Insurance Company Addresses 5 Issues Under PFIC Regs

September 9, 2019

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, D.C. 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

The Honorable Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: REG-105474-18 (Proposed Regulations on Passive Foreign Investment Companies)

Dear Messrs. Kautter, Rettig, and Desmond:

Assured Guaranty Ltd. ("AGL") welcomes the opportunity to provide comments in response to the Notice of Proposed Rulemaking, Passive Foreign Investment Companies, issued July 11, 2019 (the "Proposed Regulations").¹ We appreciate the work of the staff at the Department of the Treasury ("Treasury") and the Internal Revenue Service (the "Service") to try to implement the qualifying insurance corporation ("QIC") exception to the passive foreign investment company ("PFIC") rules in a timely fashion and to answer some additional long-standing questions regarding the PFIC rules. Our comments address the following five issues:

I. Background

The Tax Cuts and Jobs Act (the "Act") modified the QIC exception to the PFIC rules.⁴ The Act replaced a somewhat subjective test based on whether a corporation was "predominantly engaged in an insurance business" with a more objective test based on the corporation's insurance liabilities as a percentage of its total assets.⁵

Under the new QIC exception, a QIC is defined as a corporation (1) that would be subject to tax under subchapter L if it were a domestic corporation; and (2) has applicable insurance liabilities constituting more than 25 percent of its total assets as reported on the company's applicable financial statement for the last year ending with or within the taxable year (the "25-percent test").⁶ For this purpose, the term "applicable insurance liabilities" is defined to include (1) loss and loss adjustment expenses; and (2) reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance risks and claims.⁷ Should a corporation fail to qualify as a QIC solely because it does not meet this 25-percent test, the corporation may still qualify as a QIC if (1) the corporation's applicable insurance liabilities constitute at least 10 percent of its total assets (the "10-percent test"), and (2) based on the applicable facts and circumstances, the corporation is predominantly engaged in an insurance business, and its failure to qualify under the 25-percent test is due solely to runoff-related or rating-related circumstances involving such insurance business (the "Alternative Facts and Circumstances Test").⁸

As we have discussed with Treasury and the Service and detailed in prior submissions,⁹ financial guaranty insurers and reinsurers are subject to a unique set of rating agency, regulatory, and accounting requirements, which will typically cause them to be unable to satisfy the 25-percent test and may even make it difficult to satisfy the 10-percent test. Because financial guaranty insurers are limited from entering other lines of insurance business (and, thus, are often called "monolines"), they cannot engage in self-help by modifying their business to satisfy the 25-percent test.

Financial guaranty policies, also known as bond insurance, are typically long-term, often issued with terms of 30 years or more, in order to match the maturity dates of the insured securities, and these policies are noncancelable. Financial guaranty insurers typically experience a lower frequency of losses than property and casualty insurers, but when financial guaranty insurers do experience losses, those losses tend to have a high severity. As a result, financial guaranty insurers need to carry sufficient capital and surplus to be able to pay losses in a high loss year, even though in a low loss year, that level of assets may seem excessive. Losses must be paid when due under the policy and financial guaranty companies do not establish "incurred but not reported" reserves. In addition, financial guaranty insurers are subject to unique accounting rules under Generally Accepted Accounting Principles ("GAAP") under which they may not establish loss reserves for a policy until the insurer's expected loss on the policy exceeds its unearned premium reserves on the policy.¹⁰

Bond insurance is a form of credit enhancement that results in the rating of the insured security reflecting the financial strength of the insurer, thereby producing a lower borrowing cost for a lower-rated bond issuer than the bond issuer could have achieved had its security been issued without bond insurance. Thus, one of the reasons bond issuers purchase bond insurance is so that the credit rating of the financial guaranty insurer is conferred to the insured security. For this reason, financial guaranty insurers are subject to a unique set of rating agency requirements and capital adequacy models that do not apply to other property and casualty or life insurance companies. Under these models, the rating agencies stress test the insurer's liabilities to ensure that the insurer holds sufficient excess capital to satisfy all of its liabilities, as well as assess a number of other facts and circumstances, including the financial guaranty insurer's claims paying history, the length of time it has been in business, and the quality of its investments.

