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Firm Comments on Active Conduct of Insurance Business in PFIC Regs

SEP. 9, 2019

Firm Comments on Active Conduct of Insurance Business in PFIC Regs

DATED SEP. 9, 2019
DOCUMENT ATTRIBUTES

September 9, 2019

Internal Revenue Service
CC:PA:LPD:PR (REG-105474-18)
Room 5203
P.O. Box 7604, Ben Franklin Station
Washington, DC 20044

Comments on Proposed Treasury Regulations Sections 1.1297-4 and 1.1297-5 Regarding Income Derived in the Active Conduct of an Insurance Business

Dear Sir or Madam:

We respectfully submit this letter commenting on proposed Treasury Regulations sections 1.1297-4 and 1.1297-5 (the "Proposed Regulations"), relating to the determination of whether a foreign corporation is a passive foreign investment company (a "PFIC"), and specifically relating to the exception from passive income for income derived in the active conduct of an insurance business. We are writing in response to the request by the Department of Treasury ("Treasury") and the Internal Revenue Service for comments regarding when income is considered to be derived in the active conduct of an insurance business by a qualified insurance company (a "QIC") for purposes of Section 1297(b)(2)(B) of the Internal Revenue Code (the "Insurance Company Exception"). This letter represents in part the views of certain of our clients, who could be impacted by the Proposed Regulations, and with whom we have consulted in preparing these comments.

The Internal Revenue Code (the "Code") currently imposes three requirements for a foreign corporation to qualify for the Insurance Company Exception. First, the corporation must be an "insurance company" for U.S. federal income tax purposes (the "Insurance Compan Requirement") (i.e., it must be the case that the corporation would be subject to tax under subchapter L if the corporation were a domestic corporation).1 Second, the corporation's applicable insurance liabilities must constitute more than 25% of the corporation's total assets (the "25% Insurance Liability Test").2 Third, the Code provides that the Insurance Company Exception applies to income that is derived "in the active conduct of an insurance business" (the "Active Conduct Requirement").3

A variant of the Insurance Company Exception was first adopted into the Code as part of the PFIC provisions in 1986. Since the exception was introduced, there has not been significant guidance regarding the meaning of the Active Conduct Requirement, and what distinguishes a corporation that is engaged in the "active conduct of an insurance business" from other corporations that qualify as insurance companies for federal income tax purposes. The Proposed Regulations would introduce two new requirements that a QIC would be required to meet in order to satisfy the Active Conduct Requirement. First, a QIC would be treated as actively conducting an insurance business "only if the officers and employees of the QIC carry out substantial management and operational activities" (the "Officers and Employees Requirement").4 Second, income generated by the QIC would be treated as satisfying the Active Conduct Requirement only if the QIC satisfied a numerical test (the "Active Conduct Percentage"), which generally compares (i) the QIC's expenses for producing or acquiring premium or investment income paid to officers and employees to (ii) the QIC's expenses for producing such income paid to other persons.5 Thus, the Proposed Regulations would generally require that, in order to satisfy the Active Conduct Requirement, a foreign corporation would generally be required to conduct the bulk of its underwriting and/or investment activities through internal officers and employees rather than third-party contractors.

A Separate Active Conduct Test is Not Required

We do not believe it is necessary for the Treasury to impose an additional test on a QIC to satisfy the Insurance Company Exception. We respectfully request that the Treasury construe the Active Conduct Requirement broadly and eliminate the proposed Officers and Employees Requirement and the proposed Active Conduct Percentage tests. In particular, we believe that the original legislative history for the Insurance Company Exception, as well as the changes to the Insurance Company Exception made by the Tax Cuts and Jobs Act of 2017 (the "TCJA") and the legislative history surrounding those changes, indicate that Congress did not intend for the "Active Conduct Requirement" to constitute a separate requirement.

When the Insurance Company Exception was introduced in 1986, the legislative history indicated that Treasury should have regulatory authority to restrict the Insurance Company Exception "where it is necessary to prevent U.S. persons from earning what is essentially investment income in a tax deferred entity."6 The legislative history expressed two primary concerns regarding the types of companies that Congress felt should not qualify for the exception. First, the legislative history states that "it was intended that entities engaged in the business of providing insurance may derive passive income and, thus, qualify as PFICs in the event that the entities maintain financial reserves in excess of the reasonable needs of their insurance business."7 Second, the legislative history stated that "a foreign corporation established to acquire insurance coverage on behalf of related persons (a captive insurance company) may qualify as a PFIC in the event there is no shifting of risk to the foreign entity. In these captive arrangements, since there is no shifting of risk, the company is not an insurance company."8

