Insurance Trades Point Out Need for Changes in PFIC Regs

April 13, 2021

Mark Mazur, Acting Assistant Secretary for Tax Policy
Department of Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Charles Rettig, Esq., Commissioner
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224-0002

RE: Proposed Regulations on Passive Foreign Investment Companies (IRS REG-111950-20)

Dear Secretary Mazur and Commissioner Rettig:

We are writing today on behalf of the American Property Casualty Insurance Association, the National Association of Mutual Insurance Companies, and the Reinsurance Association of America (the “Trades”). We are providing comments on the proposed and final Passive Foreign Investment Company (“PFIC”) regulations published January14, 2021. The Trades collectively represent the great majority of insurance companies issuing property and casualty (non-life) insurance throughout the United States.

The Trades welcome the publication of the final Passive Foreign Investment Company (“PFIC”) regulations and commend the IRS and Treasury for issuing sections of the PFIC regulations dealing with the insurance company exception in proposed form. In particular, the addition of the Factual Requirements Test for active conduct of an insurance business was needed to allow many companies that are unquestionably bona fide insurance and reinsurance companies to qualify for the insurance exception.

Certain provisions of the proposed and final regulations need clarification or modification.

1. QUALIFYING INSURANCE CORPORATION/ACTIVE CONDUCT TEST

The Factual Requirements Test of Prop. Reg. §1297-5(c)(1)(ii) requires that the Tested Foreign Corporation's (TFC) officers and employees must “perform virtually all of the active decision-making functions relevant to underwriting functions as described in paragraph (c)(3) of this section.” That subsection requires that “virtually all” of the activities related to a Qualifying Insurance Corporation's (QIC) decision to assume an insurance risk must be conducted “by employees and not by independent contractors.” This provision would disqualify a TFC from meeting the active conduct test if it used a Managing General Agent (“MGA”)¹ to manage the insurance operations. MGAs are a long-standing, common practice in the insurance and reinsurance industries; they are independent contractors who are directly responsible to the owners and senior management of the insurance company and operate under detailed, comprehensive guidelines for acceptance of risk.

MGAs are authorized by an insurance company to underwrite, issue, and manage insurance policies within a defined class of insurance risk and agreed guidelines, using the insurance carrier's license and risk capital. They manage all or part of the insurance business of an insurer or reinsurer and act as an insurance agent or broker for the insurer, while working as an intermediary between insurers and agents and/or insureds. MGAs are required to be registered with the local insurance regulators and must abide by a number of rules and restrictions regarding how they carry out the underwriting authority given to them by the insurance and reinsurance companies by which they have been engaged.

Using an MGA allows an insurer or reinsurer to use a locally licensed and readily accessible agent who can quickly assess a risk, determine whether it meets a company's underwriting guidelines, and issue a binding contract. It relieves the insurance company of the need to establish offices in a wide range of locales and thereby reduces cost. Although the assumption of risk has been considered by many industry observers to be the crucial element demonstrating that the TFC is a bona fide insurance company, that does not mean that the use of MGAs is a reliable indicator that the TFC is not an insurance company. Companies using these managing agents conduct substantial insurance and reinsurance operations in all other ways contemplated by the proposed regulation. These arrangements do not correlate in any way to the operation of a TFC as an investment company — the anti-abuse purpose of the PFIC statute.

Recommendation: The definitions in Prop. Reg. §1297-5(f) should be modified to add paragraph (f)(11) to provide that the term employee, when used in this section, includes Managing General Agents appointed by the insurance company that are contractually subject to the insurance laws and regulations applicable to the insurance company and shall not be considered independent contractors for purposes of this section. The definition in Prop. Reg. §1297-5(f)(2) relating to compensation paid by the insurance company should be modified to include compensation paid to Managing General Agents which include fees and commissions In addition, the Preamble to any final regulation should specifically mention Managing General Agents as a common industry practice not indicative of a failure to qualify as a QIC.

