Mortgage Insurers Seek 3 PFIC Reg Changes, Delayed Effective Date

September 9, 2019

RE: Letter on Proposed Treasury Regulations Issued July 10, 2019 Under Sections 1291, 1297, & 1298 (IRS REG-105474-18)

Dear Sir or Madam:

Essent Group Ltd. ("Essent Group," "EGL," or the "Company") appreciates the opportunity to comment on the proposed regulations issued on July 10, 2019, under sections 1291, 1297, and 1298,¹ governing the passive foreign investment company ("PFIC") rules (the "Proposed Regulations").

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Table of Contents

I. EXECUTIVE SUMMARY

II. COMPANY BACKGROUND

III. RELEVANT LAW

IV. REQUESTED MODIFICATIONS TO THE PROPOSED REGULATIONS

V. CONCLUSION

APPENDIX A

APPENDIX B

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I. EXECUTIVE SUMMARY

The Proposed Regulations provide guidance under the PFIC rules of sections 1291, 1297, and 1298, including the application of the PFIC rules to insurance companies. Although the Proposed Regulations provide welcome guidance on a number of uncertain issues, they do not adequately address certain of the unique characteristics of a mortgage insurance company like those operated by Essent Group. As discussed below, due to the interaction of a number of provisions in the Proposed Regulations, the Companys shareholders (including retail investors and other small shareholders) may be subject to income inclusion, elections, and reporting obligations under the PFIC rules notwithstanding the fact that the Company and its subsidiaries are predominantly engaged in the active conduct of a bona fide insurance business.

In order to ameliorate this result, which appears to conflict with the policy goals underlying the Proposed Regulations and the PFIC regime more generally, we request that Treasury and the IRS consider several carefully tailored modifications to the Proposed Regulations. The requested modifications include the following: (1) an alternative definition of the term "qualifying insurance corporation" in the mortgage insurance context; (2) treatment of domestic mortgage insurance companies as active businesses for attribution purposes under section 1298(a)(2); and (3) an exception to the expanded attribution rules for small shareholders. We also respectfully request that the effective date of the final regulations be delayed in order to allow time to implement the appropriate compliance procedures.

II. COMPANY BACKGROUND

Essent Group, through its wholly owned operating subsidiaries, offers private mortgage insurance ("PMI") and reinsurance for mortgages secured by residential properties located in the United States. Mortgage insurance facilitates the issuance of low down payment (generally less than 20%) mortgage loans, and plays an integral role in the housing finance system of the United States. When Fannie Mae and Freddie Mac (the "government sponsored enterprises" or "GSEs") purchase single-family mortgage loans where the outstanding principal balance of the mortgage exceeds 80 percent of the value of the underlying property, their respective charters require them to obtain an acceptable form of credit enhancement for that mortgage loan. Private mortgage insurance is the most commonly used form of credit enhancement that satisfies the GSEs charter requirements for low down-payment loans. Further, private mortgage insurance reduces the GSEs' potential losses in the event of foreclosure and supports a robust secondary mortgage market in the United States. In addition, private mortgage insurance provides vital support to first-time homebuyers who may lack sufficient funds to achieve the 20% down payment required by the GSEs charters.

The Company was formed in 2008 during the financial crisis by a group of private investors including: Goldman Sachs, JP Morgan, RenaissanceRe Ventures Ltd., PartnerRe Principal Finance Inc., and Pine Brook Road Partners. In 2013, the Company sold shares in an initial public offering, and became listed on the New York Stock Exchange under the ticker symbol "ESNT". Essent Guaranty, Inc. ("Essent Guaranty"), the Company's Pennsylvania-domiciled mortgage insurance company, currently employs over 400 people in the United States, and holds a significant share of the insured loans in the PMI industry with over $153 billion of insurance-in-force at June 30, 2019, representing over 667,000 insured mortgage loans throughout the United States.

In addition, Essent Group operates a Bermuda-domiciled reinsurer, Essent Reinsurance Ltd. ("Essent Re" or "ERE"), which provides reinsurance to its affiliate, Essent Guaranty, through a 25% quota-share agreement, and also directly insures and reinsures mortgage loans held by third parties. Specifically, Essent Re and a panel of reinsurers, including other Bermuda-based insurance companies, provide reinsurance to the GSEs under their respective credit risk transfer ("CRT") programs. The CRT programs were initiated in 2012 with the support of the Federal Housing Finance Agency ("FHFN') with the goal of reducing Fannie Mae's and Freddie Mac's overall risk and, therefore, the risk they pose to U.S. taxpayers while in conservatorship. The CRT programs and private mortgage insurance are tools that enable the GSEs to hedge and transfer the credit risk embedded in their mortgage portfolio to private investors.

