is at least 10 percent;

(3) the corporation is predominantly engaged in an insurance business; and

(4) the failure to meet the requirement of section 1297(f)(1)(B) is solely due to runoff related or rating-related circumstances involving the corporation's insurance business.

(ii) A qualified shareholder is a shareholder that owns directly or indirectly less than 10 percent of a non-U.S. corporation parent, and any shareholder if the non-U.S. parent stock owned directly or indirectly by such shareholder is publicly traded.

(3) Election at parent level. — For purposes of section 1297(f)(2), a U.S. person will be deemed to elect to treat the stock it indirectly owns in a group insurance corporation as stock of a qualifying insurance corporation, if it makes an election with respect to the non-U.S. corporation parent and the non-U.S. corporation parent whose stock the U.S. person directly or indirectly owns indicates in a public filing, disclosure statement or other notice provided to U.S. persons that are its direct or indirect shareholders, the information provided in paragraph (b)(2)(i) with respect to each applicable group insurance corporation of the non-U.S. corporation parent. A U.S. person that makes an election pursuant to this paragraph (b)(3) must comply with the requirements of paragraphs (b)(1)(i) and (b)(1)(ii)(A) and (B).

(4) Alternative facts and circumstances test — solely due to rating-related circumstances involving the corporation's insurance business. —

(i) Rating related circumstances involving the corporation's insurance business. — For purposes of section 1297(f)(2)(B)(ii), rating related circumstances involving a corporation's insurance business include:

(A) an insurance corporation having a credit rating, or participating in a group rating, from an approved rating agency upon which its ability to write insurance business is in whole or part based (the “Insurance Corporation's Specified Rating”); and

(B) if in lieu of an insurance corporation having a credit rating, or participating in a group rating, from an approved rating agency the insurance corporation provides an amount of collateral equal to a full limit loss, in order to collateralize the risks the insurance corporation has assumed from a ceding insurance company, whether in trust for the ceding company or otherwise.

(ii) Approved rating agency — An approved rating agency includes Moody's, Standard & Poor's, A.M. Best, Fitch, Kroll Bond Rating Agency, or other similar rating agency.

(iii) Solely — An insurance corporation's failure to meet the requirement of section 1297(f)(1)(B) is solely due to rating-related circumstances involving the corporation's insurance business, if:

(A) A rating related circumstance involving the corporation's insurance business, as defined in paragraph (b)(4)(i)(A) of this section, is present; and the insurance corporation's applicable insurance liabilities are greater than or equal to 25% of the insurance corporation's total assets when the amount of capital required by the approved rating agency that provides the Insurance Corporation's Specified Rating is subtracted from the insurance corporation's total assets; or

(B) A rating related circumstance involving the corporation's insurance business, as defined in paragraph (b)(4)(i)(B) of this section, is present; and the insurance corporation's applicable insurance liabilities are greater than or equal to 25% of the insurance corporation's total assets when the amount of capital that would be required by an approved rating agency providing the minimum rating necessary for the insurance corporation to write its insurance business is subtracted from the insurance corporation's total assets.

(c) Loss. —

(1) In general, for purposes of section 1297(f)(3)(A)(i) loss has the meaning in paragraph (c)(1)(i) or (ii).

(i) Unpaid losses as reported on the corporation's applicable financial statement for the last year ending with or within the taxable year;

(ii) Losses incurred, including (A) losses paid net of salvage and reinsurance recovered, and (B) unpaid losses outstanding at the end of the taxable year less all unpaid losses outstanding at the end of the preceding taxable year, each as reported on the corporation's applicable financial statement for the last year ending with or within the taxable year, provided that when determining the amount of an insurance corporation's total assets as reported on the corporation's applicable financial statement for the last year ending with or within the taxable year, the amount of the insurance corporation's assets depleted to pay losses during the year are included.

(2) Alternate elections for certain lines of business.

(i) For the lines of business set forth below in this paragraph (c)(2)(i) an insurance corporation may elect to have “loss” mean an average over the number of years set forth below in this paragraph (c)(2)(i) of the ratio of losses incurred (as defined in paragraph (c)(1)(ii) above), to earned premium net of reinsurance (“net earned premium”) for the insured coverage for the same number of years, multiplied by the amount of net earned premium as reported on the corporation's applicable financial statement for the last year ending with or within the taxable year, provided that the amount of “loss” as defined in either paragraph (c)(1)(i) or (ii), above, with respect to the line of business is removed for purposes of the calculation of “loss” pursuant to paragraphs (c)(1)(i) and (ii).

(A) Catastrophe, the lesser of 10 years, or the number of years the insurance corporation has been writing the line of business;

(B) [Reserved].

(ii) For the lines of business set forth below in this paragraph (c)(2)(h) an insurance corporation may elect to have “loss” mean an average over the number of years set forth below in this paragraph (c)(2)(ii) of the ratio of losses incurred (as defined in paragraph (c)(1)(ii) above) to net earned premium for the insured coverage for the same number of years, multiplied by the sum of (a) the amount of net earned premium and (b) the unearned premium reserve of the insurance corporation, each as reported on the corporation's applicable financial statement for the last year ending with or within the taxable year, provided that the amount of “loss” as defined in either paragraph (c)(1)(i) or (ii), above, with respect to the line of business is removed for purposes of the calculation of “loss” pursuant to paragraphs (c)(1)(i) and (ii).

(A) Financial guaranty, the lesser of 10 years, or the number of years the insurance corporation has been writing the line of business;

(B) Residual value, the lesser of 10 years, or the number of years the insurance corporation has been writing the line of business;

(C) Title, the lesser of 10 years, or the number of years the insurance corporation has been writing the line of business;

(D) Extended warranty for automobiles, the lesser of 6 years, or the number of years the insurance corporation has been writing the line of business; and

(E) Extended warranty for consumer products, the lesser of 3 years, or the number of years the insurance corporation has been writing the line of business;

(F) [Reserved].