2. QUALIFYING INSURANCE CORPORATION/COMPUTATION OF ASSETS FOR CORPORATIONS WITH AN APPLICABLE FINANCIAL STATEMENT PREPARED ON A CONSOLIDATED BASIS/ASSET REDUCTION RULE

Code §1297(f)(1)(B) requires that a TFC must have Applicable Insurance Liabilities (AILs) which “constitute more than 25 percent of its total assets” determined by the assets and liabilities reported on its applicable financial statement. For a TFC in a consolidated group, the asset reduction rule of Prop. Reg. §1.1297-4(e)(4)(i) requires that the total assets of the TFC may be reduced by the AIL of a subsidiary insurance company, for purposes of the 25% test and the 10% alternative test. The asset reduction rule can result in the parent insurance corporation in a consolidated group failing to satisfy the 25% or 10% test when the two entities are stacked, even though it could meet the 25% or 10% threshold if tested on its own. Significantly, TFCs in a brother-sister structure with identical facts would not be required to reduce their AILs and would meet the thresholds for a QIC. There is no rational policy basis for such different results.

Treas. Reg. §1.1297-4(f)(1) prioritizes the GAAP financial statement as the applicable financial statement. A balance sheet prepared under GAAP will consolidate subsidiaries of the reporting corporation. However, Treas. Reg. §1297-4(f)(2)(i)(D)(2) provides that the only AILs considered are those of the TFC whose QIC status is being determined. The asset reduction rule of Prop. Reg. §1.1297-4(e)(4)(i) reduces the parent insurance company's total assets by the AILs of the consolidated subsidiary.

The example below illustrates the distortion created by the rule when applied to a stacked structure:

Insurance Company A owns 100% of Insurance Company B (both foreign). On a standalone basis, Insurance Company A has total assets of $16, including its investment in Insurance Company B. A has AILs of $5 and unearned premium reserve (UPR) and other liabilities of $10. B has total assets of $10, AILs of $3, and UPR and other liabilities of $6.

If assets and liabilities of both insurance companies were tested on a standalone basis, A's asset/liability ratio would be 31.25% and B's ratio 30%. Both would qualify as QICs. This result would be consistent with the result of a brother-sister structure.

However, in a stacked structure, in which A and B are tested using their GAAP statement, B would still have a 30% ratio, since it does not have consolidated subsidiaries. When A is tested using its GAAP statement, which consolidates A and B, A's total assets are $25 ($16 separate company assets - $1 investment in B + $10 B's assets). Under the proposed regulation's asset reduction rule, A's total assets are reduced by Insurance Company B's AILs, so that total assets used in the test are $22 ($25 - $3). The AILs used for the 25% test are only those of Insurance Company A, so that they would be $5. Insurance Company A's ratio is then 22.7%, and it would fail to qualify as a QIC unless it qualified under the alternative facts and circumstances test.

DR (CR)	Separate Co A	Separate Co B	Consol	Asset/Liab Ratio Test Adj.	Consolidated Co A
Assets	$16	$10	25	(3)	$22
AIL	(5)	(3)	(8)	(3)	(5)
UPR/Oth Liab	(10)	(6)	(16)		(16)
Capital & Surplus	(1)	(1)	(1)		NA
Asset/Liability Ratio	31.25%	30%	NA	NA	22.72%
Status as QIC	Pass	Pass	NA	NA	Fail

A major goal of sound tax policy is to treat similarly situated taxpayers in the same manner. The disparate treatment of similar foreign corporations held in a tiered structure and a brother-sister arrangement is an unreasonable and harmful outcome.

Recommendation: The asset reduction rule of Prop. Reg. §1.1297-4(e)(4)(i) should be revised so that the reduction would include all liabilities of the consolidated subsidiaries, not merely AILs. This would bring parity to the treatment of insurance companies in stacked and brother-sister structures. This modification would still prevent a consolidated group with a parent insurance company that has low AILs from avoiding PFIC status by stuffing a high AIL insurance subsidiary below the parent. As the following examples demonstrate, it is possible to achieve the regulation's goal of preventing stuffing without creating inequities in the treatment of TFCs in a stacked structure.

Example with stacked insurance companies where one company has minimal AILs

Insurance Company A owns 100% of Insurance Company B. Company A has total assets of $16, including its $1 investment in Company B. A has AILs of $3 and UPR and other liabilities of $10. B has total assets of $10, AILs of $4, and UPR and other liabilities of $5.