In summary, low loss reserves coupled with the exclusion of unearned premiums from applicable insurance liabilities keeps the numerator of a financial guaranty insurer's ratio low, while the insurer's need (driven by business, regulatory, and rating agency considerations) to maintain a substantial asset base to protect against infrequent, but potentially severe, losses keeps the denominator of its ratio large. Thus, notwithstanding that liabilities under financial guaranty insurance contracts are bona fide insurance liabilities, the 25-percent test potentially results in the treatment of financial guaranty companies as PFICs. AGL recognizes, based on our previous discussions that Treasury and the Service have determined that they lack the authority to modify the treatment of unearned premium reserves under section 1297(f) and that addressing the unintended consequence of this provision ultimately requires Congressional action. In the meantime, it is critical that financial guaranty insurers be able to rely on the Alternative Facts and Circumstances Test.

II. Comments on the Proposed Regulations

1. Exception for Rating Related Circumstances

Background

The Proposed Regulations provide that a foreign corporation will be treated as failing to meet the 25-percent test "due solely to . . . rating-related circumstances" only if:

(i) The 25 percent test is not met as a result of the specific requirements with respect to capital and surplus that a generally recognized credit rating agency imposes; and

(ii) The foreign corporation complies with the requirements of the credit rating agency in order to maintain the minimum credit rating required for the foreign corporation to be classified as secure to write new insurance business for the current year.¹¹

The preamble to the Proposed Regulations recognized the unique status of financial guaranty insurance and requested comments on how to address this line of business in the context of the rating-related circumstances test:

The Treasury Department and the IRS understand that there may be certain lines of insurance business, such as financial guaranty insurance, where market realities require a credit rating in excess of the minimum credit rating for a foreign corporation to be classified as secure to write new insurance business in the relevant business line for the current year. The Treasury Department and the IRS request comments regarding this fact pattern and how best to address these lines of business in the context of the rating-related circumstances test.¹²

As anticipated in the preamble, financial guaranty insurers cannot comfortably rely on the rating-related circumstances test as articulated in the Proposed Regulations to avoid PFIC designation. First, regarding clause (i), in our experience, none of the agencies that rate financial guaranty insurers impose a specific capital and surplus level for an insurer to maintain a specific credit rating. Their rating methodologies, instead, are more dynamic and subjective, involving both (1) an assessment of the particular exposures insured or reinsured by a particular financial guaranty insurer to determine if the insurer holds sufficient capital to satisfy stress level theoretical losses on such exposures; and (2) consideration of several other factors, including the insurer's claims paying history, the length of time it has been in business, and the quality of its investments.

Second, clause (ii) fails to recognize that the business of a financial guaranty insurer is particularly sensitive to, and reliant upon, its actual credit rating, not some "minimum" rating necessary for it to be viewed as "secure." Financial guaranty insurance is a form of credit enhancement that lowers issuers' borrowing costs when the insurer's rating assigned to the insured security is higher than the rating the security would otherwise receive based on the issuer's rating. Generally speaking, the guaranty of a financial guaranty insurer with a particular rating (e.g., AA) is of potential value only to issuers with lower individual or "stand-alone ratings (e.g., AA- and below). Thus, the downgrade of a financial guaranty insurer's credit rating reduces the number of prospective purchasers of the insurer's product in a more direct and pronounced way than a similar downgrade may affect a different type of insurer.¹³ For this reason, a financial guaranty insurer must strive to maintain assets that will support, and provide a buffer against the downigade of, its highest attainable rating, not merely a "minimum" rating required for the insurer to be viewed as "secure."

Recommendation

Consistent with the request for comments in the preamble to the Proposed Regulations regarding the application of the rating-related circumstances test to financial guaranty insurance, we believe that a special rule is warranted that deems financial guaranty insurers to satisfy the rating-related circumstances requirement contained in the Alternative Facts and Circumstances Test.¹⁴ Financial guaranty insurers would still be required to satisfy the 10-percent test, the predominantly engaged in an insurance business requirement, and the election requirement.

This special rule could be implemented through the following additions to the Proposed Regulations:

(4) Rating-related circumstances. A foreign corporation fails to satisfy the 25 percent test solely due to rating-related circumstances only if — 

(i) The 25 percent test is not met as a result of the specific requirements with respect to capital and surplus that a generally recognized credit rating agency imposes; and

(ii) Either — 

1. The foreign corporation complies with the requirements of the credit rating agency in order to maintain the minimum credit rating required for the foreign corporation to be classified as secure to write new insurance business for the current year. or

2. The foreign corporation is a financial guaranty insurance company.

a. For this purpose, "financial guaranty insurance company" means any insurance company whose sole business is to insure or reinsure only the type of business written by, or that would be permitted to be written by a company licensed under, and compliant with, a U.S. state law, modeled after the National Association of Insurance Companies Financial Guaranty Insurance Guideline, that specifically governs the licensing and regulation of financial guaranty insurance companies.