The current consolidated effective tax rate of Essent Group on a generally accepted accounting principles ("GAAP") basis post Tax Reform² is approximately 16%, with the majority of the Company's earnings and profits taxable in the United States. Also, the Company pays U.S. federal excise tax on all outbound gross premiums for direct insurance and reinsurance.

A. Contingency Reserves

The standard mortgage guaranty insurance policy is a multi-year contract that is generally non-cancellable by the insurer except for non-payment of premium. Furthermore, the typical insured mortgage carries a 30-year term. Accordingly, mortgage insurance is inherently a long-tailed risk.

Under both U.S. GAAP and statutory accounting rules, a reserve for losses is not recognized in the financial statements of a mortgage insurer until a borrower has missed two consecutive monthly mortgage payments and remains at least two payments in arrears. This accounting model does not contemplate a significant increase in defaults that could arise in future periods from an adverse nationwide economic downturn.

For these reasons, the state regulators, through rules promulgated by the National Association of Insurance Commissioners ("NAIC"), require mortgage guaranty insurers to record special reserves on a statutory accounting basis known as "contingency reserves." Statutory accounting rules are developed and promulgated by the NAIC, to address certain unique issues of regulated insurance companies, and differ from GAAP with respect to certain practices and transactions.

Contingency reserves under the statutory accounting rules are calculated as a flat 50% of all earned premiums from mortgage guaranty insurance or reinsurance, are recorded as a liability with a charge to policyholders surplus on the statutory financial statements, and are held for a period of ten years. Contingency reserves reduce surplus, and thus effectively act to limit dividends from the regulated insurance company and, accordingly, serve to protect policyholders by preserving capital to pay claims in adverse economic cycles. Contingency reserves are not recognized for GAAP accounting purposes; thus, there is a discrepancy between insurance liabilities as booked on a GAAP versus statutory basis of accounting. [See Appendix A]

B. Private Mortgage Insurer Eligibility Requirements ('PMIERs") Capital Standards

Given the significant losses that have been historically incurred by mortgage insurance companies under stress economic conditions, large amounts of capital are required to ensure that these companies will have the ability to pay their claims in times of crisis. The financial crisis resulted in a substantial increase in defaults and foreclosures of single-family mortgages, including those owned or guaranteed by the GSEs. The GSEs suffered losses across their entire mortgage portfolios. Three private mortgage insurers were placed into run-off or receivership and were restricted by their regulators from paying the full amount of claims. Instead they were directed to pay a fraction of the amount due under their policies as a result of the expectation of insufficient capital. The Federal government (through the FHFA), in its role as regulator, directed the GSEs to update their mortgage insurer eligibility requirements to help ensure that mortgage insurers possess capital and liquidity to withstand a financial crisis or severe downturn going forward. FHFA recognized the significant capital needs for writing insurance or reinsurance in the area of mortgage credit risk by issuing the Private Mortgage Insurer Eligibility Requirements or "PMIERs." The PMIERs capital requirements effectively extend to affiliated reinsurance companies, and became effective on December 31, 2015.

The PMIERs represent the standards by which private mortgage insurers are eligible to provide mortgage insurance on loans owned or guaranteed by the GSEs. The standards include financial strength requirements incorporating a risk-based framework that require insurers to have a sufficient level of liquid assets from which to pay claims. Financial adequacy under PMIERs is measured and represented by each approved insurer on a quarterly basis by providing a risk-based calculation, which compares "available assets" to minimum "risk-based required assets." Available assets for an approved insurer are calculated as:

The total risk-based required asset amount for an approved insurer is a function of its direct risk-in-force, and the risk profile of the associated loans. The risk-based required asset amount is computed as described in PMIERs using tables of factors with several risk dimensions.

PMIERs also apply to reinsurance of mortgage risk. They provide approved mortgage insurers with counterparty financial and collateral requirements for reinsurance transactions executed (including amounts ceded to affiliate reinsurers). In order for an approved insurer to receive a reduction of its risk-based required asset amount for reinsurance obtained, the reinsurer must meet certain financial strength ratings from S&P, Moody's, or AM Best, or the reinsurer must otherwise be determined to be a strong counterparty through evaluation by the GSEs. Furthermore, the risk ceded must be secured by the reinsurer with a pledge of collateral placed in a trust account that establishes the mortgage insurer as the designated beneficiary of the trust.

III. RELEVANT LAW

A. PFIC Insurance Exception

Prior to enactment of the Tax Cuts and Jobs Act, former section 1297(b)(2)(B) provided that passive income does not include income derived in the active conduct of an insurance business by a corporation that is predominantly engaged in an insurance business and that would be subject to tax under subchapter L if it were a domestic corporation. This exception from passive income applied principally to investment income of insurance companies. Income from insurance premiums generally does not constitute foreign personal holding company income and therefore would not be treated as passive under section 1297(b)(1) in any event.

