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Company Seeks Changes to Definitions Under PFIC Regs

SEP. 9, 2019

Company Seeks Changes to Definitions Under PFIC Regs

DATED SEP. 9, 2019
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September 9, 2019

HEARING OR MEETING REQUESTED

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

RE: Guidance on Passive Foreign Investment Companies
RIN 1545-B059

GPW and Associates, Inc. (“GPW”) is writing in response to the July 11, 2019 invitation for electronic comments to the above-referenced Proposed Regulations concerning Guidance on Passive Foreign Investment Companies under §1.1297.

Summary

The Scope of this discussion is limited to (1) the definition of “Applicable Insurance Liabilities” (“AIL”) under §1.1297-4(f)(2); and (2) the definition and application of “Active Conduct” under §1.1297-5. GPW thinks the definition and application of these items in the proposed regulations is inconsistent with congressional intent as well as violative of the arbitrary and capricious standard. GPW urges reconstruction of the definition of AIL and provide language below which GPW thinks better fits the Congressional Intent.1 Further, GPW urges the elimination of the language concerning “Active Conduct.”

What is deemed to be the “Active Conduct” of an insurance corporation inherently must begin with the question of “what is insurance?” Congress has chosen to be silent on the issue. However, as the IRS knows, courts, including the Supreme Court, have extensively addressed and discussed the question of insurance. As structured and as applied in the proposed regulations, the unfettered use of “active conduct” disregards our hierarchy of laws and the fundamental doctrine of stare decisis.

Background on Foreign Insurance and Reinsurance Business

Reinsurance is insurance that is purchased by an insurance company from one or more insurance companies. The Federal Insurance Office states:2

By premium volume, the United States is the largest single-country insurance market in the world. Insurers operating in the United States rely on reinsurers, both foreign and domestic, to support the issuance of new policies, to minimize fluctuations in loss experience, and to limit and diversify individual and portfolio risks, particularly in the case of catastrophes and natural disasters.

* * *

The global reinsurance market includes organizations and companies that have operated for a century or more, as well as relatively new companies and alternative forms of risk transfer. The U.S. reinsurance sector continues to be an important source of capacity for domestic insurers seeking reinsurance. Non-U.S. reinsurers also play a key role, as U.S. insurers purchase a substantial amount of reinsurance protection from companies domiciled outside of the United States, or which are part of groups headquartered outside of the United States, including in Europe, the Asia-Pacific region, Bermuda, and other jurisdictions. Additionally, in recent years, insurers, reinsurers, and various capital market participants have developed a range of insurance-linked securities and special purpose vehicles, which have a growing role in the global risk transfer market.

Without a robust global reinsurance industry, the U.S. insurance industry would not be able to offer cost-effective insurance coverage to its insureds which would put domestic economic growth at risk. In 2017, the global reinsurance market size was $247,500 million.3 According to the Reinsurance Association of America, 62.9% of 2017 reinsurance premiums were ceded by U.S.-based insurance companies to “unaffiliated” non-U.S. reinsurers (if “related reinsurers” are included, the number grows to 91.0%).4 Insurance and reinsurance companies are often multinational businesses which effectively distribute the global risk of loss over many geographical areas. The reinsurance industry is global. Thus, it is imperative that regulations directed at perceived issues relating to foreign insurance be predictable and consistent, and not improperly interfere with the important role it plays in the industry.

Background on the Tax Cuts and Jobs Act (“TCJA”) and IRC §1297

As part of the TCJA, Congress modified the exception to passive foreign investment companies (“PFIC”) in Internal Revenue Code (“IRC”) §1297(b)(2)(B) by specifically including the term Qualifying Insurance Corporation (“QIC”). Before its amendment, former §1297(b)(2)(B) provided that passive income generally did not include investment income derived in the active conduct of an insurance business by a corporation that is predominately engaged in an insurance business and that would be subject to tax under subchapter L. In order to provide more clarity, the TCJA modified the PFIC insurance exception to exclude investment income derived in the active conduct of an insurance business by a QIC.

As a new term of art, Congress, defined a QIC by adding IRC §1297(f). It states, in relevant part:

(f) Qualifying insurance corporation. — For purposes of subsection (b)(2)(B) —

(1) In general. — The term “qualifying insurance corporation” means, with respect to any taxable year, a foreign corporation —

(A) which would be subject to tax under subchapter L if such corporation were a domestic corporation, and

(B) the applicable insurance liabilities of which constitute more than 25 percent of its total assets, determined on the basis of such liabilities and assets as reported on the corporation's applicable financial statement for the last year ending with or within the taxable year.

