EY Seeks Insurance Exception Under Corporate Inversion Guidance

This letter is in response to a request for comments made in Notice 2014-52 by the U.S. Treasury and the Internal Revenue Service. In particular, this letter focuses its comments on the application of section 2.01 of the Notice to a foreign acquiring group that is primarily engaged in the business of insurance. This comment letter wishes to highlight, with respect to the definition of foreign group nonqualified property described in Section 2.01, (a) the complexity of applying an exception conditioned on meeting the requirements of section 954(i), particularly to foreign corporations with no prior U.S. tax connection; (b) the absence of any exception for domestic companies owned, directly or indirectly, by the foreign acquiring corporation that are taxed under Subchapter L of the Code as insurance companies; and (c) while Section 2.01 provides for an exception to banking institutions based on the requirements of section 1297(b)(2)(A), no similar exception is provided to the insurance industry based on the requirements of section 1297(b)(2)(B).¹

Due to the complexities of section 954(i) and the inability of many very significant foreign insurance companies to meet its requirements for substantial portions of their businesses, I respectfully request the inclusion of the Passive Foreign Investment Company ("PFIC") exception contained in section 1297(b)(2)(B) as an exception to the definition of foreign group nonqualified property provided in section 2.01 of Notice 2014-52.

Background to Notice 2014-52

A foreign corporation ("foreign acquiring corporation") generally is treated as a surrogate foreign corporation under section 7874(a)(2)(B) if pursuant to a plan (or a series of related transactions) (a) the foreign acquiring corporation completes after March 4, 2003, the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation; (b) after the acquisition, at least 60 percent of the stock (by vote or value) of the foreign acquiring corporation is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation; and (c) after the acquisition, the expanded affiliated group ("EAG") that includes the foreign acquiring corporation does not have substantial business activities in the foreign country in which, or under the law of which, the foreign acquiring corporation is created or organized, when compared to the total business activities of the EAG (hereinafter, "the 60% Test"). Further, notwithstanding section 7701(a)(4), a foreign acquiring corporation will be treated for purposes of the Code as a domestic corporation if, after the acquisition, at least 80 percent of the stock (by vote or value) of the foreign acquiring corporation is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation (hereinafter, "the 80% Test").

In January 2014, the U.S. Treasury and the Internal Revenue Service issued temporary regulations that will disregard, for purposes of determining whether and to what extent section 7874 applies, certain stock of the foreign acquiring corporation transferred for cash or other "disqualified property". In such a case, in applying the ownership requirements of section 7874 to an acquisition by a foreign acquiring corporation, equity or the foreign acquiring corporation will be disregarded in the denominator of the 80% Test or 60% Test, as applicable, if it is issued for disqualified property, which is defined in Treas. Reg. § 1.7874-4T(i)(7) as (a) cash or cash equivalents; (b) marketable securities, as defined in section 453(f)(2), with certain exceptions; (c) an obligation, as defined in Treas, Reg. § 1.752-1(a)(4)(iii), of a member of the foreign acquiring corporation's EAG and certain other persons; and (d) any property acquired with the principal purpose of avoiding section 7874.

Under section 2.01 of Notice 2014-52, the U.S. Treasury and the Internal Revenue Service announced that they would issue regulations under section 7874(c)(6) that would provide that, if more than 50 percent of the gross value of all "foreign group property" constitutes "foreign" group nonqualified property," a portion of the stock of the foreign acquiring corporation would be excluded from the denominator of the 60% Test or 80% Test (hereinafter jointly referred to as the "ownership fraction"), as applicable. This 50 percent test is applied after the acquisition and all transactions related to the acquisition, if any, are completed. For this purpose, foreign group property means any property (including property that gives rise to disqualified stock upon application of Treas. Reg. § 1.7874-4T) held by the EAG after the acquisition (and all transactions related to the acquisition, if any) are completed, other than the following property: (a) property that is directly or indirectly acquired in the acquisition and that, at the time of the acquisition, was held directly or indirectly by the domestic entity; and (b) to avoid double counting, stock or a partnership interest in a member of the EAG and an obligation described in Treas. Reg. § 1.7874-4T(i)(7)(iii)(A) (that is, an obligation of a member of the EAG).

Except as provided in the immediately succeeding sentence, foreign group nonqualified property means foreign group property that is described in Treas. Reg. § 1.7874-4T(i)(7) other than property that gives rise to income described in section 1297(b)(2)(A) or section 954(h) or (l) (determined by substituting the term "foreign corporation" for the term "controlled foreign corporation"). Foreign group property that otherwise would not be foreign group nonqualified property nevertheless is treated as foreign group nonqualified property if, in a transaction related to the acquisition, such property (substitute property) is acquired in exchange for other property (transferred property) that would be foreign group nonqualified property had such transferred property not been exchanged for the substitute property.