The legislative history of the TCJA raised concerns around the lack of clarity and precision in the PFIC insurance exception: specifically, lack of precision regarding how much insurance or reinsurance business a company must do to qualify under the exception, which made it burdensome to enforce.³ To address these concerns, the TCJA modified the PFIC insurance exception by revising section 1297(b)(2)(B) to provide that passive income does not include income derived in the active conduct of an insurance business by a qualifying insurance corporation ("QIC") and by adding section 1297(f) to define what constitutes a QIC.

Section 1297(f) defines a QIC as a foreign corporation that: (A) would be subject to tax under subchapter L if such corporation were a domestic corporation (i.e., would meet the section 816(a) definition of an insurance company)⁴; and (B) either (1) has applicable insurance liabilities constituting more than 25% of its total assets as reported on its applicable financial statement (the "25% tese),⁵ or (2) meets an elective alternative facts and circumstances test.⁶

B. PFIC Ownership Attribution Rules

Section 1298(a)(2)(A) provides that a person who directly or indirectly owns at least 50 percent (by value) of a corporation's stock is treated as owning a proportionate amount of the stock directly or indirectly owned by such corporation (the "50% Ownership Threshold"). Section 1298(a)(2)(B), in turn, provides that the 50% Ownership Threshold does not apply to a foreign corporation that is a PFIC. Therefore, shareholders in a first-tier foreign corporation that is a PFIC (irrespective of their percentage ownership in the first-tier PFIC) are treated as owning stock in foreign subsidiaries of the first-tier PFIC, and must determine whether those subsidiaries are treated as PFICs under the income and asset tests of section 1297(a). Under section 1298(a)(2)(B), section 1297(d) (which provides an exception for U.S. shareholders of a CFC) does not apply in determining whether a corporation is a PFIC for this purpose. Section 1297(d) is the only statutorily provided exception to the determination of PFIC status for purposes of section 1298(a)(2).

The Proposed Regulations provide additional exceptions to normal PFIC testing for purposes of section 1298(a)(2). In particular, the Proposed Regulations provide that two other rules (which apply generally for testing whether a foreign corporation is a PFIC) do not apply for purposes of section 1298(a)(2): (i) the Domestic Subsidiary Look-Through rule of section 1298(b)(7); and (ii) the qualified domestic insurance company ("QDIC") rule provided in Prop. Reg. § 1.1297-5.

Under section 1298(b)(7), if a tested foreign corporation ("TFC") owns at least 25 percent of the stock of a domestic corporation (a "Look-Through Subsidiary"), "qualified stock" (i.e., stock issued by a domestic C corporation that is neither a RIC nor a REIT) held by the Look-Through Subsidiary is, for purposes of determining whether the TFC is a PFIC, deemed to be an asset that does not produce passive income and is not held for the production of passive income, and any amount included in gross income with respect to qualified stock is treated as nonpassive income (the "Domestic Subsidiary Look-Through Rule"). Prop. Reg. §§ 1.1297-5(b)(2) and (e)(2) provide that the income and assets of a QDIC are not treated as passive (the "QDIC rule"). A QDIC is defined under Prop. Reg. §1.1297-5(d) as a domestic corporation that is subject to tax as an insurance company under subchapter L and is subject to U.S. federal income tax on its net income. The preamble to the Proposed Regulations provides 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.

C. Impact of the Proposed Regulations on the Company

Prior to Tax Reform, the Company was not treated as a PFIC due to the "active conduct" rules under former section 1297(b)(2)(B). The Company's primary foreign reinsurance subsidiary, ERE, would be taxable under subchapter L of the Code if it were a U.S. corporation. Furthermore, its only business was insurance and reinsurance assuming risks from both affiliates and third parties, and all of its income was derived in the active conduct of that insurance business. Accordingly, ERE's income was treated as non-passive prior to Tax Reform.

Post-Tax Reform, as discussed above, an insurance company's investment income will not qualify for the exception under section 1297(b)(2)(B) unless it meets the definition of a QIC under section 1297(0. In order to meet this definition, applicable insurance liabilities (as stated on the Company's applicable financial statement (GAAP)) must constitute at least 25% of total assets of the insurance company (with some exceptions for ratings-related and/or run-off related circumstances).

Post-Tax Reform, ERE does not meet the definition of a QIC under section 1297(0. This is because mortgage insurers and reinsurers, although required to hold a significant amount of capital due to rating agency, regulatory or counterparty requirements, including the PMIERs, do not generally have sufficient loss reserves to meet the section 1297(f) threshold until an economic downturn occurs, which may give rise to significant number of defaulted mortgages. However, in addition to loss reserves, a mortgage insurer subject to U.S. state insurance regulations is required to establish contingency reserves, which do not qualify as applicable insurance liabilities.