* * *

(3) Applicable insurance liabilities. — For purposes of this subsection —

(A) In general. The term “applicable insurance liabilities” means, with respect to any life or property and casualty insurance business —

(i) loss and loss adjustment expenses, and

(ii) reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance risks and life and health insurance claims with respect to contracts providing coverage for mortality or morbidity risks.

(B) Limitations on amount of liabilities. Any amount determined under clause (i) or (ii) of subparagraph (A) shall not exceed the lesser of such amount —

(i) as reported to the applicable insurance regulatory body in the applicable financial statement described in paragraph (4)(A) (or, if less, the amount required by applicable law or regulation), or

(ii) as determined under regulations prescribed by the Secretary.

(4) Other definitions and rules. — For purposes of this subsection —

(A) Applicable financial statement. The term “applicable financial statement” means a statement for financial reporting purposes which —

(i) is made on the basis of generally accepted accounting principles,

(ii) is made on the basis of international financial reporting standards, but only if there is no statement that meets the requirement of clause (i), or

(iii) except as otherwise provided by the Secretary in regulations, is the annual statement which is required to be filed with the applicable insurance regulatory body, but only if there is no statement which meets the requirements of clause (i) or (ii).

(B) Applicable insurance regulatory body. The term “applicable insurance regulatory body” means, with respect to any insurance business, the entity established by law to license, authorize, or regulate such business and to which the statement described in subparagraph (A) is provided.

Prop. Reg. §1.1297-4(f)(2) is inconsistent with Congressional intent to define Applicable Insurance Liabilities

Congress expressly indicated its intent to limit the construction of how AIL is defined. IRC §1297(f)(3)(A) unambiguously states:

“The term 'applicable insurance liabilities' means, with respect to any life or property and casualty insurance business

(i) loss and loss adjustment expenses, and

(ii) reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance risks and life and health insurance claims with respect to contracts providing coverage for mortality or morbidity risks.”

(emphasis added)

In the Conference Report, “property and casualty" loss reserves are expressly included in the reserve calculation for purposes of IRC § 1297(f)(3).5 Contrary to Congressional intent, as expressed in the Conference Report, the proposed regulations under §1.1297-4(f)(2) omit any reference to “property and casualty” loss reserve. The proposed regulations further reconstruct the definition of an AIL as follows:

(i) Occurred losses for which the foreign corporation has become liable but has not paid before the end of the last annual reporting period ending with or within the taxable year, including unpaid claims for death benefits, annuity contracts, and health insurance benefits;

(ii) Unpaid expenses (including reasonable estimates of anticipated expenses) of investigating and adjusted unpaid losses described in paragraph (f)(2)(i) of this section; and

(iii) The aggregate amount of reserves (excluding deficiency, contingency, or unearned premium reserves) held for future, unaccrued health insurance claims and claims with respect to contracts providing coverage for mortality or morbidity risks, including annuity benefits dependent upon the life expectancy of one or more individuals.

Proposed regulation §1.1297-4(f)(2)(i) inserts the vague and ambiguous word “Occurred losses . . .” in place of the Congressional term “loss and loss adjustment expenses.” However, the term “occurred losses” is not a recognized term in the insurance industry. Moreover, “occurred losses” is not a term commonly found in U.S. Generally Accepted Accounting Principles (“GAAP”), International Financial Reporting Standards (“IFRS”), or Statutory Accounting Principles(“SAP”). This is unfortunate because the proposed regulations elsewhere indicate that use of well-established GAAP and IFRS principles will result in compliance. The introduction of an unfamiliar term will inevitably cause confusion.

On the other hand, the term “loss and loss adjustment expenses” is commonly found in accounting principles and financial statement presentation under GAAP, SAP, and (although worded differently) IFRS. The commonly used term “loss and loss adjustment expense” is commonly understood to include both outstanding claims payable (which are no longer a component of the company's loss reserves) and the loss reserves of the insurance company.

Indeed, Congress expressly created a preference to use and rely on GAAP or IFRS through IRC §1297(f)(4). Therefore, the use of any term that is not recognized constricts the definition of AIL, under IRC § 1297(f)(3).

