Attorney Comments on Proposed Hedge Fund Reinsurance Regs

This letter is in response to a request for comments made by the U.S. Department of Treasury and the internal Revenue Service in REG-108214-15, issued on April 23, 2015 ("the proposed regulations"). The proposed regulations provide guidance regarding the insurance company exception to the passive foreign investment company ("PFIC") rules, as provided by section 1297(b)(2)(B).¹

Absent the PFIC insurance company exception, almost all insurance companies would fail the PFIC asset test because most of the assets held by insurance companies consist of securities generating interest or dividends. Congress did not want that result so it included in the final PFIC legislation, in section 1297(b)(2)(B), an exception to the definition of "passive income" for insurance companies.⁵

Enacted as part of the Tax Reform Act of 1986 (the "1986 Act"),⁶section 1297(b)(2)(B) provides as follows:

Prop. Reg. 1.1297-4(a) provides that "the term passive income does not include income earned by a foreign corporation that would be subject to tax under subchapter L if it were a domestic corporation, but only to the extent the income is derived in the active conduct of an insurance business."⁷

An entity that qualifies as an insurance company, under U.S. tax principles, necessarily has investments that are used in the active conduct of its insurance business. In most cases, all of the investments held by an insurance company would generate income "derived in the active conduct of an insurance business" because all of its assets would be needed either to back its insurance reserves or to provide the capital necessary to attract and safely assume the risks that the company has underwritten. In other cases, an insurance company might be overcapitalized, such that some of its assets would not be needed in its insurance business and, to that extent, it would have excess assets.

I agree with the concept put forth by Senator Wyden in the Offshore Reinsurance Tax Fairness Act that a safe harbor should be developed that would allow foreign insurance companies to readily determine whether they escape PFIC status.

However, if a company does have assets above the safe harbor, then it should be able to rely on a facts and circumstances approach to prove that assets above the safe harbor threshold are active. For example, financial guaranty insurance and reinsurance companies have very low reserves when times are good and therefore may not meet a safe harbor based on insurance reserves. However, as was starkly illustrated during the great recession, when the cycle turns reserves go through the roof. When it happened then, many financial guaranty companies lacked the necessary capital to pay their losses and continue in business. They clearly did not have excess capital, but they may have needed to rely on a facts and circumstances test to prove it.

As originally contemplated by Congress, a company gains entry into section 1297(b)(2)(B) by virtue of its insurance company status. It should not have to face a further status question as is effectively posed by Prop. Reg. 1.1297-4(b)(1): does the insurance company employ its own operational personnel and managers or does it hire third parties to provide some of these services?

There is no support in the legislative history of the PFIC insurance company exception for a rule that requires a foreign insurance company to meet the active conduct test in section 367(a) in order to qualify for relief. The active conduct provisions of section 367 are aimed at defining whether a transfer of business assets to a foreign corporation avoids recognition of gain if the transaction otherwise qualifies for tax-free treatment. By contrast, the PFIC insurance company provision echoes language in section 904(d)(2)(C), a provision that, like section 1297(b)(2)(B), applies specifically to insurance companies and for the same purpose: to separate passive income from active income.

Adding the section 367(a) requirement is inconsistent with Congressional intent because it almost swallows the general rule, subjecting most captive insurance companies and many divisions of commercial insurance groups to the PFIC rules, a result the 1986 Congress clearly did not intend and sought to avoid.

For the many reasons set forth in the attached article, section 367(a) is the incorrect standard for the PFIC insurance company exception.⁸Why the IRS should not incorporate the section 367(a) standard into the PFIC insurance company exception is the focus of the attached article, so I respectfully request that you please consider the attachment.

I recommend that Prop. Reg. 1.1297-4(b)(1) be eliminated and replaced by a rule that allows any company that would be taxable as an insurance company under U.S. tax principles to proceed directly to the application of the excess assets test.

The preamble notes that, "the proposed regulations do not set forth a method to determine the portion of assets held to meet obligations under insurance and annuity contracts," and requests comments "with regard to how to determine the portion of an insurance company's assets that are held to meet obligations under insurance contracts issued or reinsured by the company."

There are two principal aspects to that inquiry. The first and easier (but not easy) question concerns the loss reserves, unearned premium reserves, and other reserves common to insurance companies. An insurance company must have assets to back its insurance reserves, so that amount of assets should pass easily as generating "income derived in the active conduct of an insurance business."

