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Firm Addresses Insurance Look-Through Rule in PFIC Regs

SEP. 9, 2019

Firm Addresses Insurance Look-Through Rule in PFIC Regs

DATED SEP. 9, 2019
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Comments on Proposed Treasury Regulation Section 1.1297-5(f) Regarding Income and Assets of Certain Look-Through Subsidiaries Held by a Qualified Insurance Company

September 9, 2019

Internal Revenue Service
CC:PA:LPD:PR (REG-105474-18)
Room 5203
P.O. Box 7604, Ben Franklin Station
Washington, DC 2004

Dear Sir or Madam:

We respectfully submit this letter commenting on proposed Treasury Regulation section 1.1297-5(f) (the "Insurance Look-Through Rule"), relating to the treatment of assets and items of income held by certain subsidiaries of an insurance company for purposes of determining whether the insurance company is a passive foreign investment company (a "PFIC") for U.S. federal income tax purposes. We are writing in response to the request by the Department of Treasury ("Treasury") and the Internal Revenue Service (the "Service") for comments regarding proposed Treasury Regulations sections 1.1297-4 and 1.1297-5 and certain related proposed regulations (the "Proposed Regulations"). This letter represents in part the views of certain of our clients, who could be impacted by the Proposed Regulations, and with whom we have consulted in preparing these comments.

Overview of the Insurance Look-Through Rule

Under section 1297(c) of the Internal Revenue Code (the "Code"), if a foreign corporation (the "tested corporation") owns, directly or indirectly, at least 25% of the stock of a second corporation, then for purposes of determining if the tested corporation is a PFIC, the tested corporation is generally treated as holding its proportionate share of the assets and recognizing its proportionate share of the income of the second corporation (the "Subsidiary Look-Through Rule"). The Proposed Regulations include certain rules that would clarify the application of the Subsidiary Look-Through Rule. For example, proposed Treasury Regulation sections 1.1297-1(c)(2) and -1(d)(2) would generally extend the Subsidiary Look-Through Rule to partnerships in which the tested corporation owns a 25% or greater interest and provide rules for characterizing the assets and income of a partnership subject to the Subsidiary Look-Through Rule, and proposed Treasury Regulation section 1.1297-2 would provide various clarifying rules for applying the Subsidiary Look-Through Rule.

Under section 1297(b)(2)(B) of the Code (the "Insurance Companv Exception"), income derived by a non-U.S. insurance company in the active conduct of an insurance business, and assets generating such income, may be treated as active for purposes of the PFIC rules if the insurance company meets certain requirements (such an insurance company, a "QIC"). In order for a company to be treated as a QIC, among other requirements, the company's applicable insurance liabilities must generally constitute more than 25% of the company's total assets, generally determined on the basis of the company's financial statement (the "25% Insurance Liability\Test").

The Insurance Look-Through Rule provides a corollary to the Subsidiary Look-Through Rule as applied in conjunction with the Insurance Company Exception. Under the Insurance Look-Through Rule, if a tested corporation is a QIC, any assets and income attributed to the QIC under the Subsidiary Look-Through Rule may be characterized as active under the Insurance Company Exception based on the activities of the QIC (the "General Rule"). However, the rule further provides that the General Rule only applies to a subsidiary entity if the QIC's applicable financial statement includes the assets and liabilities of the subsidiary entity (the "Applicable Statement Limitation").

Comments on the Insurance Look-Through Rule

We strongly agree with the General Rule. Broadly speaking, the General Rule permits non-U.S. insurance companies to hold investment assets through subsidiary entities without causing those investment assets to be automatically excluded from the Insurance Company Exception, and we believe this is the correct result. It is not uncommon for insurance companies (as well as other businesses) to hold investment assets through subsidiary vehicles for a number of reasons, including a desire to segregate assets for liability purposes, a desire to invest in a specific legal form, a desire to invest in a joint venture with other investors, or a desire to invest in pooled investment vehicles managed by external investment advisors. In particular, an insurance company may invest in a pooled investment vehicle at a time when the vehicle has already been established, so that the insurance company does not have control over the structure of the investment vehicle. Investments made by a QIC in subsidiary entities, and particularly pooled investment vehicles, should be eligible for the Insurance Company Exception, since such assets remain available by the QIC to support its obligations on its insurance contracts regardless of the form through which such assets are held.

However, the Applicable Statement Limitation would severely limit the application of the General Rule and result in a broad range of investment assets being inappropriately excluded from the Insurance Company Exception. We respectfully request that the Treasury remove the Applicable Statement Limitation from the final regulations.

