Firm Seeks Changes to PFIC Regs, Removal of Some Requirements

September 9, 2019

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

Comments on Proposed Treasury Regulations Sections 1.1297-5 (Regarding the Exception from the Definition of Passive Income for Income Derived in the Active Conduct of an Insurance Business) and 1.1298-4 (Regarding the Rules for Foreign Corporations Owning Twenty-Five Percent or More of the Stock of One or More Owned Domestic Corporations)

We respectfully submit this letter commenting on proposed Treasury Regulations Section 1.1297-5, regarding the exception from the definition of passive income for income derived in the active conduct of an insurance business for purposes of the passive foreign investment company (“PFIC”) rules, and Section 1.1298-5, regarding the rules for foreign corporations owning 25% or more of the stock of one or more domestic corporations.

We are writing in response to the request by the Department of Treasury (“Treasury”) and the Internal Revenue Service (the “Service”) for comments regarding whether it is appropriate to determine whether a qualified insurance company (a “QIC”) is engaged in the active conduct of an insurance business based on the relative amount of certain expenses for insurance activities incurred by the QIC and certain of its affiliates. We are also writing with reference to the rule in the proposed Treasury Regulations that provides that the income and assets of a “look-through subsidiary” or “look-through partnership” may only be treated as active by a QIC if the assets and liabilities of such look-through subsidiary or look-through partnership are included on the applicable financial statement of the QIC.

We are also writing in response to the request by Treasury and the Service for comments regarding the rule in the proposed Treasury Regulations that provides that stock owned by a foreign corporation will be attributed for purposes of the PFIC rules to the shareholders of such foreign corporation unless the foreign corporation is not a PFIC, determined without regard to the general rule treating “qualified stock” (as defined below) held by a 25% or greater owned domestic subsidiary as a non-passive asset and income from such qualified stock as non-passive income.

Background

Active Conduct of an Insurance Business by a QIC

Section 1297(b)(1)¹ generally defines the term “passive income” for purposes of the PFIC rules as “any income of a kind that would be foreign personal holding company income.” In enacting the PFIC rules, Congress has recognized that, under the general definition of “passive income,” investment assets that a foreign insurance company holds to support its obligations under insurance or annuity contracts issued or reinsured by the foreign company could inappropriately be treated as assets that produce or that are held for the production of passive income. Accordingly, Congress has provided an exception for income derived by a foreign insurance company engaged in the active conduct of an insurance business. Specifically, under Section 1297(b)(2)(B), except as provided in Treasury regulations, the term “passive income” does not include income derived in the active conduct of an insurance business by a QIC (the “Insurance Exception”). The Insurance Exception was modified by the Tax Cuts and Jobs Act to require that any insurance company seeking to qualify as a QIC must be subject to tax under subchapter L if it were a domestic corporation and that certain insurance liabilities must constitute more than 25% of its balance sheet assets.

Treasury and the Service have issued proposed regulations which define “insurance business” to mean the business of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies, together with investment activities and administrative services that are required to support (or that are substantially related to) those insurance, annuity or reinsurance contracts issued or entered into by a QIC (“Insurance Contracts”).² The proposed regulations further provide that the exception from the definition of passive income provided for income derived in the active conduct of an insurance business is calculated by reference to the QIC's passive income earned with respect to assets of the QIC that are available to satisfy liabilities of the QIC related to such insurance business. The exception will apply either to all of such income, if the QIC's “active conduct percentage” equals or exceeds 50%, or none, if the QIC's active conduct percentage is less than 50%.³

The QIC's “active conduct percentage” is the percentage calculated by dividing (a) the aggregate amount of expenses, including compensation and related expenses, for services of the officers and employees of the QIC (or officers and employees of entities that meet the Control Test, as defined below) incurred by the QIC for the taxable year that are related to the production or acquisition of premiums and investment income on assets held to meet its obligations under Insurance Contracts by (b) the aggregate of (i) the expenses described in (a) and (ii) all other expenses paid by the QIC for the production or acquisition of premiums and investment income on assets held to meet obligations under the Insurance Contracts.⁴

The proposed regulations provide additional rules for determining whether the insurance company is engaged in the active conduct of an insurance business. The proposed regulations require that the officers and employees of the QIC carry out substantial managerial and operational activities. For these purposes, the officers of and employees of the QIC include officers and employees of another entity only if (a) either (i) the QIC owns, or is considered to own, more than 50% of the other entity's vote and value (for a corporation) or capital and profits interests (for a partnership) or (ii) a common parent owns 80% of the vote and value (for a corporation) or 80% of the capital and profits (for a partnership) of each of the QIC and the other entity ((i) and (ii), the “Affiliation Test”), (b) the QIC exercises regular oversight and supervision over the services performed by the other entity's officers and employees for the QIC and (c) the QIC either (i) directly pays the compensation for the other entity's officers and employees attributable to services performed for the production of acquisition of premiums and investment income on assets held to meet the QIC's obligations on Insurance Contracts or (ii) reimburses the other entity for the portion of its expenses, including compensation and related expenses, for the insurance services performed for the QIC or by the other entity's officers and employees ((a), (b) and (c), the “Control Test”).⁵

