PwC Tax Group Raises Concerns With Proposed Active Conduct Tests

April 14, 2021

CC:PA:LPD:PR (REG-111950-20)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

RE: Guidance on Passive Foreign Investment Companies and the Treatment of Qualified Improvement Property under the Alternative Depreciation System for Purposes of Sections 250(b) and 951A(d)

PricewaterhouseCoopers Tax Services Limited¹ appreciates the opportunity to provide comments on the 'active insurance exception' described in Prop. Reg. secs. 1.1297-4 through 1.1297-6 (the 2021 proposed regulations) published on January 15, 2021. We are offering comments on behalf of a group of small and midsize, non-publicly traded reinsurers domiciled outside of the United States. These entities have US shareholders and policyholders and play an important role in the risk management of both taxable and nontaxable US policyholders by providing cost-effective insurance coverage that otherwise might not be available.

Executive summary

The Passive Foreign Investment Company (PFIC) regime was enacted to target US investors of foreign corporations whose purpose is to generate passive investment income that is not subject to current US taxation. With the introduction of the PFIC regime, Congress recognized that certain industries, including the insurance industry, would be unfairly impacted by the general PFIC rules, and thus provided the 'active insurance exception' to the PFIC rules under Section 1297(b)(2)(B).

More recently, concern has arisen that the active insurance exception to the PFIC rules may be subject to abuse by an insurance company formed offshore for the purpose of investing in hedge funds or hedge-fund-like investments. We understand that the purpose of Section 1297(f) (the Qualified Insurance Corporation (QIC) Test), as included in the Tax Cuts and Jobs Act (TCJA), and recent proposed and final regulations, is to address this perceived abuse. In our view, the existing guidance is sufficient and accomplishes this goal without the additional prescriptive language in the proposed regulations regarding the 'active conduct' test.

In order for a foreign insurance company to qualify for the 'active insurance exception', it always has needed to be treated as an 'insurance company' under Subchapter L if such corporation were a domestic corporation. The term 'insurance company' is defined as “any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies”.² Under this test, more than 50% of a foreign insurance company's business must relate to insurance activities (as opposed to investment activities). The QIC test further limits the ability of companies to maintain excess assets for passive investment by limiting the amount of total assets to a ratio of its applicable insurance liabilities. We believe the combination of the 'more than half of the business' test and the QIC test effectively addresses the perceived abuse that Congress was targeting.

In addition, the “active conduct” requirement³ limits the ability of a foreign insurance company to avoid PFIC status. In practice, this requirement causes low-maintenance and limited-purpose insurance vehicles, such as certain special-purpose insurers, to be PFICs regardless of whether they satisfy the 'more than half of the business' test and QIC test. We believe that the combination of the QIC test and the rules impacting special-purpose insurers effectively curtail the abusive structures about which Congress was concerned.

In our view, the 2021 proposed regulations go beyond Congressional intent regarding the active insurance exception provisions. We believe the language in the 2021 proposed regulations related to the active conduct test is overly prescriptive and inappropriately favors large insurance vehicles. In addition, it penalizes US shareholders of small and midsize entities, particularly in the reinsurance industry, and creates inconsistencies with respect to the QIC test.

We believe that Congressional intent was to target vehicles whose principal purpose was investing in hedge funds and hedge fund-like investments with limited insurance activity and risk. Nowhere in our reading of Section 1297(b)(2)(B), the General Explanation of the Tax Reform Act of 1986, Notice 2003-34⁴, or the General Explanation of the Public Law 115-97 did we find any indication that Congress intended that a preference should exist for insurance companies with larger operations or staffing needs. Accordingly, a foreign reinsurance vehicle that requires a limited workforce to conduct its insurance business should not result in that entity being treated as a PFIC. Such an entity may reinsure multiple lines of insurance business, have significant insurance liabilities, and a very limited investment portfolio (e.g., US government T-bills only), yet still would be considered a PFIC under the 2021 proposed regulations.