In enumerating the two concerns described above, the legislative history to the Insurance Company Exception did not indicate that Congress meant that companies that utilize significant external resources in operating their business would not qualify for the exception. Although the original formulation of the Insurance Company Exception used the same language regarding the "active conduct of an insurance business" that is included in the current formulation, the legislative history did not make any distinction between an "active" or "passive" insurance business, other than as described above. Rather, the legislative history stated that "[i]ncome of a bona fide insurance company that is not treated as passive income is that income which would be subject to taxation under subchapter L if the income were derived by a domestic insurance company."9

It should be noted that the law surrounding the Insurance Company Exception has developed so that the two concerns expressed by Congress are adequately addressed under current law without the additional tests introduced by the Proposed Regulations. The first concern (that an insurance company may maintain financial reserves in excess of the reasonable needs of its insurance business) has been addressed by the 25% Insurance Liability Test, added by the TCJA. The second concern, that an insurance company would write related-party insurance contracts that do not sufficiently shift risk, is addressed by the requirement that a company qualify as an insurance company under subchapter L to qualify for the exception. The type of company described in the legislative history as not assuming "shifting of risk" would not be eligible for the Insurance Company Exception because it would not qualify as an insurance company under subchapter L, as has been clarified and emphasized by subsequent guidance.10

Similarly, the legislative history of the TCJA suggests that Congress introduced the 25% Insurance Liability Test as an alternative to any test that might be based on the particular activities of the officers and employees of the company. In its explanation of the 25% Insurance Liability Test, the legislative history for the TCJA stated that the TCJA modifies the Insurance Company Exception by replacing an earlier requirement that the corporation be "predominately engaged in an insurance business" with the 25% Insurance Liability Test.11 In declining to follow the 2015 proposed regulations, the legislative history further stated: "Treasury regulations proposed in 2015 have taken a different approach that is based on the current statutory rule" (emphasis added).12 This statement suggests that the TCJA's 25% Insurance Liability Test was included as a substitute for the active conduct test proposed in the 2015 proposed regulations. As indicated above, the rule proposed in the 2015 proposed regulations was substantially similar to the currently-proposed Officers and Employees Requirement, which Congress, in passing the TCJA, reviewed but did not adopt. Thus, the legislative history of the TCJA suggests that Congress intended the 25% Insurance Liability Test as a substitute for the prior version of the Active Conduct Requirement that had been proposed in the 2015 proposed regulations and, by extension, the similar requirements included in the current Proposed Regulations.

Furthermore, although the TCJA did not alter the language in the Insurance Company Exception requiring that income be derived in the "active conduct" of an insurance business, the legislative history to the TCJA does not suggest that an insurance company would be required to meet any additional requirements in order for its business to be considered "active." Although there are numerous grants of regulatory authority in the TCJA in general, and in the TCJA revisions to the Insurance Company Exception in particular, and although the TCJA specifically revises the Insurance Company Exception to limit its application to companies that are overcapitalized relative to their insurance liabilities, the TCJA does not contemplate that Treasury would impose additional restrictions to distinguish an "active" from a "passive" insurance company, or include any new grant of authority for Treasury to do so.

For these reasons, we believe it would be inconsistent with Congressional intent for Treasury to impose additional tests to distinguish between an "active" and a "passive" insurance business that otherwise satisfies the Insurance Company Requirement and the TCJA's 25% Insurance Liability Test, nor would such a test be necessary to prevent the Insurance Company Exception from applying inappropriately. We respectfully request that Treasury eliminate the Officers and Employees Requirement and the Active Conduct Percentage test when the Proposed Regulations are finalized.

Alternative Conceptions of the Active Conduct of an Insurance Business

If, notwithstanding the preceding discussion, Treasury concludes that the "active conduct" language in the Code was intended to impose a separate substantive requirement on companies that otherwise qualify for the Insurance Company Exception, we respectfully request that Treasury consider alternative conceptions of "active conduct" that are more in line with the practice of the insurance and reinsurance industry to the tests provided in the Proposed Regulations. In particular, we would propose that a QIC would satisfy the Active Conduct Requirement if the company pursues a business plan of assuming risk under multiple distinct insurance or reinsurance contracts either (i) with multiple counterparties that are unrelated to one another, or (ii) that cover multiple divergent lines of business, and thus represent distinct underwriting processes.