DR (CR)	Separate Co A	Separate Co B	Consol Adj	Consol	Consolidated Ratio Test. Prop. Reg.	Consolidated Ratio Test. Our Proposal
Assets	$16	$10	$(1)	$25	21	$16
AIL	(3)	(4)		(7)	(3)	(3)
UPR/Other liab	(10)	(5)		(15)	(15)	(10)
Capital and Surplus	$(3)	$(1)	$1	$(3)	(3)	(3)
Ratio	19%	40%	NA	NA	14%	19%
Status as QIC	Fail	Pass	NA	NA	Fail	Fail

On a standalone basis, Company A's ratio would be 19% and Company B's 40%.

Under the proposed regulations, A's ratio is 14% and B's ratio is 40%.

Under the Trades' proposal, A's ratio is 19% and B's ratio is 40%. A still fails the test. This results in an equitable outcome for both the taxpayer and the government.

If we had instead proposed that A be allowed to include all the AILs shown on the GAAP consolidated financial statement, A's ratio would be 28% (7 total AILs divided by 25 total assets). This would allow abuse of the rule by the taxpayer, so it is not proposed as a solution.

Example with insurance company that owns a leveraged investment sub

Insurance Company owns 100% of Investment Subsidiary. Insurance Company has total assets of $21, including its $6 investment in Investment Subsidiary. Insurance Company has AILs of $6 and UPR and other liabilities of $10. Insurance Subsidiary has total assets of $12 and liabilities of $6.

DR (CR)	Ins Co	Inv Co	Consol Adj	Consol	Consolidated Ratio Test Prop. Reg	Consolidated Ratio Test Our Proposal
Assets	$21	$12	$(6)	$27	$27	$21
AIL	(6)	(0)		(6)	(6)	(6)
UPR/Other liab	(10)	(6)		(16)	(16)	(10)
Capital and Surplus	$(5)	$(6)	$6	(5)	(5)	$(11)
Asset Liability Ratio	29%	NA	NA	NA	22%	29%
Status as QIC	Pass	NA	NA	NA	Fail	Pass

Standalone, Insurance Company's ratio would be 29%.

Under the proposed regulation, Insurance Company's ratio is 22% (6 of AILs divided by 27 total assets).

Under the Trades' proposal, Insurance Company's ratio is 29% (6 of AILs divided by 21 total assets). Under the rule in Reg. §1.1297-6(d), because of the investment capital held at Investment Subsidiary, only $6 of Investment Sub's assets may be treated as active assets if Insurance Company was a QIC. The remaining $6 of Investment Subsidiary assets are still passive. This rule seems to protect the government from potential abuse, even with our proposed change.

3. PFIC STATUS/TREATMENT OF ASSETS AND INCOME OF INSURANCE HOLDING COMPANIES

Insurance companies hold substantial investments to satisfy future claims. In recognition that these investment holdings would cause insurance companies to be treated as PFICs, the PFIC statute created an exception for qualifying insurance corporations (“QICs”) in the active conduct of an insurance business (Code §1297(b)(2)(B)).

Multinational insurance company groups typically consist of a top-level holding company (Holdco) that owns one or more insurance companies directly, with the insurance companies holding investment assets to satisfy future claims. It is quite common for insurance companies to hold investment assets that exceed the 50% test. It is also common for the insurance companies to not own the investment assets directly, but rather hold interests in investment subsidiaries or partnerships that own the assets that produce investment income. A U.S. shareholder will ordinarily own shares of the Holdco.

A QIC with investments in Look Through Subsidiaries or Partnerships (LTS and LTPs) can qualify for the insurance company exception to PFIC status under section §1297(b)(2)(B) and Treas. Reg. §1.1297-6. This final regulation provides that for purposes of section 1297 and Treas. Reg. §1.1297-1, the income, and assets of a QIC derived from the active conduct of an insurance business, and income and assets of a Qualifying Domestic Insurance Company (QDIC) will be non-passive income. See Treas. Reg §1.1297-6(b) and (c) for the income and assets exceptions, respectively. Importantly, Treas. Reg §1.1297-6(d) also contains an exception from passive treatment for certain income and assets of an LTS or LTP. For purposes of applying paragraphs (b)(1) and (c)(1) of Treas. Reg. §1.1297-6, a QIC is treated as receiving the income or holding the assets of an LTS or LTP to the extent provided in section 1297(c) and Treas. Reg. §1.1297-2(b)(2) or (b)(3). This special insurance rule treats the insurer's investments in LTS and LTPs as non-passive income and assets.