Thus, ERE is expected to be considered a PFIC. However, as a statutory matter (i.e., before the effective date of the Proposed Regulations), no U.S. person is treated as owning stock in ERE under section 1298(a)(2) because (i) ERE is wholly owned by the Company, (ii) no single shareholder owns at least 50 percent of the Company's stock, and (iii) the Company is not a PFIC. In particular, in applying the asset test under section 1297(a)(2), the stock of Essent US Holdings Inc. is treated as non-passive under the Domestic Subsidiary Look-Through rule of section 1298(b)(7). Thus, because the stock value (i.e., the net assets) of the Company's U.S. subsidiaries exceeds the value of ERE's gross assets, the Company is not a PFIC.

The Proposed Regulations, however, would change the ownership attribution rules of section 1298(a)(2) in a manner that would cause the Company's shareholders to be treated as owning stock of ERE. For purposes of determining whether the Company is a PFIC for purposes of section 1298(a)(2) (i.e., whether the Company's shareholders are subject to the 50% Ownership Threshold), the Proposed Regulations "turn ofr the Domestic Subsidiary Look-Through rule of section 1298(b)(7), thereby requiring application of the general look-through rule under section 1297(c). If the QDIC rule were operative (and thus the domestic insurance subsidiaries assets were treated as nonpassive), this change would increase the amount of the Company's nonpassive assets for PFIC testing purposes, because section 1297(c) deems the Company to hold the gross assets of the Company's U.S. subsidiaries (in contrast to the Domestic Subsidiary Look-Through rule, which applies to the stock of the Look-Through Subsidiary, valued net of the Look-Through Subsidiary's liabilities). However, for purposes of section 1298(a)(2), the Proposed Regulations also "turn off" the QDIC rule, and thus, a substantial amount of the domestic insurance subsidiaries assets are expected to be treated as passive for this purpose. The combined effect of eliminating relief under both the Domestic Subsidiary Look-Through Rule and the QDIC rule is that, under the Proposed Regulations, the Company would be treated as a PFIC for purposes of section 1298(a)(2). Therefore, its shareholders would not be subject to the 50% Ownership Threshold for ownership attribution purposes and would be treated as owning stock in ERE under section 1298 (a)(2)(B).

IV. REQUESTED MODIFICATIONS TO THE PROPOSED REGULATIONS

A. Definition of Qualifying Insurance Corporation Under Section 1297(f)

1. Proposed Regulations

Generally, section 1297(f) provides that a QIC is a foreign corporation that (1) would be subject to tax under subchapter L if it were a domestic corporation (the subchapter L test) and (2) has applicable insurance liabilities that constitute more than 25 percent of its total assets (the 25 percent test). The 25 percent test is applied based on the foreign corporation's liabilities and assets as reported on the corporation's applicable financial statement for the last year ending with or within the taxable year. Prop. Reg. § 1.1297-4(c) provides guidance regarding the application of the 25 percent test. As noted above, mortgage insurers and reinsurers, although required to hold a significant amount of capital due to counterparty, rating agency or regulatory requirements that include the PMIERs, do not generally have significant loss reserves in a benign credit environment.

We acknowledge that the 25 percent test is a reasonable threshold for most insurance businesses. However, because of the significant difference in how mortgage credit risk behaves versus other insurance risks, as well as the long duration, multi-year, non-cancellable nature of the mortgage insurance contract, this test is not appropriate for the mortgage guaranty industry.

In a favorable credit environment that includes a consistent, measured home price appreciation and favorable employment trends, the default and claim rate for mortgages is generally low, resulting in low loss levels. By way of example, Essent Guaranty and Essent Re's reserves as a percentage of assets were 2% and 1% as of December 31, 2018. Similarly, as noted in Table 1, in the period 2001 through 2006 preceding the financial crisis, reserve levels of the existing mortgage insurers were modest, with the industry average ranging from 11% to 14%. However, beginning in 2007, as the financial crisis worsened with defaults and claims in the PMI industry accelerating, reserves increased substantially, with the industry average at 28% in 2007 and ranging from 53% to 72% in the 2008 through 2010 time period. Note further that over the 10-year period from 2001 through 2010 that included both a more benign credit environment, as well as a stress period, the average industry reserves were 33% of assets (i.e., above the 25% threshold for reserves as a percentage of assets required for a QIC under the Proposed Regulations).

The concept of contingency reserves was developed in the statutory accounting model specifically to address the phenomenon in the mortgage credit risk cycle — long periods of favorable operating results and profitability supported by strong credit performance followed by substantial losses experienced in stress events. Contingency reserves act in part to retain capital generated from earnings in a favorable credit environment to pay claims in periods of economic stress. Contingency reserves, however, do not qualify as applicable insurance liabilities.