Fundamentally, insurance companies can be distinguished from other businesses in that insurance companies are primarily focused on assuming risk. The test described above would distinguish between insurance companies that actively assume risk from companies that do not, based on the nature and diversity of the risks that they assume. This test would thus distinguish between different categories of insurance companies in a manner that reflects fundamental differences in their business plans. In addition, the proposed test would rely on distinctions that are highly relevant to investors in evaluating and understanding a company. The test would thus have the benefit of not creating distinctions that would appear arbitrary or artificial to investors. Furthermore, the test would reflect the manner in which many practitioners have tended to construe the Active Conduct Requirement in the decades since it has been enacted, and would thus create less disruption in the insurance industry.

A broad variety of vehicles exist in the insurance space, and the U.S. insurance market benefits greatly from the products offered by virtue of that structural diversity. Insurance companies range from full-service corporate groups that offer broad varieties of insurance and reinsurance products to special-purpose vehicles such as catastrophe bond ("Cat Bond") issuers, which in their simplest form write a single contract at inception and never engage in any further underwriting activities. The main features that distinguish these companies relate to the nature of the risks the companies assume, rather than the process that the companies follow in identifying and managing these risks. In particular, the variety of the counterparties that the company will reinsure, or the risks that the company will assume, have a much greater influence on investors expectations with respect to the company than the extent to which the company might choose for cost-efficiency or other reasons to engage with external resources for certain aspects of operating its business.

One could argue that a simple Cat Bond, which would not satisfy the Active Conduct Test we propose above, is not an "active" insurance business in this sense because the issuer writes a single contract and will never engage in further underwriting, and the investment securities into which the investors' capital are invested are pre-determined. This fundamentally shapes the investor's experience with the investment; the investor has up-front visibility to all of the risks that the vehicle will assume in both the asset and liability portfolios. The investor is in a position similar to the position the investor would be in if the investor entered into the insurance contract as a reinsurer itself — the investor assumes the risks and rewards associated with the contract that are established at the inception of the investment and will remain static throughout the life of the investment. Importantly, after the initial investment, the performance of the vehicle does not rely on the performance and skill of any individuals, other than the basic routine administration of the vehicle.

In contrast, when an investor invests in a company (or a corporate group) that pursues multiple lines of insurance or reinsurance exposures, either from multiple sources or with respect to divergent categories of risks, the investor is not investing in a static transaction, but is investing in a business that will evolve based on the skill of the management team. Such a company has a going concern value that is independent from the specific portfolios of insurance risks and investments to support those insurance portfolios that the company holds at the time of the investor's investment in the company, and the returns of both such components are unknown and will vary with the company's liability and timing of claims payments under the insurance and reinsurance risks it assumes. In essence, the investor is investing in, and putting its faith in, the ability of the management team to develop and execute on their strategy to assume profitable risks.

From the investor's perspective, what makes the insurance company "active" is the fact that the success of the company depends on the management team's ability to successfully source and manage risks in the market. This is true regardless of the extent to which the senior team managing the company performs this sourcing and risk management solely through employees of the company or through external personnel that provide services to the company as contractors. An investor in the company is not likely to distinguish between a management team that utilizes external contractors significantly and a company that relies solely on its own employees, but is more likely to be concerned with the abilities of the senior team (including their ability to manage any outsourced functions) and the nature of the risks the team intends to pursue. Since the goal of the PFIC provisions is to distinguish operating businesses from companies that are essentially investment companies, it would be inappropriate for vehicles that are viewed by investors as operating businesses to be subject to the PFIC rules based on features that do not significantly affect the way the company is understood by investors.

We note that in certain other contexts, the PFIC authorities distinguish between an active and passive business based on the extent to which the business is conducted by employees and officers of the company. For example, the rules for determining whether leasing and licensing activities are considered active or passive for purposes of the PFIC rules incorporate rules under Code Section 954 that generally require that activities be conducted through officers and employees of the company to be considered active.13 However, leasing and licensing companies generally enter into transactions where the company receives a fixed return and retains very little risk. As a result, if such a company outsources its operational functions to third parties, the company is similar to a company that merely holds passive investments and collects the return on the investments. For example, a company that holds a number of long-term net leases and outsources all operational activities with respect to such leases might resemble a company that holds a portfolio of bonds. Insurance companies are distinguishable in that, provided the company's insurance contracts shift insurance risk as required for the company to qualify as an insurance company for U.S. federal income tax purposes, the risk profile of the company is fundamentally different from a passive investment company. The insurance company is not guaranteed a return on its contracts, and, in fact, by the nature of its contracts the company is exposed to potential significant losses. Investors in the insurance company are exposed to the managerial decisions of the insurance company in continuously assuming and administering additional risks, which is an active process that more resembles an operating business than a passive investment holding company, even if significant aspects of the company's operations are outsourced to third parties (which are in turn directed and supervised by the insurance company's management). As a result, the considerations that suggest that a leasing or licensing company should be considered passive if it outsources significant components of its operational functions do not lead to the same conclusion in the context of an insurance company.