As to what reserves to count, it would seem unfair to use U.S. tax reserves, with discounting and U.S. payment patterns, etc. And simply modifying these rules to adapt them more precisely to foreign insurance companies, as contemplated by section 954(i)(4), would still require too great a U.S. tax computation for the population of foreign insurance companies potentially subject to the PFIC rules absent relief under section 1297(b)(2)(B).

A company's insurance reserves could be based on its regulatory filings, on financial statements prepared in accordance with international accounting standards, or on financials prepared in accordance with generally accepted accounting principles. In applying a facts and circumstances test, any conservative reserving practices should be reflected in a reduction of the capital needed to meet obligations under the insurance contracts.

This brings us to the second, more difficult component of excess assets: capital and how to determine the amount of capital that is needed to meet insurance obligations. Simply using the average capital levels of all U.S. companies would not take account of the greater capital needs of a global insurance or reinsurance group, as compared with a strictly domestic insurance operation. It would therefore seem advisable for any safe harbor to take account of data available in respect of companies operating global insurance and reinsurance operations.

Because of the many business models and risk profiles in the industry, it is imperative that a facts and circumstances approach be permitted that would allow a foreign insurance company to demonstrate the amount of capital that is reasonably related to its insurance business, taking into account its insurance regulatory and business needs, any applicable credit rating requirements, domestic and foreign insurance-industry comparables, and any unique underwriting exposures or market conditions faced by the company.

If a company presses the boundaries of what assets might reasonably be needed to meet its insurance obligations, a challenge could presumably be made on the grounds that it would not be treated as an insurance company under U.S. tax principles or that it has so many excess assets that it fails the 50% PFIC asset test. These may not be easy cases, but that is no reason to artificially or arbitrarily narrow the universe of foreign insurance companies that can seek relief under section 1297(b)(2)(B). Regulations should not be drafted that make it difficult for the majority of legitimate insurance companies to operate as they have without being concerned that they might inadvertently be pulled into the PFIC regime.

The vast majority of foreign insurance companies deserve to have assurances that they continue to have access to the PFIC insurance company exception. A safe harbor ratio that would treat assets within the safe harbor as active would be the most practical solution. The mechanical application of the 50% PFIC asset test builds in a margin for error, and a facts and circumstances approach would allow companies to justify any level of assets held in excess of the safe harbor.

I do not know if the formula in the bill introduced by Senator Wyden draws the line at the correct level and, as discussed above, there would still be issues concerning the calculation of insurance liabilities. Nevertheless, in my view, a safe harbor would be a practical solution for the many bona fide insurance and reinsurance companies in the world that should not have to be concerned with the U.S. PFIC rules.

However, the 1986 Congress also did not foresee the frequency and magnitude of natural disaster and terrorist risks, or catastrophe bonds or sidecars or any number of other risk transfer developments in the insurance industry over the past almost 30 years. Any regulations that are proposed at this point, so many years after enactment of the provision, should not run contrary to the legitimate business purpose of providing capital to support these risks. Indeed, at a time when every effort is being made to ensure that banks increase their capital to levels that would allow them to survive the next financial crises, the IRS should not be pushing in the opposite direction by promulgating regulations that drive capital out of the global insurance industry.

Finally, due to the complexity of the issues involved, I would urge that any new set of regulations be issued first in proposed form. If they are issued as final regulations, please give consideration to adopting a delayed effective date to permit foreign insurance companies to adjust their activities or assets to conform, if possible, to any final standards adopted.

Please feel free to contact me on rsafranek@gmail.com if you have any questions with respect to this letter.

²Section 1297(a).

³Section 1297(a)(2); Notice 88-22, 1988-1 C.B. 489.

⁴Section 1297(b)(1).

⁵This paper focuses principally on the PFIC asset test. If an insurance company passes that test, it is unlikely it would fail the income test.

⁶ P.L. 99-514, § 1235(a) (October 22, 1986).

⁷As noted in the preamble to the Proposed Regulations, a company that meets the "more than half" test for insurance company status under sections 816 and 831(c) necessarily meets the predominantly engaged test in section 1297(b)(2)(B).

⁸See, Richard J. Safranek & Diana B. Chapman, Restrictive Regs May Threaten Insurance Company Exception to PFIC Rules, 13 INS. TAX REV. 1147 (July 1997).