If the 50 percent threshold is satisfied, the portion of the stock of the foreign acquiring corporation that will be excluded from the denominator of the ownership fraction is the product of (a) the value of the stock of the foreign acquiring corporation other than (i) stock described in section 7874(a)(2)(B)(ii) (that is, stock held by reason of), and (ii) stock excluded from the denominator of the ownership fraction under either Treas. Reg. § 1.7874-1(b) (because it is held by a member of the EAG) or Treas. Reg. § 1.7874-4T(b) (because it is disqualified stock); and (b) a fraction ("foreign group nonqualified property fraction"), the numerator of which is the gross value of all foreign group nonqualified property, and the denominator of which is the gross value of ail foreign group property. Solely for purposes of the preceding sentence; property received by the foreign acquiring corporation that gives rise to disqualified stock (within the meaning of Treas Reg. § 1.7874-4T(c)) that is excluded from the denominator of the ownership fraction pursuant to Treas. Reg. § 1.7874-4T(b) is excluded from both the numerator and the denominator of the foreign group nonqualified property fraction. The regulations to be issued also will contain a rule that incorporates the principles of Treas. Reg. § 1.7874-4T(h) (regarding the interaction of the expanded affiliated group rules with the rule that excludes disqualified stock from the denominator of the ownership fraction) with respect to stock of the foreign acquiring corporation that is excluded from the denominator of the ownership fraction.

Foreign Group Nonqualified Property

Foreign group nonqualified property means foreign group property that is described in Treas. Reg. § 1.7874-4T(i)(7), that is, (a) cash or cash equivalents; (b) marketable securities as defined in Treas. Reg. § 1.7874-4T(i)(6); (c) an obligation owed by any of the following: (i) a member of the expanded affiliated group that includes the foreign acquiring corporation; (ii) a former shareholder (within the meaning of Treas. Reg. § 1.7874-2(b)(2)) or former partner (within the meaning of Treas. Reg. § 1.7874-2(b)(3)) of the domestic entity; or (iii) a person that, before or after the acquisition, either owns stock of, or a partnership interest in, a person described above; and (d) any other property acquired in a transaction (or series of transactions) related to the acquisition with a principal purpose of avoiding the purposes of section 7874. Thus, not all property held by an insurance company will be treated as foreign group nonqualified property -- only items described above. Thus, for example, certain intangibles or obligations from unrelated person would generally not be considered foreign group nonqualified property. However, the bulk of an insurance company's assets would likely be included in this definition.

Complexity of Applying Section 954(i)

Foreign group nonqualified property, as stated above, excludes property that gives rise to income described in section 1297(b)(2)(A) or section 954(h) or (l) (determined by substituting the term "foreign corporation" for the term "controlled foreign corporation").

The cross-reference to section 954(i), as with the cross-reference to section 1297(b)(2)(A) and section 954(h), is an explicit and logical recognition that certain financial institutions, such as banks and insurance companies, hold significant amounts of investment assets in the ordinary course of an active business. The cross-reference to section 954(i), however, overlays an inordinate amount of unnecessary complexity for purposes of determining whether a foreign insurance company assets are used in an active insurance business. Moreover, the Notice is not clear about which parts of section 954(i), and indirectly section 953(e), should be taken into account in making this determination and what happens to the exception when section 954(i) expires, as it has seven times before. Consider below some of the highlights of section 954(i)'s complexity, noting that foreign acquiring corporations, with no prior U,S. tax connection, would have to assess the application of these complex rules to all affiliates within their group prior to offering stock in the acquisition of a domestic corporation.

For taxable years of a foreign corporation beginning after December 31, 1998, and before January 1, 2014, section 954(l) provides that foreign personal holding company income does not include qualified insurance income of a qualifying insurance company ("QIC").² This exception provides for the exclusion of two amounts under the definition of qualified insurance income: the unrelated ordinary and necessary investment income attributable to exempt contracts and the unrelated investment income attributable to exempt contracts from required surplus.³ These two amounts parallel the two former exceptions to section 954(c) provided in former section 954(c)(3)(B) and former section 954(c)(3)(C).