In addition to the reasons described above, the test we propose above based on the diversity of assumed risks is preferable to a test based on the level of outsourcing of the insurance company because outsourcing arrangements have historically been a prominent element of insurance and reinsurance companies business. For example, "managing general agent" or "MGA" arrangements have been a prominent element of the insurance landscape for decades. In these arrangements, a third party MGA, acting as an independent contractor, sources, evaluates, and binds risks on behalf of multiple insurance and reinsurance companies. Similarly, insurance and reinsurance companies commonly retain brokers and intermediaries to assist in sourcing business. In addition, alternative insurance vehicles with robust business plans commonly rely almost exclusively on outsourced services. Examples include insurance funds that seek to enter into several reinsurance contracts with various counterparties on behalf of investors and are typically managed by a third-party manager. Although these insurance "funds" may raise capital from investors in a manner that resembles other alternative investment funds, the vehicles may deploy the capital by entering into multiple reinsurance transactions over time pursuant to a defined business plan, and thus may operate similarly to any other active reinsurance provider in the market. Other examples include Lloyd's syndicates, in which managing agencies underwrite business and manage the affairs of a pool of capital that supports the underlying insurance contracts.

It is also common for an insurance company's investment function to be fully or partially outsourced to third-party investment managers. Utilizing one or more third-party investment managers may give an insurance company access to highly specialized investment programs and the expertise to evaluate those opportunities that the insurance company would not be able to produce on its own, and may allow the insurance company to pool its capital with other capital sources in order to hold more diversified investments, or get access to investments with a high barrier to entry without diminishing the diversification of the insurance company's overall investment holdings. For these reasons, the insurance company may determine that it can achieve higher investment returns by utilizing external investment advisors to implement the company's investment strategy. But this does not change the fact that the company operates as an active participant in the insurance market.

The benefit of these various insurance business models is increased competition, which results in lower insurance premiums for individual consumers and businesses. Given the level of outsourcing that is common in the insurance landscape, the Active Conduct Percentage test in the Proposed Regulations would cause many active insurance, and in particular reinsurance, companies to be inappropriately classified as PFICs, and potentially would reduce investor appetite in some bona fide insurance and reinsurance enterprises, leading ultimately to higher insurance prices. We therefore respectfully submit that the test we propose above focused on the assumption of underwriting risk would be more consistent with the manner in which existing insurance companies operate their businesses, and would not exclude companies that assume large volumes of risk from various sources solely because the company relies on the traditional outsourcing practices described above.

For these reasons, we believe that a company should be considered active for purposes of the Insurance Company Exception if the company pursues a business plan of entering into multiple insurance transactions with diverse features, regardless of the extent to which the company outsources to third party resources in conducting its business.

Additional Aspects of the Active Conduct Requirement

Separate and apart from the legislative history and other points raised above that we believe obviate the need for an additional Active Conduct inquiry beyond the TCJA's 25% Liabilities to Assets Test, to the extent that Treasury concludes that Congress intended that a separate Active Conduct Requirement should apply, we would propose that Treasury consider incorporating a test that includes multiple sufficient conditions for a company to be considered as active.14 For example, a company that meets the Insurance Company Requirement (i.e., would be taxed under subchapter L if it were a domestic company) and meets the 25% Insurance Liability Test could be considered to satisfy the Active Conduct Requirement to the extent that it either (i) satisfies the multiple-and-diverse risks test described in the preceding section or (ii) satisfies certain other characteristics shared by most insurers active in the market. For example, factors that could be taken into account to determine if a company should be treated as active could include (a) the company operates in an NAIC Qualified Jurisdiction15 or a jurisdiction that has enacted robust economic substance legislation,16 and the company is in compliance with such economic substance legislation, (b) the company prepares financial reports under either U.S. GAAP or IFRS rules, (c) the company conducts significant management and oversight of internal and any outsourced operations, including both core insurance functions and strategies for investing assets that support the insurance portfolio, and (d) the company employs strong corporate governance practices, a formal enterprise risk management and an internal controls framework. Such an approach would be consistent with the broad range of models for active insurance companies in the market.