2. Effective Date/Reliance on Proposed Regulations

Background

The amendment made by the Act to the definition of QIC in section 1297(0 is effective for taxable years beginning after December 31, 2017.¹⁵ The regulations are proposed to be effective for taxable years of U.S. shareholders beginning on or after the date the regulations are published as final.¹⁶ However, taxpayers may elect to apply Prop. Reg. §§ 1.1297-4 and -5 for taxable years beginning after December 31, 2017, provided they consistently apply the Proposed Regulations.¹⁷

As discussed above, financial guaranty insurers generally will not be able to satisfy the 25-percent test for QICs. In addition, as anticipated in the preamble, the Alternative Facts and Circumstances Test, as articulated in the Proposed Regulations, does not help financial guaranty insurers because the language of the Proposed Regulations regarding rating-related circumstances does not fit or describe the situation of financial guaranty insurers. Because failure to meet the QIC exception for one year effectively results in being treated as a PFIC for future years, it is critical that financial guaranty insurers be provided guidance for taxable years before the regulations are published as final.

Recommendation

We respectfully recommend that the final regulations clarify that financial guaranty insurers may apply a reasonable interpretation of the exception for rating-related circumstances under section 1297(0(2)(B)(ii) for taxable years prior to the effective date of final regulations. Alternatively, if final regulations adopt rules specific to financial guaranty insurers such as those recommended above, we recommend permitting reliance on the final regulations retroactively to taxable years beginning after December 31, 2017.

3. Election Mechanics

Background

The Proposed Regulations provide that a U.S. person may make the election to apply the Alternative Facts and Circumstances Test in section 1297(0(2) if the foreign corporation provides directly to its shareholders, or makes publicly available (such as in a public filing or disclosure), a statement to shareholders that it satisfied the requirements of section 1297(f)(2) during the corporation's taxable year.¹⁸ The election must be made by a U.S. person that owns stock in the foreign corporation filing a limited-information Form 8621 and attaching the statement provided by the corporation.¹⁹

Recommendation

We believe that this requirement to file a limited-information Form 8621 is burdensome for shareholders of public companies like AGL. We respectfully recommend that the final regulations deem the election to apply the Alternative Facts and Circumstances Test to be made for shareholders of publicly traded foreign corporations²⁰ where the foreign corporation makes the appropriate statement publicly available. This approach is consistent with numerous other deemed elections where the election is almost universally taxpayer-favorable and the election requirement would otherwise end up creating a trap for the unwary.²¹ The deemed election approach will also reduce administrative burden on the electing taxpayer, as well as on the Service, because it will avoid requests for late elections. If a U.S. shareholder would like to elect out of the Alternative Facts and Circumstances Test, an option could be provided for an affirmative election out of the test.

Alternatively, the final regulations could provide for a deemed election or de minimis exception to the requirement for filing Form 8621 for shareholders owning less than a certain threshold for "small" shareholders (e.g., 10 percent).²²

4. Applicable Insurance Liabilities

Background

The Proposed Regulations define "applicable insurance liabilities" with respect to property and casualty insurance as:

Due to the nature of financial guaranty insurers, measuring losses in a single year does not adequately reflect their loss profiles. For example, most policies cover terms of 30 years or more and are noncancelable. Losses may not be incurred until several years into the policy's term, but when they are, they can be substantial. Insurance regulators require financial guaranty companies to hold sufficient assets to cover the substantial losses, even if those losses have not yet been incurred. As a result, the assets required to be held (the denominator) will generally remain large throughout the term of the policy, but the losses (the numerator) will be highly variable.²⁴

Recommendation

We respectfully recommend that the final regulations permit financial guaranty companies to take into account average losses for purposes of computing applicable insurance liabilities. This rule could be implemented by modifying the third prong of the definition of applicable insurance liabilities as follows with respect to financial guaranty insurers:

5. Qualifying Domestic Insurance Company Exception

Background

The Proposed Regulations provide general guidance on several aspects of the rules related to determining whether a foreign corporation ("Tested Foreign Corporation" or "TFC") qualifies as a PFIC. Under section 1297(c), a proportionate share of the income and assets of a TFC's 25-percent owned subsidiaries (Look-Through Subsidiaries") are treated as if they are the income and assets of the TFC itself for purposes of determining whether the income or assets are passive. Under section 1298(b)(7), certain U.S. stock held by a U.S. Look-Through Subsidiary is treated as producing active income.²⁵