We are also concerned that the 2021 proposed regulations (1) do not take into account the regulatory precedent regarding the definition of the term active conduct by looking only to the activities of officers and employees and ignoring shareholders of a closely held corporation, (2) mandate significant operational direction to the foreign insurance company regarding how it should run its trade or business, and (3) creates inconsistency between the statute and regulations, specifically with respect to Section 1297(f)(2)(B)(ii).

We suggest the 2021 proposed regulations be amended by removing the prescriptive nature of the language around how an insurance company should function through a more conceptual test. In that regard, we suggest rewording Prop. Reg. sec. 1.1297-5(c)(1) as follows:

(c) Factual Requirements Test — (1) In general. A QIC satisfies the factual requirements test of paragraph (b)(1)(i) of this section if all the following are met

(i) The officers, employees or closely held shareholders of the QIC carry out substantial managerial and operational activities on a regular and continuous basis with respect to its core functions as described in paragraph (f)(4) of this section. DELETE THE BALANCE OF Prop. Reg. sec. 1.1297-5(c).

We further suggest removing any references to a number of employees that might create the unintended exclusion of small and midsized insurers and reinsurers that may not employ a significant number of employees, or whose closely held shareholders are significantly involved in running the business, or avoiding any reference to a number of employees required to meet the active conduct test. In our view, this language is contained in Prop. Reg. sec. 1.1297-5(b)(2)(i), Prop. Reg. sec. 1.1297-5(c)(2)(F), and Prop. Reg. sec. 1.1297-5(c)(4).

Legislative history of the active insurance exception

The Tax Reform Act of 1986 (the TRA of 1986)⁵ added Sections 1291-1298 to the Internal Revenue Code in order to address PFICs. The General Explanation of the Tax Reform Act of 1986 (the 1986 Blue Book) provided background on the Congressional necessity of the PFIC rules:

Congress did not believe that tax rules should effectively operate to provide U.S. investors tax incentives to make investments outside the United States rather than inside the United States. Since current taxation generally is required for passive investments in the United States, Congress did not believe that U.S. persons who invest in passive assets should avoid the economic equivalent of current taxation merely because they invest in those assets indirectly through a foreign corporation . . .⁶

In addition to defining a PFIC⁷ and the means by which a PFIC would be taxed to a US investor,⁸ Congress also acknowledged the need to provide exceptions for certain active trades or businesses (e.g., banks, insurance companies, and securities dealers) that otherwise might be classified as a PFIC due to significant holdings of passive assets.⁹ The TRA of 1986 added Section 1297(b)(2)(B) to the Internal Revenue Code, which excluded from passive income any income “derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business and which would be subject to tax under subchapter L if it were a domestic corporation.” The 1986 Blue Book added little commentary as it relates to the active insurance exception, except to say:

Income of a bona fide insurance company that is not treated as passive income is that income which would be subject to taxation under subchapter L if the income were derived by a domestic insurance company . . .

As indicated, the Act provides regulatory authority to restrict the exception for income derived by bona fide banks and insurance companies where it is necessary to prevent U.S. persons from earning what is essentially investment income in a tax deferred entity . . .

Further, it was intended that entities engaged in the business of providing insurance may derive passive income and, thus, qualify as PFICs in the event the entities maintain financial reserves in excess of the reasonable needs of their insurance business . . .¹⁰

The IRS identified an unintended use of the active insurance exception in Notice 2003-34, cautioning taxpayers about foreign insurance companies whose main business purpose was capturing investment returns, not underwriting returns.

Notice 2003-34 states:

Treasury and the Internal Revenue Service have become aware of arrangements, described below, that are being used by taxpayers to defer recognition of ordinary income or to characterize ordinary income as a capital gain. The arrangements involve an investment in a purported insurance company that is organized offshore which invests in hedge funds or investments in which hedge funds typically invest. This notice alerts taxpayers and their representatives that these arrangements often do not generate the claimed Federal tax benefits.

Notice 2003-34 focused on foreign corporations owned by US persons that took the position that the foreign corporation (FC) was an insurance company engaged in the active conduct of an insurance business such that it was not a PFIC. The following are a few of the facts highlighted by the IRS in its underlying analysis:

• Some of the contracts did not cover insurance risks. Other contracts significantly limited the risks assumed by FC through retrospective rating arrangements, unrealistically low policy limits, finite risk transactions, or other similar means.