We understand that the intent of Congress in modifying the insurance company rules as they relate to the PFIC regime was to address certain perceived abuses by US investors in off-shore companies using an insurance company structure to defer taxation on investments that are not needed for the insurance business. The primary purpose of our investment portfolio is to support the mortgage insurance that we write. The PMIERs provide limitations on the type of investments that qualify as Available Assets. As noted above, non-public equity investments receive no credit as Available Assets under PMIERs, while public equity investments receive credit equal to 75% of their current market value. Accordingly, the investment portfolios of Essent Guaranty and Essent Re are comprised primarily of investment grade fixed income securities and generate commensurate yields of 3.0% and 2.4%, respectively, for the year ended December 31, 2018.

2. Requested Modification

We request that Treasury and IRS exercise their broad grant of authority under section 1298(g) to provide a rule that allows foreign companies that are engaged in the business of mortgage insurance and reinsurance to be treated as QICs. Such a rule, for example could provide that any foreign corporation is deemed to meet the definition of a QIC under section 1297(f) if: (A) it would be subject to tax under subchapter L if it were a domestic corporation; (B) at least 80% of its net written premiums is derived from mortgage guaranty insurance or reinsurance of mortgage guaranty insurance; and (C) its gross investment income is less than 50% of its net written premiums as reported on its applicable financial statement for the last year ending with or within the taxable year. Requiring the insurance company's investment income to be less than 50% of net written premiums should address any concerns that its investments are disproportionate to the reasonable needs of the underlying insurance business (and thus preclude any opportunity for abuse).

B. Treatment of a QDIC for Purposes of Section 1298(a)(2)

1. Proposed Regulations

Section 1298(a)(2)(A) provides a 50% Ownership Threshold, under which a person who owns less than 50 percent of a corporation's stock is not treated as owning the stock that is owned by such corporation. Under section 1298 (a)(2)(B), the 50% Ownership Threshold does not apply to a foreign corporation that is a PFIC. Thus, a shareholder who owns any stock in a PFIC is treated as owning a proportionate amount of the stock owned by the PFIC. Under the Proposed Regulations, the QDIC rule (discussed above) does not apply for purposes of ownership attribution under section 1298(a)(2).

2. Comments

In determining whether a foreign parent company is a PFIC for purposes of section 1298(a)(2) whether shareholders of the foreign parent are subject to the 50% Ownership Threshold), the income and assets of a domestic insurance subsidiary are tested under the look-through rule of section 1297(c) and Prop. Reg. § 1.1297-2.⁷ Because insurance companies typically hold capital and funds needed for the payment of claims in the form of passive investments, a domestic insurance company's assets will generally be considered passive (unless the QDIC rule applies).

However, the QDIC rule does not apply for purposes of ownership attribution under section 1298(a)(2). Moreover, a domestic insurance company is excluded from the definition of a QIC under section 1297(f) and Prop. Reg. § 1.1297-4(b) (which require a QIC to be a foreign corporation). Thus, a domestic insurance companys assets will generally be considered passive for purposes of section 1298(a)(2) (i.e., for purposes of determining whether shareholders of the domestic insurance company's foreign parent are subject to the 50% Ownership Threshold). This holds true regardless of whether the domestic insurance company is engaged in the active conduct of an insurance business, and regardless of whether the domestic insurance company's assets are proportionate to its insurance liabilities.

We believe that this outcome is inappropriate, as illustrated by the following examples.

a) Example 1

FC1, a foreign corporation, owns all of the stock of FC2, a foreign corporation that is treated as a PFIC under section 1297(a). FC1 also owns all of the stock of FC3, a foreign insurance company that is a QIC within the meaning of section 1297(f) and Prop. Reg. § 1.1297-4(b). No shareholder owns 50 percent or more of the stock of FC1 within the meaning of section 1298(a)(2)(A). FC3's assets would all be treated as passive if it were not a QIC. The income and assets of FC3 represent 60 percent of the income and assets of FC1 (after applying section 1297(c)).

In example 1, FC1 is not considered a PFIC under section 1297(a). Because FC3 is a QIC, its income and assets are treated as non-passive under section 1297(b)(2)(B) and Prop. Reg. §§ 1.1297-5(b)(1) and (e)(1). Moreover, shareholders holding less than 50 percent of the stock of FC1 are not treated as owning a proportionate amount of the FC2 stock held by FC1 under section 1298(a)(2). Therefore, although FC2 is a PFIC, FC1 shareholders are not treated as owning stock in a PFIC.

b) Example 2

FC1, a foreign corporation, owns all of the stock of FC2, a foreign corporation that is treated as a PFIC under section 1297(a). FC1 also owns all of the stock of DC3, a domestic insurance company that is a QDIC within the meaning of Prop. Reg. § 1.1297-5(d). No shareholder owns 50 percent or more of the stock of FC1 within the meaning of section 1298(a)(2)(A). DC3's assets would be treated as passive if it were not a QDIC. The income and assets of DC3 represent 60 percent of the income and assets of FC1 (after applying section 1297(c)).