The first amount representing qualified insurance income is income received from a person other than a related person (within the meaning of section 954(d)(3)) and derived from the investments made by a QIC or a QIC branch, in the case of its property and casualty and life insurance business, of its reserves allocable to exempt contracts or, in the case of property and casualty insurance business, of 80 percent of its unearned premiums from exempt contracts. The second amount representing qualified insurance income is QIC income received from a person other than a related person (within the meaning of section 954(d)(3)) and derived from the investments made by a QIC or a QIC branch of an amount of its assets allocable to exempt contracts equal to (1) in the case of property, casualty or health insurance contracts, one-third of its premiums earned on such insurance contracts during the taxable year (as defined in section 832(b)(4); and (2) in the case of life insurance or annuity contracts, 10 percent of the life reserve amount for such contracts.⁴

For purposes of both amounts, the definitions of a QIC, a QIC branch, or an exempt contract, are found in section 953(e), which are presumably also modified by Notice 2014-52. For a foreign corporation to qualify as a QIC, three main requirements must be met: (a) the foreign corporation must be subject to insurance regulations in its home country; (b) the corporation must derive more than 50 percent of its net written premiums, on an aggregated basis, from the insurance or reinsurance by such foreign corporation (including all QIC branches) of contracts covering applicable home-country risks of such corporation or branch, as the case may be, and (c) the foreign corporation must be engaged in the insurance business and, if it were a domestic corporation, would be subject to tax under subchapter L of the Code. For a branch to qualify as a QIC branch, three main requirements must be met. (a) the branch must be a qualified business unit within the meaning of section 989(a); (b) the branch must be subject to insurance regulations in its home country; and (c) the branch must be a branch of a QIC.

For an insurance or reinsurance contract of a QIC or QIC branch to qualify as an exempt contract such contract must meet three main requirements: (a) the contract must insure only non-U.S. risks; (b) no contract of a QIC or of a QIC branch shall be treated as an exempt contract unless such company or branch derives more than 30 percent of its net written premiums from exempt contracts (i) which cover "applicable home country risks;" and (ii) with respect to which no policyholder, insured, annuitant or beneficiary is a related person (as defined in section 954(d)(3); and (c) if the contract insures risks other than home-country risk, the QIC or QIC branch must conduct substantial home-country activities.

For these purposes, the unearned premiums and loss reserves of a QIC or a QIC branch with respect to property, casualty or health insurance contracts is determined using the same methods and interest rates that would be used if such company or branch were subject to tax under Subchapter L, except that (1) the interest rate determined for the functional currency of the company or branch, and which, except as provided by the Secretary, is calculated in the same manner as the federal mid-term rate under section 1274(d), is substituted for the applicable federal interest rate, and (2) such company or branch must use the appropriate foreign loss payment pattern. Notice 2002-69 provides rules on computing the discounted unpaid losses of a CFC (with respect to a property and casualty insurance business) by applying the general rules of section 846, as modified by section 954(i)(4), when determining the amount of undiscounted unpaid losses, the applicable interest rate and the applicable loss payment pattern.⁵

The amount of reserves of a QIC or QIC branch for any life insurance or annuity contact (life reserve amount) will be equal to the greater of (a) the net surrender value of such contract (as defined in section 807(e)(1)(A)), including the balance in the policyholder's fund in the case of pension plan contracts); or (b) the section 954(i)(5) reserve on such contract.⁶ The section 954(i)(5) reserve on a life or annuity contract is the amount of the reserve on such contract determined in the same manner as it would be determined if the QIC or QIC branch were subject to tax under Subchapter L, except that in applying such subchapter (a) the interest rate determined for the functional currency of the company or branch (and which, except as provided by the Secretary, is calculated in the same manner as the federal mid-term rate under section 1274(d)) is substituted for the applicable federal interest rate;⁷ (b) the highest assumed interest rate permitted to be used in determining foreign statement reserves is substituted for the prevailing state-assumed interest rate; and (c) tables for mortality and morbidity which reasonably reflect the current mortality and morbidity risks in the company's or branch's home country are substituted for the mortality and morbidity tables otherwise used for such subchapter. Section 954(i)(4)(B)(ii) provides that a foreign corporation may use its foreign statement reserves for purposes of section 954(i)(4)(8) if, pursuant to a ruling request submitted by the taxpayer or as provided in published guidance, the Secretary determines that the factors taken into account in determining the foreign statement reserve provide an appropriate means of measuring income.⁸

It is unclear whether the cross-reference in Notice 2014-52 to section 954(i) would likewise implicate the modifications to section 954(i) made in section 953(e), such as, sections 953(e)(1)(C) (separate determination rule), section 953(e)(5) (turning off sections 72(s), 101(f), 817(h), and 7702), and section 953(e)(7) (anti-abuse rules). Further, it is unclear whether any private letter ruling guidance provided under section 954(i) would equally be applicable under section 2.01 of Notice 2014-52. Moreover, it is unclear under Notice 2014-52 whether these investment assets are excluded in whole from the property that is described in Treas. Reg. § 1.7874-4T(i)(7) because some of its income is exempt from Subpart F under section 954(i) or whether only a proportional amount of assets are excluded in the same proportion as the investment income is excluded from Subpart F.