• Actual insurance activities, if any, were relatively small compared to investment activities.

• FC's portfolio generated investment returns that substantially exceeded the needs of FC's 'insurance' business.¹¹

The IRS stated that it would scrutinize these arrangements and apply the PFIC rules where it determined that FC was not an insurance company for federal income tax purposes.¹²

Members of Congress introduced a number of legislative provisions with the goal of addressing by statute the issues identified in Notice 2003-34:

• In 2014, Representative Dave Camp and Senator Max Baucus introduced The Tax Reform Act of 2014, which contained legislative text designed to address the situations identified by the IRS in Notice 2003-34. The bill established a threshold test (although it did not define a QIC) which would have required a foreign corporation's 'applicable insurance liabilities' to exceed 35% of its 'total assets' as shown in the foreign corporation's 'applicable financial statements'.¹³

• In April 2015, at the urging of Senator Ron Wyden, the IRS issued proposed regulations to define the term 'active insurance business' as used under Section 1297(b)(2). The proposed regulations provided definitions for the previously undefined terms 'active conduct' and 'insurance business' as used in the 'active insurance exception' to the PFIC rules. According to the preamble, the proposed regulations were intended to address situations in which hedge funds establish a purported foreign reinsurance company to defer and reduce their US tax liability by taking advantage of the Section 1297(b)(2)(B) exception from the definition of 'passive income' that applies to income derived in the active conduct of an insurance business.¹⁴

• In June 2015, Senator Wyden introduced the Offshore Reinsurance Tax Fairness Act (ORTFA). ORTFA was intended to amend the PFIC rules by providing a bright-line numerical test for determining whether a foreign insurance company meets the exception under the PFIC rules. ORTFA incorporated the applicable insurance liabilities test previously seen in the Camp and Baucus proposals, although it utilized a 25% threshold instead of the 35% threshold in the prior proposals. Additionally, ORTFA defined applicable insurance liabilities to include loss and loss adjustment expenses and reserves, similar to the Camp and Baucus proposals, but it did not include unearned premiums.¹⁵

• In 2017, with respect to a provision that would be incorporated substantially into the TCJA, the legislative history stated: “The Committee is concerned about a lack of clarity and precision in the exception to the passive foreign investment company rules for income derived in the active conduct of an insurance business by a corporation that is predominantly engaged in an insurance business. This lack of clarity and precision makes the scope of the exception difficult to ascertain and to enforce. In particular, the Committee is concerned about the lack of precision regarding how much insurance or reinsurance business the company must do to qualify under the exception. The Committee has been informed of offshore arrangements applying the present-law exception that reinsure risks and that invest in U.S. hedge funds, and that have been structured in a manner that raises concerns about the potential for base erosion. The Committee believes that a more mechanical, formulaic rule that is more straightforward to enforce and to apply is appropriate while still preserving the opportunity for a corporation to present facts and circumstances showing it is predominantly engaged in the insurance business, provided the corporation's applicable insurance liabilities are at least 10 percent of its total assets.”¹⁶

The TCJA was signed into law on December 22, 2017.¹⁷ The TCJA amended Section 1297(b)(2)(B) to read:

(B) derived in the active conduct of an insurance business by a qualifying insurance corporation (as defined in subsection (f)). {emphasis added}

Section 1297(f) reads:

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.

The General Explanation of Public Law 115-97 (the 2017 Blue Book) released by the staff of the Joint Committee on Taxation (JCT) includes the following:

The provision modifies the requirements for a corporation the income of which is not included in passive income for purposes of the PFIC rules. The provision replaces the test based on whether a corporation is predominantly engaged in an insurance business with a test based on the corporation's insurance liabilities. The requirement that the foreign corporation would be subject to tax under subchapter L if it were a domestic corporation is retained.¹⁸

We believe that the Congressional intent behind Public Law 99-514 (TRA of 1986) and Public Law 115-97. (TCJA) was:

• to prevent US persons from earning what essentially is investment income in a tax-deferred foreign entity;

• to prevent entities from maintaining financial reserves in excess of the reasonable needs of their insurance businesses; and

• to provide a mechanical test that replaces the test based on whether a corporation is predominantly engaged in an insurance business with a test based on the corporation's insurance liabilities.