GPW urges the elimination or modification of the definition under §1.1297-4(f)(2). For twenty-one years, GPW's firm practice has focused exclusively on the insurance and reinsurance industry. Applying GPW's vast industry knowledge to the statutory language as well as a review of the conference reports, GPW interprets IRC §1297(f)(3)(A) “loss and loss adjustment expenses” and “Reserves” to be properly defined as the applicable insurance liabilities related to property and casualty risks and life and health insurance risks, inclusive of unpaid claims and loss adjustment expenses payable, loss reserves, and accrued loss adjustment expenses. Reserves do not include deficiency, contingency, or unearned premium reserves.

By way of a simple example, if a foreign insurance company reinsures the risk on a four-year property and casualty policy with a net premium $1,000, an asset is recorded for $1,000. Further, using reasonable actuarial calculations and applying IFRS, assume the same foreign insurance company records a corresponding $600 loss reserve, a $300 deferred profit, and a $100 cancellation reserve. After applying the proposed regulations, the applicable insurance liabilities are zero with the assets at $1,000 as “property and casualty loss reserves” are excluded. Moreover, it is unclear that an “occurred loss” is equal to the loss reserve. Essentially, the proposed regulations create a scheme in which there would never be a property and casualty reserve that would ever be recognized. The more accurate interpretation of the statutory language intent and the intent from the Congressional Conference Report, assuming the use of IFRS, indicate, that the correct insurance liabilities would be $600 and therefore constitute 60% of its total assets ($1,000 ÷ $600)

“Active Conduct” is arbitrary and capricious in both its definition and application in §1.1297-5

The TCJA further amended IRC §1297(b)(2)(B) to limit the exception to a Qualifying Insurance Corporation to income that is “derived in the active conduct of an insurance business . . .” The proposed regulations introduce an Active Conduct Percentage calculation under §1.1297-5(c)(1) and (4) which is then used to determine whether income derived by a QIC is in the active conduct of an insurance business.6 Congress set forth that a QIC in the active conduct of an insurance business is not a PFIC. It is an acrobatic leap of logic to claim a self-serving formula determines active conduct. The not-so-subtle overlooked step is applying the facts and circumstances to the well-established common law definition of insurance.

The application of the Active Conduct Percentage

In Part II. B of the Proposed Regulations Explanation of Provisions, the IRS states that “[f]or this purpose active conduct is intended to be interpreted consistently with the active conduct standard in §1.367(a)-2(d)(5).” However, within the language of §1.367(a)-2(d)(5), there exists no such test similar to the newly-formed Active Conduct Percentage.7 Rather, the determination of active conduct, under common law, is based on all of the facts and circumstances through analysis of various factors that begin with risk-shifting and risk distribution.8 The use of “facts and circumstances” is not a coincidence. Developed case law has not set forth a narrow bright-line test since the question of “active conduct” is necessarily driven first by the question of “what is insurance?” As partially discussed below and as the IRS is aware, there is extensive common law to provide guidance on this question as well as guidance on framing “Active Conduct” in the Regulations to IRC §1297(b)(2)(B). The attempt to limit “active conduct” through the percentage calculation in §1.1297-5(c)(4) is a thinly disguised attempt to redefine “insurance.”

Before determining whether a company is an insurance company, it is necessary to determine what is insurance.9 It is undisputed that Congress has chosen to remain silent on the matter. However, as the IRS is aware, there is already much precedent and discussion on the definition of insurance within the common law. Neither the IRC nor the regulations define “insurance.” Avrahami v. Comm'r, 149 T.C. No. 7 at 49 (2017); Securitas Holdings, Inc. v. Comm'r, T.C. Memo. 2014-225, at *18 (2014). The Supreme Court has stated that insurance is a transaction that involves “an actual 'insurance risk'” and that “[h]istorically and commonly insurance involves “risk-shifting and risk-distribution.” Avrahami, 149 T.C. No. 7 at 49 citing Helvering v. Le Gierse, 312 U.S. 531, 539 (1941). The use of the Active Conduct Percentage to determine if a business is in the “active conduct” of a Qualifying Insurance Company is an attempt to define insurance in a manner contrary to well-established common law.