In example 2, FC1 is generally not considered a PFIC under section 1297(a). Because DC3 is a QDIC, its income and assets are treated as non-passive under Prop. Reg. §§ 1.1297-5(b)(2) and (e)(2). However, the QDIC rule does not apply for purposes of section 1298(a)(2). Therefore, FC1 is considered a PFIC because (for this purpose) at least 50 percent of FC1's assets (on a look-through basis) are passive. Thus, under section 1298(a)(2), all shareholders of FC1 are treated as owning a proportionate amount of the FC2 stock held by FC1. All FC1 shareholders are treated as owning stock in a PFIC (i.e., FC2).

c) Comparison of Example 1 and Example 2

Example 1 and example 2 are nearly identical. In both examples FC1 is not a PFIC but FC2 is a PFIC. The only difference is that in example 1, FC1 holds stock of a foreign insurance company (FC3), which is a QIC, whereas, in example 2, FC1 holds stock of a domestic insurance company (DC3), which is a QDIC. However, the tax consequences to FC1 shareholders differ dramatically. Although FC2 is a PFIC in both examples, FC1 shareholders are not treated as owning stock in that PFIC in example 1. In contrast, they are treated as owning stock in that PFIC in example 2 under the Proposed Regulations. In other words, FC1 shareholders are put in a worse position in example 2 because FC1's insurance subsidiary is domestic (and subject to U.S. federal income tax) rather than foreign.

3. Requested Modification

The Treasury Department and the IRS should modify the Proposed Regulations to provide that the QDIC rule applies (and the assets and income of a QDIC are treated as nonpassive) for purposes of section 1298(a)(2). This would align the treatment of a QDIC with that of a QIC, and thus produce parity between domestic and foreign insurance companies. The same policy reasons that justify treating a QDIC's income and assets as nonpassive for general PFIC testing purposes (i.e., an entity that is subject to U.S. federal income tax and meets the definition of an insurance company for purposes of subchapter L cannot easily be used as a device to improperly shelter passive income) apply equally for purposes of section 1298(a)(2).

However, if Treasury and the IRS conclude that the QDIC rule should be "turned off for attribution purposes as a general matter, the Proposed Regulations should be modified to provide an exception for active domestic mortgage insurance companies. In the case of a domestic mortgage insurance company that is engaged in the active conduct of an insurance business and holds assets proportionate to its insurance liabilities, a modified version of the QDIC rule should apply to treat such insurance company's income and assets as nonpassive even for purposes of section 1298(a)(2).

In this regard, we believe the modified QDIC rule should apply for purposes of section 1298(a)(2) where (A) 80% of the QDIC's net written premiums are derived from mortgage guaranty insurance or reinsurance of mortgage guaranty insurance; and (B) its gross investment income is less than 50% of its net written premiums as reported on the annual statement of the QDIC for the last year ending with or within the taxable year of the TFC. As discussed above, the fact that an insurance company's investment income is less than 50% of net written premiums should be sufficient to demonstrate that its investments are proportionate to the underlying insurance business (and do not afford the opportunity for abuse).

Alternatively, a modified version of the QDIC rule should apply to treat a mortgage insurance company's income and assets as nonpassive for purposes of section 1298(a)(2) where the QDIC's contingency reserves as required to be established under State law or regulations within the meaning of section 832(e) are more than 25% of its total assets as reported on the annual statement of the QDIC for the last year ending with or within the taxable year.

A mortgage insurer that meets these tests is a bona fide active enterprise from an economic perspective, and does not afford the opportunity to improperly shelter passive assets from the application of the PFIC regime. Moreover, because the QDIC rule is a regulatory creation, the requested modification to the QDIC rule is within the scope of the government's regulatory authority.