In addition, we note that insurance operations are often conducted across multiple different vehicles within a particular group. In particular, it is not uncommon, particularly given jurisdictional and regulatory constraints, for an insurance group's insurance transactions to be housed in multiple corporations under a holding company. Since the companies would be classified as insurance companies for federal income tax purposes, each group company would be required to be classified as a corporation. Notwithstanding this classification, the separate companies could be part of a single corporate group and could operate a unitary insurance business that, taken as a whole, constitutes an active business. We therefore respectfully request that Treasury consider adopting a rule that would apply the Active Conduct Requirement on an aggregate basis where multiple QICs are wholly-owned within a single group.

Conclusion

As described above, we respectfully request that Treasury remove the Active Conduct Percentage and the Officers and Employees Requirement from the Proposed Regulations because we believe that the existing requirements for satisfying the Insurance Company Exception adequately limit the exception to bona fide insurance companies. To the extent that Treasury concludes that Congress intended for a separate active conduct test to be instituted, we respectfully request that, in lieu of a test focusing on the degree of outsourcing conducted by a company, Treasury instead adopt the test described above, based on the number and diversity of contracts entered into by the company. For the reasons provided above, this test appropriately distinguishes between a company that is actively managed on a continuing basis and a company that operates in a more passive form. We have proposed above certain additional indicia of an active insurance business that could be considered relevant to this determination, and that we believe are more customary characteristics of an actively managed insurance company than focusing on the activities performed directly by employees as opposed to activities that are outsourced, particularly given that regulatory jurisdictions typically require that the direction and supervision by management of any outsourced service providers be as integral as supervision of employees. To the extent that Treasury determines that multiple tests or factors are relevant for determining if an insurance business is actively conducted, we respectfully request that Treasury consider a test in which a company could satisfy alternative sufficient conditions for being considered active, given the diversity in business models and structures that play an active role in the insurance and reinsurance market. Finally, given that a corporate insurance group may consist of multiple entities that are required to be treated as separate corporations for federal income tax purposes, we respectfully request that any test for active conduct apply on an aggregate basis to entities within a corporate group.

Respectfully submitted,

Michael Seaton
Clifford Chance US LLP
New York, NY

FOOTNOTES

2Code Section 1297(f)(1)(B). A corporation that does not satisfy the 25% Insurance Liability Test can satisfy an alternative 10% test under certain limited circumstances. Section 1297(f)(2).

4Prop. Treas. Reg. § 1.1297-5(c)(3)(i). For this purpose, the officers and employees of the QIC would be considered to include the officers and employees of certain entities under common control with the QIC that meet certain requirements. Id. The Officers and Employees Requirement is a variation on a requirement that was included in Treasury Regulations proposed in 2015, which were withdrawn by the Proposed Regulations.

5Prop. Treas. Reg. § 1.1297-5(c)(4).

61986 Blue Book, p. 1025.

7Id.

8Id.

9Id.

10See, e.g., Rev. Rul. 2002-89, 2002-2 CB 984.

11The prior "predominately engaged in an insurance business" test has generally been viewed as superfluous, since a company is not viewed as qualifying as an insurance company under subchapter L unless it is predominately engaged in an insurance business, and moreover, under earlier regulations, whether a company was predominately engaged in an insurance business was the specific test for determining if the company is an insurance company

12TCJA Conference Report, p. 547, n. 1579

13Treas. Reg. §§ 1.954-2(c); 1.954-2(d).

14Thus, we are proposing that the Active Conduct Requirement could resemble in this respect the test for an active rental business included in Treasury Regulation Section 1.954-2(c), in which a rental operation can meet one of four alternative tests in order for rental income to be treated as active.

15The National Association of Insurance Commissioners maintains a list of "qualified jurisdictions" based on factors such as the financial solvency regulation and other relevant oversight in that jurisdiction. Jurisdictions that qualify as qualified jurisdictions are generally viewed more favorably for "credit for reinsurance" purposes — i.e., the degree to which U.S. insurance companies can recognize a reduction in their liabilities for the amount of liabilities ceded to a company regulated in the qualified jurisdiction.

16Certain jurisdictions such as Bermuda have recently enacted such legislation, which generally requires that entities subject to the legislation maintain substantive physical presence and management and direction in the jurisdiction.

END FOOTNOTES

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