The calculation of the Active Conduct Percentage

The proposed regulations employ a second flawed approach attempting to define insurance with a formula calculation in §1.1297-5(c)(4). Aside from the arbitrary use of an Active Conduct Percentage to determine active conduct, the newly created calculation excludes traditional ordinary and necessary industry insurance and reinsurance expenses that have formed the foundation of the industry.10

In relevant part, the calculation §1.1297-5(c)(4) is determined by dividing

(A) The aggregate amount of expenses, including compensation (or reimbursement of compensation) and related expenses, for services of the officers and employees of the QIC . . . incurred by the QIC for the taxable year that are related to the production or acquisition of premiums and investment income on assets held to meet its obligations under the insurance, annuity, or reinsurance contracts issued or entered into by the QIC, by;

(B) The aggregate of —

(1) The amount described in paragraph (c)(4)(i)(A) of this section; and

(2) The amount of all expenses paid for the taxable year by the QIC to a person other than a person whose services for the QIC are covered by the expenses included in paragraph (c)(4)(i)(A) of this section for the production or acquisition of premiums and investment income on assets held to meet obligations under the insurance, annuity, or reinsurance contracts issued or entered into by the QIC

The calculation of the Active Conduct Percentage is written in such a narrow scope as to exclude any foreign insurance or reinsurance company other than an exclusively dedicated “large” insurance company. The formula, in its current form, ignores high costs of a QIC from consideration including, but not limited to fees paid to a direct writer for claims administration, administrative costs, and other costs that are directly related to the business of insurance as is commonly and historically treated within the industry. The result is an artificially smaller percentage by excluding costs from the numerator.

Globally, the industry trend is to outsource costs within the insurance and reinsurance industry. Many industries have evolved into an “outsourcing” model to effect operational efficiencies and to remain competitive in the global marketplace. The use of an outsourced service provider versus employing persons helps keep employment costs lower for small and mid-sized businesses because the employees of service providers can perform the same business functions for many entities.

In the reinsurance space, resource sharing is often necessary because the technical skills required for underwriting, catastrophe modeling, enterprise risk management, claims handling, insurance accounting, investment management, and actuarial services are in short supply and competition is fierce for relevantly qualified staff globally.

GPW believes this is a global trend which affects both domestic and non-U.S. businesses. Based on one source, the global market for outsourced services increased from $45.6B in 2000 to $85.6B in 2018.11

In a recent report published by the National Association of Insurance Commissioners (“NAIC”), the NAIC reported that 49% of U.S. insurers outsourced to an unaffiliated investment manager as of the end of 2017. The NAIC reported that the percentage increased to 64% when looking at small insurers (whose total cash and investable assets are less than $250M).

By ignoring traditional industry standards as well as significant global trends, the proposed regulations in their current form arbitrarily and capriciously penalize an industry whose balance sheets are focused on the assumption of true insurance and reinsurance risks. Consequently, GPW urges the rejection of the use of any form of limiting Active Conduct Percentage and appropriately determine active conduct based on all facts and circumstances. Implementing the active conduct percentage test in both its calculation as well as its application in the proposed regulations improperly narrows the well-established definition of insurance in our common law.

Thank you for considering GPW's comments. GPW respectfully requests a hearing or meeting with appropriate participants to discuss these issues at greater length, to which GPW expects to invite industry representatives with knowledge of the above issues and the likely impact of the regulations as drafted. If you have any questions or need additional information, please contact Gregory L. Petrowski at (602) 200-6900.

Gregory L. Petrowski, CPA12, ACI
Senior Vice President
GPW and Associates, Inc.
3101 N. Central Avenue, Suite 400
Phoenix, AZ 85012
Direct: (602) 200-6924
Fax: (602) 200-6901
Cell: (602) 421-9852
www.gpwa.com

Mark R. Baran CPA13, JD14
Director-Tax Research
GPW and Associates, Inc.
3101 N. Central Avenue, Suite 400
Phoenix, AZ 85012
Direct: (602) 200-6924
Fax: (602) 200-6901
Cell: (216) 536-1981
www.gpwa.com

FOOTNOTES

1For convenience “loss and loss adjustment expenses” and “Reserve” is defined as the applicable insurance liabilities related to property and casualty risks and life and health insurance risks, inclusive of unpaid claims and loss adjustment expenses payable, loss reserves, and accrued loss adjustment expenses. Reserves do not include deficiency, contingency, or unearned premium reserves.