C. Treatment of Small Shareholders Under Section 1298(a)(2)

1. Proposed Regulations

Section 1298(a)(2)(A) provides a 50% Ownership Threshold, under which a person who owns less than 50 percent of a corporation's stock is not treated as owning stock owned by such corporation. Section 1298(a)(2)(B), in turn, provides that the 50% Ownership Threshold does not apply to a foreign corporation that is a PFIC. Under section 1298(a)(2)(B), the determination as to whether a corporation constitutes a PFIC is made pursuant to the same rules that generally apply for PFIC testing purposes (except for section 1297(d)). The Proposed Regulations, however, "turn off two PFIC testing rules for ownership attribution purposes: (i) the QDIC rule;⁸ and (ii) the Domestic Subsidiary Look-Through Rule.⁹

2. Comments

As discussed above, because the Proposed Regulations "turn off' Section 1298(b)(7) and the QDIC rule for the purpose of section 1298(a)(2), a non-PFIC (and non-CFC) foreign parent corporation can be treated as a PFIC for purposes of ownership attribution. Thus, the foreign parenVs shareholders may be treated as owning its foreign subsidiaries under section 1298(a)(2) (regardless of such shareholders proportionate ownership interest). This contrasts with the statutory rule, under which ownership is not attributed to shareholders of a non-PFIC unless they meet the 50% Ownership Threshold, and PFIC status is determined under the same rules that apply generally for PFIC testing purposes (with section 1297(d) being the sole exception).

Although the purpose of the 50% Ownership Threshold is not explicitly stated in the legislative history, it was likely intended to prevent the attribution of ownership through a non-PFIC corporation to minority shareholders (i.e., shareholders owning less than 50% of the corporation's stock) who may not have the power to direct the corporation's actions or the means to ascertain all the company's holdings and determine the character of its investments. The difficulties faced by a minority shareholder in this regard are particularly acute in the context of retail investors and other small shareholders owning less than 5 percent of a corporation's stock. Indeed, numerous provisions of the Code (including certain PFIC-related provisions¹⁰), provide for special rules with respect to small shareholders. For example, in the FIRPTA context, section 897(c)(3) provides that publicly traded stock of a domestic corporation is not treated as a U.S. real property interest with respect to a shareholder that does not own more than 5% of the relevant class of stock during the applicable holding period.¹¹ In the section 367 context, a transferor can qualify for non-recognition treatment in connection with an outbound transfer of stock without the need for a gain recognition agreement if the transferor owns less than 5% of the transferee corporation's stock after the transfer.¹²

Under the Proposed Regulations, because shareholders (including small shareholders) of a foreign parent corporation are not permitted to apply the Domestic Subsidiary Look-Through Rule and the QDIC rule for purposes of testing PFIC status under section 1298(a)(2), they may be treated as owning stock of foreign subsidiaries held by the foreign parent, even though the foreign parent is not treated as a PFIC for other purposes. Small shareholders of non-PFIC (and non-CFC) foreign parent corporations would thus be potentially subject to income inclusion, elections, and reporting obligations under the PFIC rules. However, as discussed above, small shareholders do not have the right to participate in the management or investment decisions of the foreign parent, may not be able to obtain information concerning the income and assets of the foreign parent's subsidiaries, and may lack the resources to understand and comply with their obligations under the PFIC regime.¹³ Thus, the expanded attribution rules provided by the Proposed Regulations would impose a heavy compliance burden on small shareholders who are not equipped to bear it. This outcome appears to conflict with the purpose of the statutory 50% Ownership Threshold.

In order to mitigate this harsh result, Treasury and the IRS should consider granting relief to small shareholders owning less than 5% of the stock of a foreign parent corporation. As discussed above, similar relief has been provided in other contexts in order to reduce the compliance burden on small shareholders.

3. Requested Modification

The final regulations should provide an exception to the expanded PFIC testing rules under section 1298(a)(2) for small shareholders (i.e., shareholders owning less than 5 percent of the shares of the first-tier foreign corporation). In particular, small shareholders should be permitted to apply both the QDIC rule and the Domestic Subsidiary Look-Through Rule to determine whether a first-tier foreign corporation is a PFIC for purposes of ownership attribution under section 1298(a)(2).

D. Delayed Effective Date

1. Proposed Regulations

As a general matter, the Proposed Regulations, including the rules of Prop. Reg. §§ 1.1297-4 and 1.1297-5, apply to taxable years of U.S. persons that are shareholders in certain foreign corporations beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register.¹⁴

Until the Proposed Regulations are finalized, though, U.S. persons may choose to apply (i) the Proposed Regulations in their entirety (other than the rules under Prop. Reg. §§ 1.1297-4 and 1.1297-5) to all open tax years, and (ii) the rules of Prop. Reg. §§ 1.1297-4 and 1.1297-5 for taxable years beginning after December 31, 2017, as if they were final regulations provided they do so consistently.

2. Comments

The Proposed Regulations, which were issued after a period of almost 30 years without final¹⁵ regulatory guidance addressing the statutory exception for insurance companies under the PFIC regime, include a substantial number of technical clarifications and material changes to the rules governing not only the PFIC insurance exception specifically but also the PFIC income and asset tests more generally. Although the additional guidance provided by the Proposed Regulations is welcome and sheds light on a wide variety of long-standing issues, it also adds significant complexity and might create new implementation challenges.