The Applicable Statement Limitation in essence requires that, in order for the Insurance Look-Through Rule to apply, the QIC must file a consolidated financial statement with the relevant subsidiary for financial reporting purposes. The rationale behind the Applicable Statement Limitation appears to be that, if the assets of the subsidiary are characterized as active on the basis that they would be treated as active if held by the QIC directly, the 25% Insurance Liability Test should also apply on the basis as if the assets were held directly. But the QIC's investment in the subsidiary is reflected on the QIC's balance sheet whether or not the subsidiary is consolidated. In cases where the subsidiary is not consolidated, the QIC's total assets would include the QIC's interest in the subsidiary. The interest would be reflected on the balance sheet differently than if the subsidiary were consolidated with the QIC (and in particular, typically the net asset value rather than the gross asset value would be reflected on the balance sheet), but the interest would nonetheless be included in the QIC's total assets. As a result, the Applicable Statement Limitation would have the effect of excluding from the Insurance Company Exception investments in certain entities, even though the QIC's investment in the entity is in fact taken into account in the denominator 25% Insurance Liability Test.

Moreover, the practical effect of the Applicable Statement Limitation would not be to require that a QIC include the assets of a look-through subsidiary on its financial statement, but rather to exclude from the Insurance Company Exception a broad range of pooled investment vehicles where it is commercially impractical for the QIC to file a consolidated financial statement with the vehicle. The circumstances under which an entity is consolidated with its parent are typically governed by the commercial terms of the investment, such as the governance rights of the parent with respect to the subsidiary, the parent's ownership over the subsidiary, and the degree of control exercised by other investors in the subsidiary. As a result, it is not generally possible to change whether a subsidiary is consolidated with its parent without changing the terms of the investment, which may not be possible as a practical matter. The Applicable Statement Limitation would therefore limit a QIC's ability to make investments in various vehicles, particularly where the QIC intends to acquire a minority (but greater than 25%) investment in the vehicle. This is true regardless of the fact that, as indicated above, the QIC's equity interest in the investment would be included on the QIC's balance sheet and therefore would be appropriately taken into account in the 25% Insurance Liability Test.

The distortive impact of the Applicable Statement Limitation can be seen by the cliff effect that would be created by the rule. For example, compare a QIC that acquires 24% of a pooled investment vehicle treated as a corporation for federal tax purposes with a QIC that acquires 26% of the same vehicle. Since the first QIC would not be subject to the Subsidiary Look-Through Rule, in applying the PFIC asset and income tests the QIC would take into account as income any dividends and capital gains with respect to the subsidiary's stock, and would include as an asset its stock in the subsidiary. This income and asset would be characterized as active if the QIC satisfied the applicable requirements of the Insurance Company Exception. And, assuming the QIC did not consolidate with the subsidiary, it would presumably include on its balance sheet for financial reporting purposes the value of its stock of the subsidiary.1

In contrast, the second QIC would be subject to the Subsidiary Look-Through Rule. As a result, in applying the PFIC asset and income tests, the second QIC would take into account its proportionate share of the subsidiary's income and assets. However, assuming that the QIC does not consolidate with the subsidiary for financial reporting purposes, these items could not be treated as active under the Insurance Company Exception as a result of the Applicable Statement Limitation. This is true notwithstanding the fact that the two QICs would report the two investments on their balance sheets in exactly the same manner (increased proportionately in the second example). As a result, the Applicable Statement Limitation would create undue friction by imposing arbitrary distinctions between investments that are substantially identical for all practical purposes.2

If the General Rule were included in the final regulations without the Applicable Statement Limitation, the two examples described above would be treated in the same manner. In both cases, the Insurance Company Exception would apply to the QIC's investment in the subsidiary if the QIC satisfied the applicable requirements of the Insurance Company Exception, and the investment would impact the QIC's 25% Insurance Liability Test in the same manner (adjusted proportionately). There would be a "disconnect," in a sense, between the PFIC asset test and the QIC's financial reporting, since the former would take into account a proportionate amount of the gross assets of the subsidiary, and the latter would include only the net equity of the subsidiary's shares. But this "disconnect" merely reflects Congress's decision to utilize a 25% bright-line test for the Subsidiary Look-Through Rule and to rely on financial accounting (which generally requires a higher level of ownership for consolidation) for purposes of the 25% Insurance Liability Test.