2FEDERAL INSURANCE OFFICE, U.S. DEPARTMENT OF THE TREASURY, The Breadth and Scope of the Global Reinsurance Market and the Critical Role Such Market Plays in Supporting Insurance in the United States, December 2014.

3Orbis Research, Global Reinsurance Market and Insurance Industry Size, Share, Premium, Overview, Brokers, Services, Company Profile, Trends, Status and Outlook to 2025 (11/25/2018).

4Reinsurance Association of America, Offshore Reinsurance in the U.S. Market, 2017 Data

5See H.R. Rep. No. 115-466, at 670 (2017) (Conf. Rep.) (“For the purpose of the provision's exception from passive income, applicable insurance liabilities mean, with respect to any property and casualty or life insurance business (1) loss and loss adjustment expenses, (2) reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance risks and life and health insurance claims with respect to contracts providing coverage for mortality or morbidity risks. This includes loss reserves for property and casualty, life, and health insurance contracts and annuity contracts.”) (emphasis added)

6Prop. Reg. §1.1297-5(b) is titled “Exclusion from passive income of active insurance income.” §1.1297-5(c)(1) sets forth a new formula to be implemented in assessing the exclusion. Depending on how and which numbers are used, it is an all or nothing result. If the Active Conduct Percentage is greater than 50%, then ALL of income is “active conduct.” (i.e. all is income derived in the active conduct of an insurance business in §1.1297-5(c)) If the Active Conduct Percentage is less than 50%, then NONE of the income is “active conduct.” (i.e. all is PFIC)

7(5) Use in the trade or business. Whether property is used or held for use by the foreign corporation in a trade or business is determined based on all the facts and circumstances. In general, property is used or held for use in the foreign corporation's trade or business if it is —

(i) Held for the principal purpose of promoting the present conduct of the trade or business;

(ii) Acquired and held in the ordinary course of the trade or business; or

(iii) Otherwise held in a direct relationship to the trade or business. Property is considered held in a direct relationship to a trade or business if it is held to meet the present needs of that trade or business and not its anticipated future needs. Thus, property will not be considered to be held in a direct relationship to a trade or business if it is held for the purpose of providing for future diversification into a new trade or business, future expansion of trade or business activities, future plant replacement, or future business contingencies.

(emphasis added)

8It is noteworthy to pause and consider the use of the words “active conduct” throughout the proposed regulations. As an example, §1.1297-5(c)(3) recognizes active conduct is determined based on all facts and circumstances. However, the next sentence states active conduct exists “only if the officer and employees of the QIC carry out substantial managerial and operational activities.” (emphasis added) The second sentence of §1.1297-5(c)(3) begs the question, what is the support for inserting “substantial managerial and operational activities?” The unfettered use of “active conduct” creates an appearance that the IRS is attempting to circumvent the fundamental doctrine of stare decisis.

9The court has recognized this fundamental step as it stated “[i]n determining whether payments to [the reinsurance company] were deductible, our initial inquiry is whether [the captive] was a bona fide insurance company.” Rent-A-Center, Inc. et. al. v. Comm'r, 142 T.C. No. 1 at 17 (2014). The IRS claimed the Rent-A-Center reinsurance captive was a sham. In rejecting this claim, the court flatly rejected this claim through reasoning that the Rent-A-Center captive met the common law definition of insurance. Rent-A-Center, Inc., 142 T.C. No 1 at 17, 20-22.

10It is GPW's view that the proposed regulations form an intent to eliminate substantially all foreign insurance and reinsurance company by creating a test that places them into the “Passive Income” category unless the company equivalent to a large, dedicated insurance company such as the U.S. companies of Allstate, Progressive, or Nationwide. Large U.S. insurance companies write their own policies, administer their own claims, and directly manage all aspects of their insurance. As discussed further below, this ignores the global changes of the foreign insurance and reinsurance industry. As discussed throughout this comment letter, this does not reflect the prior and current history of insurance and reinsurance in the United States and is contrary to existing precedent and congressional intent. Simply put, this view is wholly contrary to how the global insurance and reinsurance industry traditionally operates as well as how it is evolving, and GPW sees no evidence that Congress intended such an outcome.

12Actively Licensed with the Arizona Board of Accountancy

13Actively Licensed with the Accountancy Board of Ohio as well as the Arizona Board of Accountancy

14Actively Licensed with the Supreme Court of Ohio and Admitted to the United States District Court for the Northern District of Ohio

END FOOTNOTES

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