The Proposed Regulations generally provide that the income and assets of a QDIC areper se active for purposes of section 1297 (the "QDIC Rule").²⁶ A QDIC is defined as a domestic corporation that is subject to: (1) tax as an insurance company under subchapter L of chapter 1 of subtitle A, and (2) federal income tax on its net income.²⁷ Accordingly, to the extent a TFC owns 25 percent of a QDIC, the income and assets of that QDIC that are treated as the income and assets of the TFC under section 1297(c) are considered active. We commend the Treasury and the Service for providing the QDIC Rule, which is consistent with the objectives and design of the PFIC regime. The PFIC regime is intended to apply to U.S. shareholders of foreign investment companies — that is, foreign corporations with predominately passive income or assets. It is not intended to apply to foreign corporations that are primarily engaged in active business operations, either directly or through subsidiaries.²⁸ Accordingly, TFCs that are primarily engaged in the conduct of active business operations through subsidiaries should not be treated as PFICs.

The preamble to the Proposed Regulations explains that the QDIC Rule is intended to address situations where a TFC "owns a domestic insurance corporation through a structure to which section 1298(b)(7) does not apply."²⁹ While we agree with this rationale, we believe an even more compelling rationale is that the QDIC Rule gives effect to section 1297(c) in cases where a QDIC is a Look-Through Subsidiary of the TFC. In such cases, and assuming that section 1298(b)(7) does not apply,³⁰ section 1297(c) provides that a proportionate share of the income and assets of the QDIC are treated as the income and assets of the TFC. Absent the QDIC Rule, the income and assets of a QDIC could be treated inappropriately as passive because there is no other rule that addresses the income and assets of a Look-Through Subsidiary that is a domestic insurance company. The exception to foreign personal holding company income in section 954(i) for income derived in the active conduct of the insurance business will not apply because Treasury and the Service have determined that Congress instead intended to apply section 1297(b)(2)(B) — the rules for QICs — to test such income.³¹ But section 1297(b)(2)(B) by its terms applies only to income earned or assets held directly by a foreign corporation,³² and was enacted to address issues with the application of the PFIC rules to foreign corporations claiming to conduct an active insurance business.³³ Accordingly, the QDIC Rule is necessary to ensure that a proportionate share of the income and assets of a U.S. Look-Through Subsidiary that is predominately engaged in active business operations — namely, insurance operations — are treated as active income and assets of the TFC for PFIC purposes, consistent with the mandate of section 1297(c).

The operative PFIC rules apply only to U.S. persons that own stock of a PFIC. In addition to any stock that a U.S. person owns directly or through a pass-through entity, a U.S. person is treated as owning the stock it owns proportionately through a 50-percent owned corporation.³⁴ This 50-percent limitation, however, does not apply when the corporation itself is a PFIC; in such a case, the U.S. person is treated as owning the stock it owns proportionately through that PFIC even if the U.S. person holds a minority interest in the PFIC.³⁵

The Proposed Regulations provide special rules for determining whether a TFC is a PFIC solely for the purpose of applying the stock attribution rule of section 1298(a)(2)(B). In particular, the Proposed Regulations provide that section 1298(b)(7), which treats certain U.S. stock as held by a U.S. Look-Through Subsidiary of a TFC, does not apply for this purpose.³⁶ The preamble to the Proposed Regulations explains that this special rule is needed to prevent foreign corporations from attempting "to avoid being treated as PFICs notwithstanding their direct and indirect ownership of predominately passive assets by ensuring that a sufficient amount of such assets are held indirectly through two tiers of domestic subsidiaries."³⁷ While the preamble does not mention the QDIC Rule in this context, the text of the Proposed Regulations provides that the QDIC Rule does not apply to determine whether a TFC is a PFIC for purposes of applying the stock attribution rule of section 1298(a)(2)(B).³⁸ The preamble to the Proposed Regulations welcomes comments on the special rules that apply solely for the purpose of applying the stock attribution rule of section 1298(a)(2)(B).³⁹

Recommendation

We respectfully recommend that the QDIC Rule apply to determine whether a TFC is a PFIC for all purposes, including for the purpose of applying the stock attribution rule of section 1298(a)(2)(B). The preamble to the Proposed Regulations does not provide any rationale for limiting the application of the QDIC Rule in the stock attribution context. Because the QDIC Rule is described as intended to address situations where a TFC owns a domestic insurance corporation through a structure to which section 1298(b)(7) does not apply, it is possible that the drafters of the Proposed Regulations believed that any limitation imposed on section 1298(b)(7) should also be imposed on the QDIC Rule. But as explained above, the QDIC Rule also serves the purpose of effectuating the general look-through rule of section 1297(c) in the case of TFCs that conduct active business operations through domestic insurance companies. Unless the QDIC Rule applies, the income and assets of a QDIC will always be treated as passive for determining whether a TFC is a PFIC for the purpose of applying the stock attribution rule. This result is contrary to the objective of section 1297(c), which is to ensure that a TFC that conducts active business operations through subsidiaries is not treated as a PFIC.