The Applicable Statement Limitation may be motivated by a concern that QICs could adjust their balance sheet in a manner intended to cause the QIC to satisfy the 25% Insurance Liability Test. Since an interest in a non-consolidated entity is generally accounted for on a net equity basis, a QIC's decision to invest in an entity on a non-consolidated basis as opposed to a consolidated basis would generally reduce the denominator of the QIC's 25% Insurance Liability Test to the extent of any debt incurred by the subsidiary. However, as described above, the determination of whether a parent consolidates with its subsidiary is generally determined based on features of the commercial arrangement, and is not easily manipulated. As a result, in order for a QIC to accomplish this result, the QIC would typically need to significantly change the commercial arrangement with respect to the subsidiary entity. The framework of the 25% Insurance Liability Test reflected a Congressional intent to rely on financial reporting rules in applying the test, presumably in part because of the significant integrity of applicable financial reporting rules and the fact that they are not easily manipulated. Furthermore, even if the Applicable Statement

Limitation were included in the final regulations, this would not prevent a QIC from structuring its arrangements in a manner that favorably impacted the 25% Insurance Liability Test. For example, a QIC could cause its balance sheet to reflect the net amount of assets, as opposed to the gross assets, by holding the assets through a less-than-25% owned subsidiary, or by investing in assets (such as derivatives) that provide exposure that is similar to a pool of levered assets. The QIC's ability to do this would doubtless be impacted by various commercial considerations, and would be limited by the amount of the leverage that could be prudently incurred by a subsidiary vehicle. But the same kinds of commercial considerations would impact a QIC's decision to invest in a consolidated, as opposed to a non-consolidated, vehicle. The fact that a QIC can take certain steps to favorably impact its 25% Insurance Liability Test, if those steps are commercially feasible, results from Congress's decision to utilize a bright-line test for the 25% Insurance Liability Test.

Furthermore, where a QIC owns an interest in a non-consolidated entity, the net asset value of the investment is a more appropriate measure of the QIC's interest in the entity. If an entity is not consolidated with the QIC for financial accounting purposes, typically the QIC would hold less than 50% of the entity and would not be able to exercise control over the entity. In such circumstances, the QIC would typically have limited control over the specific activities of the entity, and in particular the amount of leverage incurred by the entity. The gross assets and income of the entity would generally be less relevant to the QIC than the QIC's net investment in the entity and the expected net return from the entity, since the QIC would have limited involvement with the entity-level operations of the entity. These considerations are doubtless part of the reason for the financial accounting treatment of the entity. As a result, the fact that the net asset value of the entity (rather than its gross assets) is taken into account for purposes of the 25% Insurance Liability Test would typically reflect the reality of the dynamics between the QIC and the entity, rather than a manipulation of the 25% Insurance Liability Test.

Moreover, it should be noted that, where a QIC holds a less than 100% interest in a subsidiary, requiring the QIC to consolidate with the subsidiary also has a distortive effect. When a parent consolidates with a subsidiary for financial reporting purposes, the parent generally includes 100% of the assets of the subsidiary in the parent's total assets, regardless of the percentage of the subsidiary actually owned by the parent. So, a QIC that makes a 51% investment in a subsidiary and consolidates with the subsidiary would generally include 100% of the subsidiary's assets in the QIC's total assets on its balance sheet — almost double the QIC's actual economic interest in the subsidiary's gross assets. The portion of the assets that correspond to interests in the subsidiary held by third parties would not reduce total assets, but instead would be reflected as a liability. As a result, even if a QIC could adjust its investment in a vehicle to make sure that the QIC consolidated with the vehicle so as to satisfy the Applicable Statement Limitation, the QIC would be artificially disadvantaged to the extent the QIC acquired less than 100% of the vehicle. The Applicable Statement Limitation therefore does not eliminate a potential distortion, but rather creates a distortion in the opposite direction. This distortion is even less reflective of the underlying facts; as discussed above, where a QIC owns a minority interest in an entity, the QIC's net interest in the entity appropriately reflects the substance of the QIC's investment in the entity. In contrast, in the example described above, the QIC does not in substance have any interest in the 49% "outside" interests in the consolidated entity, either on a gross or net basis, even though these would be reflected in the QIC's 25% Insurance Liability Test.

Alternatives to Eliminating the Applicable Statement Limitation

As discussed above, we respectfully submit that the appropriate result would be achieved if the General Rule was maintained and the Applicable Statement Limitation was removed. However, if there are concerns with this approach, there are two other approaches that we would suggest.