Scope of the Insurance Exception

The proposed regulations also contain rules clarifying which assets and income of the QIC will benefit from the insurance company exception. In particular, the proposed regulations provide that an interest in and income from a subsidiary or partnership can qualify as active under the insurance company exception. However, the rules add an additional requirement for 25%-owned corporate subsidiaries and 25%-owned partnerships (“Subsidiaries”), under which the Subsidiary's assets and liabilities would need to be reflected in the applicable financial statement of the relevant insurance company used for the qualifying insurance liabilities test in Prop. Treas. Reg. 1.1297-5.⁶

Attribution of Lower-Tier PFIC Stock

Under Section 1298(a)(2) of the Code, shareholders that own less than 50% of a non-U.S. corporation generally are treated as owning stock owned by such corporation only if such corporation is itself treated as a PFIC. Thus, if a shareholder owns less than 50% of a non-PFIC, it does not need to determine separately whether or not any subsidiaries of the foreign corporation are themselves PFICs.

Section 1298(b)(7) of the Code generally provides that with respect to a tested foreign corporation, stock of a domestic corporation (“qualified stock”) that is not a regulated investment company or real estate investment trust will not be treated as a passive asset, and income from such stock is not treated as passive income if the tested foreign corporation (a) is subject to section 531 tax and (b) owns at least 25% by value of the stock of a domestic corporation which owns the qualified stock (the “25% Domestic Corporation Rule”).⁷ However, under the proposed regulations, for purposes of the attribution rules of Section 1298(a)(2), a tested foreign corporation must determine whether or not it is a PFIC without regard to the 25% Domestic Corporation Rule.⁸ Accordingly, if the tested foreign corporation would be a PFIC but for the 25% Domestic Corporation Rule, its shareholders will for purposes of the PFIC rules be attributed their pro rata share of stock held by the tested foreign corporation.⁹ Similar proposed rules turn off look-through rules treating income and assets of qualifying domestic insurance companies (“QDICs”) as active for purposes of the Insurance Exception for purposes of Section 1298(a)(2).¹⁰

Recommendations

Discussion

Active Conduct of an Insurance Business by a QIC

We believe that the final regulations should test for active conduct of an insurance business based on all of the relevant facts and circumstances. We believe this determination would take into account the type and duration of the insurance business written, the method of sale or distribution of the insurance written, the nature of the underwriting function and underwriting season with respect to the relevant types of insurance, the nature of the activities performed internally and of those outsourced, and whether the QIC's operations are in a start-up phase. If the Active Conduct Percentage test is retained, it should operate as a “safe harbor” rather than as a bright-line test. Given that a particular insurance company's expenses are highly dependent on its specific factual situation and type of business, an inflexible bright-line test creates a meaningful risk either of treating as PFICs bona fide insurance companies that have made a commercial judgment as to outsourcing certain tasks or of forcing bona fide insurance companies to perform such tasks internally against their commercial judgment. In other words, if a QIC's officers and employees are engaged in substantial managerial and operational activities in relation to the insurance business, as required by Prop. Treas. Reg. §1.1297-5(c)(3), the regulations should not dictate how such QIC should deploy its resources (through internal hires or external service providers) to support such officers and employees in performing these functions. For example, an insurance company that has a large business appetite for underwriting risk may make substantial use of third-party brokers to source business. It is also commonplace throughout the insurance industry for insurance companies, whose primary expertise is in underwriting and risk management, to hire third-party investment managers to ensure that investment management does not distract from those areas of focus. In either case, we do not believe that the use of third parties is a proper indicator of passivity. In addition, in many instances the scale of a QIC's operations would mean that it is not viable to develop some functions (such as brokerage or investment management) internally to the same degree of quality and sophistication as could be obtained from third-party service providers. Finally, we do not see any indication that the Tax Cuts and Jobs Act changes to the PFIC rules, which adopted a bright-line rule for applicable insurance liabilities, support implementing a second bright-line rule in relation to the inherently facts-and-circumstances-based determination of whether a foreign corporation is engaged in the active conduct of an insurance business.

If the final regulations retain the Active Conduct Percentage test, even as a “safe harbor,” we believe that it is necessary to either more appropriately reflect certain typical third-party expenditures, such as brokerage or investment management fees that are commonly incurred by insurers (for example, by reflecting in the numerator and denominator only expenses relating to the evaluation and pricing of insurance contracts and risk management), or to lower the percentage threshold for qualification for such safe harbor to 25%, as many bona fide insurance companies are unlikely, for bona fide non-tax reasons, to have employee compensation form the majority of their expenses.