It is clear that no contract insuring U.S. risks would qualify as an exempt contract and thus would not qualify for exemption under section 954(i). Furthermore, section 954(i), as applied by Notice 2014-52, only applies to foreign corporations, and thus domestic corporations are not eligible for the section 954(i) exclusion from the foreign group nonqualified property. Accordingly, the reference to section 954(i) would have the effect of eliminating from the value of a foreign acquiring group significant active business of a foreign-owned insurance group to the extent it owns a U.S. subgroup engaged in the business of insurance in the United States, or a foreign insurance company that insures or reinsures U.S. risks without regard to the materiality, activity, or significant business and financial importance of such operations.

Finally, the application of section 954(i) to a foreign corporation with no prior tax connection with the United States -- and without the infrastructure to track and qualify the required levels of home-country risk insured, the character of their insurance products, and the U.S.-tax equivalent of their insurance reserves -- makes the cross-reference to section 954(i) very difficult to comply with and likely will result in the unintended consequence of deterring legitimate foreign investment in the United States.

The PFIC Insurance Exception

I suggest that a more appropriate standard to cross-reference as an exception to the definition of foreign group nonqualified property would be the exception provided under section 1298(b)(2)(B). Notably absent from the exceptions to foreign group property that are described in Notice 2014-52 and Treas. Reg. § 1.7874-4T(i)(7) are properties that otherwise gives rise to income described in section 1297(b)(2)(B), commonly referred to as the PFIC insurance exception. This absence is made even more striking by the inclusion of a similar exception for banks under section 1297(b)(2)(A). No explicit or implicit U.S. tax policy would appear to justify this disparate treatment of a significant sector of our financial industry.

Under the PFIC rules, every U.S. person who owns stock in a PFIC is required to take into income an interest charge on the deferred tax liability with respect to any distributions made, or, any gain recognized, on such stock,⁹ A PFIC is defined as any foreign corporation if, for the taxable year, (1) 75 percent or more of its gross income is passive income or (2) at least 50 percent of its assets are held for the production of passive income.¹⁰ For these purposes, passive income has the same meaning as foreign personal holding income under section 954(c).¹¹ Passive income, however, does not include certain banking income (active banking income exception) or insurance income (active insurance income exception).¹²

Specifically, section 1297(b)(2)(A) provides that "passive income" does not include any income derived in the active conduct of a banking business by an institution licensed to do business as a bank in the United States (or, to the extent provided in Treasury regulations, by any other corporation). The proposed regulations expand on this exception to foreign corporations by providing that banking income earned by an Active Bank or a Qualified Bank Affiliate, both as defined in the proposed regulations, is non-passive income.¹³ Section 1297(b)(2)(B), however, provides an exception for insurance companies, whether domestic or foreign. Specifically, this exception states:

While I recognize there is limited guidance on the application of section 1297(b)(2)(B), it is clear that its rules are self-executing and have been applied by foreign insurance groups for the last 40 years, consistent with all available guidance. Based on the above, there appears to be no U.S. tax policy justification for the exclusion of assets described under section 1297(b)(2)(A) but not section 1297(b)(2)(B). I would respectfully submit that section 1297(b)(2)(B) be added to the exceptions to foreign group nonqualified property as its application would provide a more practical application of an exception to foreign insurance groups than merely relying on section 954(i) and would permit the assets of U.S. insurance subgroups of a foreign acquiring corporation to be likewise excluded from the definition of foreign property nonqualified property. Furthermore, as more guidance is developed under section 1297(b)(2)(B), it would be expected that this subsequent PFIC guidance would equally impact the scope of property excluded from the definition of foreign group nonqualified property of Notice 2014-52.

I appreciate any thoughts or comments you may have with respect to this letter.

² § 954(i)(1).

³ § 954(i)(2).

⁴ § 954(i)(2)(B). See also Notice 2002-69, 2002-43 I.R.B 730.

⁵ § 954(i)(4)(A)

⁶ § 954(i)(4)(B)(i) and H.R. Rep. No. 817, 105th Cong., 2d Sess. 47 (1998),

⁷ § 954(i)(5). See H.R. Rep. No. 817, 105th Cong., 2d Sess. 47 (1998).

⁸ § 954(i)(4)(B)(ii).

⁹ § 1291(a), Prop. Regs. §§ 1.1291-2 and 1.1291-3.

¹⁰ § 1297(a).

¹¹ § 1297(b)(1). Section 1297(b)(1) (formerly § 1296(b)(1)) was amended to define "passive income" for PFIC purposes by reference to § 954(c) purposes rather than § 904(d)(2)(A). Both the 1988 House and Senate Reports stated: "The bill conforms the PFIC definition of passive income to the definition of passive income under Subpart F (sec. 954(c)), subject to an exclusion for dividends and other amounts received with respect to stock in certain related corporations organized in the same country as the shareholder (sec. 954(c)(3))[.]"

¹² § 1297(b)(2)(B).

¹³ Prop. Regs. § 1.1296-4(a).

¹⁴ P.L. 100-647, 100th Cong., 2d Sess. (1988).