First, final regulations could provide that, in lieu of the Applicable Statement Limitation, the Subsidiary Look-Through Rule (i.e., Code section 1297(c)) should be limited in the case of a QIC, so that the PFIC income and asset tests should follow the treatment of a subsidiary on the QIC's financial statement. 'thus, if a QIC owns an interest in a 25%-or-greater subsidiary that is not consolidated, the final regulations could provide that the QIC should only include the subsidiary's net assets and net income in the QIC's PFIC income and asset tests. This result would eliminate the "disconnect" between the PFIC asset test and the 25% Insurance Liability Test, since generally speaking the subsidiary would be taken into account in the same manner in both tests. It would also achieve an appropriate result of allowing the Insurance Company Exception to apply to investments in subsidiaries. There may be a concern that this approach would require the regulations to limit Code section 1297(c) in a manner that does not seem to be contemplated by Congress. However, we believe that this approach would appropriately harmonize Code section 1297(c) with the 25% Insurance Liability Test.

Alternatively, final regulations could provide that, in lieu of the Applicable Statement Limitation, if a QIC holds an interest in a look-through subsidiary that is not consolidated on the QIC's financial statements, the assets and income of the subsidiary that are attributed to the QIC are eligible for the Insurance Company Exception only to the extent that the assets are reflected on the QIC's financial statements. Thus, suppose a QIC held an interest in a look-through subsidiary and $1,000 of the subsidiary's assets are attributed to the QIC under Code section 1297(c). However, suppose that the QIC's interest in the subsidiary on the QIC's balance sheet is only $600 (because, for example, the entity carries liabilities equal to 40% of its gross assets). The final regulations could provide that $600 of the assets attributed to the QIC could be treated as active under the Insurance Company Exception, and the remaining $400 of assets would not be eligible for the exception. This approach would also harmonize Code section 1297(c) with the 25% Insurance Liability Test without limiting the application of Code section 1297(c).

Conclusion

In sum, the General Rule contained in the Insurance Look-Through Rule would give insurance companies appropriate flexibility in structuring their investment holdings, since it would generally treat investment assets held through a look-through subsidiary in the same manner as assets held directly. However, the Applicable Statement Limitation would significantly limit this flexibility in a manner that would result in artificial distinctions and broad distortions. Although the Applicable Statement Limitation may be intended to coordinate the PFIC asset test with the 25% Insurance Liability Test, the limitation is more likely to create severe impediments in a QIC's ability to invest in certain pooled investment vehicles. For these reasons, we respectfully request that Treasury omit the Applicable Statement Limitation from the final version of Treasury Regulation section 1.1297-5(f), or alternatively replace the Applicable Statement Limitation with one of the two alternatives we have described above.

Respectfully submitted,

Michael Seaton
Clifford Chance US LLP
New York, NY

FOOTNOTES

1The example posits a subsidiary that is treated as a corporation for U.S. federal income tax purposes. We believe that the same treatment is intended to apply to a less-than-25% owned partnership, although this result is not entirely clear in the Proposed Regulations. Proposed Treasury Regulation section 1.1297-1(c)(2)(ii) provides that an interest in a less-than-25% owned partnership is characterized as passive, and there is no rule analogous to the General Rule providing that an interest in a less-than-25% owned partnership held by a QIC can be characterized as active under the Insurance Company Exception. Notwithstanding the foregoing, since no look-through rule applies, arguably the interest in the partnership, and the income from the partnership, should be tested as active or passive at the level of the QIC, and therefore should be characterized as active to the extent the Insurance Company Exception applies (in the same manner as an interest in a less-than-25% owned corporation). We therefore respectfully suggest that this be clarified in the final regulations. However, the example described above avoids this ambiguity by considering a corporation rather than a partnership subsidiary.

2A QIC would not necessarily be treated as a PFIC as a result of this investment if the QIC held other assets that sufficiently counterbalanced the assets of the subsidiary in the QIC's PFIC income and asset tests. However, the impact of this result on the QIC's PFIC tests should not be discounted. For purposes of the PFIC income and asset tests, the QIC would be required to take into account its proportionate share of the gross income and assets of the subsidiary. A QIC could therefore become treated as a PFIC as a result of investments in these subsidiaries, even where the net equity in these subsidiaries and the net income from the subsidiaries reflects a relatively small portion of the QIC's net assets.

END FOOTNOTES

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