Finally, we recommend that the final regulations permit a QIC to take into account the activities of any person over whom it exercises regular oversight and supervision and for whose services the QIC pays, whether through payment of employee compensation, expense-reimbursement arrangements or third-party service fees, regardless of the degree of affiliation between such QIC and such person's employer. We believe that a QIC should be treated as having sufficient contact and control in respect of outsourced functions by virtue of such regular oversight and supervision and associated payment. If an affiliation requirement is to be retained, the Affiliation Test should be broadened to include entities that are under common practical control. In assessing whether a company is actively conducting an insurance business, we believe that it is more important to analyze the amount of business and number of contracts written by the company, and time spent on underwriting, claims and relationships with counter-parties, as opposed to whether the people engaging in these activities are employees of the company itself, employees of a parent of a group or controlling shareholder of the company, employees of a service company that employs the employees of all members of a group for the sake of convenience, or employees of a commonly controlled insurance or investment management company. If an insurance platform encompassing multiple entities operates as a commonly controlled group, we do not believe that PFIC status should turn on whether individual companies within the group are financed by equity funded by investors in different proportions. Adopting a rule that requires the relevant personnel to be housed within entities that meet a mechanical relationship test elevates form over substance and does not address the core policy issues at the heart of the Insurance Exception. Moreover, the proposed regulations are out of harmony with the governance structure for many bona fide insurance vehicles that form a significant presence in the insurance market, such as collateralized reinsurance vehicles in which services are provided to the insurance vehicle by an affiliate of the person who controls the insurance vehicle as a governance matter but is not typically an 80% beneficial owner of such vehicle.

Scope of the Insurance Exception

We believe that final regulations should eliminate the requirement of consolidation on the applicable financial statement for income and assets of Subsidiaries to qualify for the Insurance Exception. The statutory framework does not contemplate the application of the Insurance Exception by reference to an applicable financial statement, which is relevant only to testing for QIC status. Moreover, the QIC status test itself defers to the contents of the tested foreign corporation's applicable financial statement and does not impose any additional requirements as to the consolidation or non-consolidation of the tested foreign corporation's subsidiaries or partnerships when comparing applicable insurance liabilities with assets — the assets of a consolidated subsidiary are counted on a gross basis and a nonconsolidated subsidiary on a net basis, depending on the relevant accounting treatment. In addition, we do not see any compelling policy reason why the availability of the Insurance Exception should depend on whether or not applicable accounting rules require consolidation, since the accounting rules governing consolidation do not speak to the core policy issues at the heart of the Insurance Exception — in particular, whether or not an investment asset is held for use in an insurance business. More broadly, this rule affords negative treatment to an insurance company that owns a non-consolidated, 25%-owned investment partnership as compared with an insurance company that owns the same investment assets directly. There are many legitimate business reasons to hold assets in partnership form. For example, they provide great flexibility in both governance and economic arrangements for joint ventures. Provided that the partnership and its assets are held to support the company's insurance risks, we do not believe this worse treatment is appropriate, whether or not consolidated.

Attribution Rules

The final regulations should eliminate the requirement for a tested foreign corporation to make a separate determination in connection with the 25% Domestic Subsidiary Rule and with respect to QDICs for purposes of general PFIC status and for purposes of the Section 1298(a)(2) attribution rules. The statutory framework does not contemplate using different tests for PFIC status in this circumstance, and Section 1298(a)(2) clearly articulates the circumstances in which shareholders should be attributed lower-tier stock, with one rule for PFICs and another (the ownership threshold) for non-PFICs. We believe this binary approach reflects an appropriate balancing of the United States' interest in preventing excessive tax deferral with the burdens of PFIC compliance that could be imposed on minority shareholders, who may not have the ability to obtain the information necessary to make a judgment as to the PFIC status of every subsidiary in a corporate group, or to make a QEF election with respect to such subsidiaries. Accordingly, we believe the proposed regulations could lead to inappropriate results. For example, if the shareholders of a foreign public company that is not a PFIC, in part because of U.S. operations which are fully subject to United States tax, are attributed shares of a relatively minor PFIC subsidiary of such public company, the resulting non-tax consequences, including public disclosure, reporting challenges and consequential harm to the foreign public company's share price, could be significantly disproportionate to the benefits to the United States of imposing PFIC taxes. These consequences could potentially arise in situations such as an insurance subsidiary's failure to meet the Qualifying Insurance Company test in a year where the insurance operations of the public group are clearly active as a whole, for example, if the group is establishing a new subsidiary to write a particular line of business. In addition, to avoid such detrimental consequences, the foreign public company could be forced to undergo costly restructuring, including potentially disposing of the PFIC subsidiary where doing so is not otherwise commercially warranted. For these reasons, we believe that the proposed regulations should revert to the attribution tests in Section 1298(a)(2) without imposing additional limitations.

Respectfully yours,

Peter A. Furci
Peter F.G. Schuur
Debevoise & Plimpton
Washington, DC