Accordingly, companies and their advisors still need time to absorb and understand the Proposed Regulations, including the new rules regarding the PFIC insurance exception, which if not properly considered may cause unexpected and unintended results. Taxpayers will likely not be able to institute the necessary internal procedures to comply with the new rules under the Proposed Regulations until at least the end of next year.

3. Requested Modification

The Treasury Department and the IRS should modify the Proposed Regulations to provide that its provisions, including the rules of Prop. Reg. §§ 1.1297-4 and 1.1297-5, will apply to taxable years of U.S. persons that are shareholders in certain foreign corporations beginning on or after (i) December 31, 2020, or (ii) the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register, whichever is later.

V. CONCLUSION

As discussed above, mortgage insurance is an important element of the U.S. housing finance system. The Company and its subsidiaries comprise an active insurance business whose income and assets should not, as a policy matter, be considered passive. However, because of the unique nature of the mortgage insurance business, the expanded attribution rules provided in the Proposed Regulations (which apply a broader test for determining PFIC status in the context of section 1298(a)(2)) have the potential to treat the Company's shareholders (including retail investors and other small shareholders) as owning stock in a PFIC (i.e., ERE). For the reasons set forth above, we believe this outcome is inappropriate as a policy matter and imposes unnecessary compliance burdens (particularly in the small shareholder context).

Therefore, we respectfully request the following modifications to the Proposed Regulations. First, the QIC rule should be modified in order to allow a mortgage insurance company to be treated as a QIC where certain requirements are met. Second, in testing a foreign parent corporation for purposes of applying the ownership attribution rules of section 1298(a)(2) to determine whether a shareholder owns an indirect interest in a PFIC, the QDIC rule should be "reinstated." If it is not reinstated generally, a modified QDIC rule should apply in the case of a mortgage insurance company which meets certain tests demonstrating that it is operating within capital standards as set forth by the GSEs, and primarily engaged in the business of mortgage guaranty insurance and reinsurance. [See Appendix B & Appendix C]. In addition, if necessary, we think that any rules that take into account the special characteristics of the mortgage insurance industry could be made sufficiently narrow to prevent abuse by other taxpayers by tying such exception language to existing section 832(e). Third, an exception to the expanded definition of a PFIC for attribution purposes should apply in the context of a small shareholder that owns less than 5% of the stock of a publicly traded foreign parent company. Finally, the effective date of the final regulations should be deferred to allow taxpayers adequate time to comply with the new guidance.

Once again, thank you for the opportunity to provide these comments. If you have any questions or require additional information, please feel free to contact Lawrence McAlee at 610-230-0293 and Joe Wenger at 610-230-0565.

Sincerely,

Lawrence E. McAlee
Senior Vice President and Chief Financial Officer

Joseph E. Wenger
Vice President — Tax

Essent Group Ltd.
Pembroke, Bermuda

Copies to:
Hon. David Kautter, Assistant Secretary (Tax Policy), Department of the Treasury

Lafayette "Chip" G. Harter III, Deputy Assistant Secretary (International Tax Affairs), Department of the Treasury

Douglas L. Poms, International Tax Counsel, Department of the Treasury

Brian Jenn, Deputy International Tax Counsel, Department of the Treasury

Kevin Nichols, Attorney Advisor, Office of International Tax Counsel, Department of the Treasury

Daniel Winnick, Senior Counsel, Office of International Tax Counsel, Department of the Treasury

Michael J. Desmond, Chief Counsel, Internal Revenue Service

William M. Paul, Deputy Chief Counsel (Technical), Internal Revenue Service

Drita Tonuzi, Deputy Chief Counsel (Operations), Internal Revenue Service

Peter Blessing, Associate Chief Counsel (International), Internal Revenue Service

Robert H. Wellen, Associate Chief Counsel (Corporate), Internal Revenue Service

Daniel M. McCall, Deputy Associate Chief Counsel (International), Internal Revenue Service

Margaret O'Connor, Deputy Associate Chief Counsel (International), Internal Revenue Service

Lisa Fuller, Deputy Associate Chief Counsel (Corporate), Internal Revenue Service

Raymond J. Stahl, Special Counsel, Office of Associate Chief Counsel (International), Internal Revenue Service

John J. Merrick, Special Counsel, Office of Associate Chief Counsel (International), Internal Revenue Service

Marie Milnes-Vasquez, Special Counsel to the Associate Chief Counsel (Corporate), Internal Revenue Service

Angela Walitt, Attorney Advisor, Department of the Treasury

Josephine Firehock, Attorney Advisor, Internal Revenue Service

David Brazell, Financial Economist, Department of the Treasury