Consider the typical foreign insurance structure where a Holdco owns 100% of a QIC which in turns owns 100% of an investment subsidiary. A rational approach to testing the Holdco for PFIC status would be to look through to the assets and income of the QIC, which is a LTS vis-à-vis the Holdco under section 1297(c). Under Treas. Reg. §1.1297-2(b)(2), the Holdco's pro rata share of the assets and income of the QIC would be characterized as either active or passive based on their characterization in the hands of the QIC. Under Treas. Reg. §1.1297-6(b) and (c), the Holdco would treat the QIC's assets and income as active for its PFIC tests under section 1297. Additionally, the Holdco would also need to look through and include its pro rata share of its indirectly held investment LTS assets and income in accordance with section 1297(c). The assets of the lower-tier investment LTS would already be included for PFIC testing and characterized at the QIC via the application of Treas. Reg. §1.1297-6(b), (c) and (d), which provide that the QIC is treated as holding and receiving the assets and income of the investment LTS for purposes of applying section 1297(c), Treas. Reg. §1.1297-2(b)(2) and (b)(3). Accordingly, the Holdco would test the aggregate assets and income of its two LTS as required under section 1297(c), and likely not be treated as a PFIC under section 1297(a), assuming the majority of the group's assets and income are held and generated by the QIC and its investment LTS.

This approach would be consistent with the overall intent of the exception provided in section 1297(b)(2)(B). From a policy perspective it would also treat U.S. shareholders that own a direct interest in a foreign insurance company consistently with those that own their interest indirectly through a holding company. For a U.S. shareholder, treating the Holdco as a PFIC would, in most cases, discourage investment in foreign insurance groups, a result not warranted — or even foreseen — by the policy concerns that led to the creation of PFIC status.

Whether the final regulations clearly support and articulate this reasonable approach to testing the Holdco for PFIC status is less clear. There is no explicit reference to Treas. Reg. §1.1297-6 contained in the general rules for treatment of LTS and LTPs under Treas. Reg. §1.1297-2, and the exception that allows a tested foreign corporation to recharacterize assets of a LTS that would otherwise be passive under subsection (e). Perhaps this is because such an explicit reference is not technically needed, as the rules under Treas. Reg. §1.1297-6 may be reasonably read to sufficiently address the treatment of an investment LTS in an insurance Holdco structure. Nevertheless, it would provide taxpayers with additional comfort to have the application of Treas. Reg. 1.1297-6(b) through (d) clarified in the context of an insurance Holdco structure.

Recommendation: We recommend that Prop. Reg. §1297-2 and Prop. Reg. §1297-6 be modified to clarify that holding companies with insurance subsidiaries which meet the requirements of a QIC may treat assets and income attributable to the QIC's LTS and LTPs as non-passive items under Treas. Reg §1.1297-2(b)(2). These assets and income represent an integral part of the insurance companies' operations. This clarification would confirm that the QIC's investments are to be treated as active insurance income and assets and prevent the Holdco's misclassification as a PFIC.

If you have any questions, please feel free to contact Joseph Sieverling (sieverling@reinsurance.org or 202-783-8312), Brenda Viehe-Naess (bvns@att.net 202-841-3902), David Pearce (david.pearce@apci.org or 202-828-7114), or Jonathan Rodgers (jrodgers@namic.org or 317-876-4206).

Sincerely,

David F. Pearce Jr.
Vice President and Director of Tax Policy
American Property Casualty Insurance Association

Jonathan Rodgers
Director of Financial and Tax Policy
National Association of Mutual Insurance Companies

Joseph B. Sieverling
Senior Vice President and Director of Financial Services
Reinsurance Association of America