In addition to effectuating the policy objective of section 1297(c), applying the QDIC Rule to determine whether a TFC is a PFIC for all purposes would not open the possibility for inappropriate results identified in the preamble to the Proposed Regulations. The preamble to the Proposed Regulations expresses policy concerns with the broad application of section 1298(b)(7) by TFCs that are not primarily engaged in the conduct of active business operations for the purpose of escaping PFIC treatment.⁴⁰ In particular, the preamble to the Proposed Regulations expresses concern about the stuffing of investment assets by TFCs into domestic subsidiaries in sufficient amounts to avoid PFIC status.⁴¹ If a TFC held stock in another foreign corporation that is a PFIC, a U.S. person holding a small interest in the stock of the TFC would not be a U.S. shareholder of the PFIC.

This policy concern, however, does not support treating the income and assets of U.S. Look-Through Subsidiaries conducting active business operations as passive. Put another way, a TFC that held stock in another foreign corporation that is a PFIC may also hold Look-Through Subsidiaries that conduct active business operations. In such a case, the income and assets of those subsidiaries that are treated as the income and assets of the TFC should not be regarded as passive for any purpose of the PFIC rules, including the determination of whether the TFC is a PFIC for the purpose of the stock attribution rule of section 1298(a)(2)(B). That should be the case regardless of whether the Look-Through Subsidiary conducting active business operations is foreign or domestic, or whether the active business operation being conducted is an active industrial business, or an active technology business, or an active insurance business. Because the QDIC Rule applies only with respect to domestic insurance companies that are subject to net basis federal income tax under subchapter L,⁴² it extends only to a company whose income is subject to U.S. income tax and in which greater than 50 percent of its business during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.⁴³ Treasury has previously defined an insurance company as one "whose primary and predominate business activity . . . is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies."⁴⁴ A U.S. person that holds a minority interest in a TFC that is primarily engaged in the conduct of active business operations, either directly or through subsidiaries, should not be. treated as a U.S. shareholder of a PFIC held by that TFC.⁴⁵

Finally, we note that the failure to adopt our recommendation could inadvertently provide a disincentive for TFCs primarily engaged in the conduct of active insurance operations to maintain or increase their investments in active business operations in the United States. Insurance companies invest their reserves and other capital in investment assets. Accordingly, there is always some risk that a foreign subsidiary of a TFC parent of a multinational insurance group might be classified as a PFIC in a particular year and might therefore retain that status with respect to any U.S. shareholder for future years.⁴⁶ The consequences of this should be limited so long as the TFC parent itself is not characterized as a PFIC or is not majority owned by a single U.S. shareholder. However, if the income and assets of a ODIC that are treated as the income and assets of the TFC under section 1297(c) are per se passive assets for the purpose of applying the stock attribution rule of section 1298(a)(2)(B) to the TFC, then at the margin the TFC would be discouraged from maintaining or growing the business of the QDIC. Indeed, at the margin the PFIC rules would provide an incentive to invest in an insurance business outside the United States. There is no policy rationale under the PFIC rules for such a perverse and counterproductive result.

Thank you for your consideration of the recommendations contained in this corriment letter. Please let us know if you have any questions.

Sincerely,

Robert A. Bailenson
Chief Financial Officer
Assured Guaranty Ltd.
Hamilton HM D6 Bermuda

cc:
Lafayette G. "Chip" Harter III, Deputy Assistant Secretary (International Tax Affairs), Department of the Treasury
Douglas Poms, International Tax Counsel, Department of the Treasury
Brett York, Associate International Tax Counsel, Department of the Treasury
Angela Walitt, Attorney-Advisor, Department of the Treasury
William M. Paul, Deputy Chief Counsel (Technical), Internal Revenue Service
Peter Blessing, Associate Chief Counsel (International), Internal Revenue Service
Helen Hubbard, Associate Chief Counsel (FIP), Internal Revenue Service
Peter Merkel, Branch Chief, Branch 5 (CC:INTL:B05), Internal Revenue Service
Alexis MacIvor, Branch Chief, Branch 4 (CC:FIP:B04), Internal Revenue Service
Je Baik, Senior Technician Reviewer, Branch 5 (CC:INTL:B05), Internal Revenue Service
Josephine Firehock, Attorney-Advisor, Branch 5 (CC:INTL:B05), Internal Revenue Service