We believe Section 1297(f) adds two mechanical balance sheet tests to the statutory requirement that the foreign corporation be an 'insurance company'. In our view, the addition of these balance sheet tests is consistent with the Congressional concerns regarding foreign insurance companies holding excess assets (i.e., those beyond the reasonable needs of the insurance business).

We do not believe that the attempt by the IRS to define the term 'active,' as contained in the original statutory language under the TRA of 1986, is consistent with Congressional intent.

In 2015, the IRS issued proposed regulations¹⁹ (2015 proposed regulations), which, in part, attempted to define the term 'active' as used in the context of Section 1297(b)(2)(B). In the preamble, the IRS stated:

. . . the term “active conduct” had the same meaning as in §1.367(a)-2T(b)(3), except that officers and employees are not considered to include the officers and employees of related entities. The proposed regulations define the term “insurance business” to mean the business activity of issuing insurance and annuity contracts and the reinsuring of risks underwritten by insurance companies, together with investment activities and administrative services that are required to support or are substantially related to insurance contracts issued or reinsured by the foreign insurance company.²⁰

The Preamble to the 2015 proposed regulations went on to state:

The proposed regulations further provide that investment activities will be treated as required to support or as substantially related to insurance or annuity contracts issued or reinsured by the foreign corporation to the extent that income from the activities is earned from assets held by the foreign corporation to meet obligations under the contracts.²¹

We commented at the time that we felt that the definition of 'active' by reference to Reg. sec. 1.367(a)-2T(b)(3) (now Reg. sec. 1.367(a)-2(d)(3)) was too prescriptive when taking into account the realities of small and midsize insurers and reinsurers domiciled in Bermuda. Our view was based on the facts of a number of our clients, which we believe constitute bona fide insurance and reinsurance companies though they rely heavily on independent contractors rather than employees due to their size and the administrative burdens associated with the workplace in Bermuda. We note that the Board of Directors for each of these companies often is comprised of significant shareholders, and these Boards maintain significant oversight over the operational activities of the independent contractors.

In 2019, the IRS issued proposed regulations²² (the 2019 proposed regulations) that replaced the 2015 proposed regulations. The 2019 proposed regulations continued to focus only on the activities of officers and employees (including those of related parties) in determining whether an active insurance business is conducted.²³ Those regulations attempted to establish a definition of 'active' based on a mechanical percentage (active conduct percentage), which was a comparison of the QIC's employee-related costs to the QIC's total costs.²⁴

The industry submitted a number of comments regarding the 2019 proposed regulations, including comments concerning the active conduct percentage. In response, the IRS published a second set of proposed regulations (the 2021 proposed regulations) in an attempt to provide 'more flexibility' in determining whether a QIC is engaged in the active conduct of an insurance business.²⁵ The 2021 proposed regulations added the 'factual requirements test' and modified the active conduct percentage test.²⁶

We have provided below a number of comments regarding the 'active conduct' tests as set forth in the 2021 proposed regulations.

Inconsistency with existing final regulations under Sections 367 and 355 defining active trade or business

We believe there is an inconsistency found in both the 2019 proposed regulations and the 2021 proposed regulations relating to the definition of an active trade or business. The 2015 proposed regulations define an active insurance business by cross-reference to the requirements for active conduct contained in existing regulations under Treas. Reg. sec. 1.367(a)-2(d)(3), which requires that a trade or business be conducted by 'officers and employees' and exclude the activities of independent contractors. Similar active conduct requirements are found in Treas. Reg. sec. 1.355-3(b)(2)(iii), which looks to the facts and circumstances, and requires active and substantial management and operations to be conducted by individuals who are not 'outside' the corporation. These regulations implement the 'outsider' rule by excluding the activities of independent contractors. Of note, Treas. Reg. sec. 1.355-3(b)(2)(iii) does not limit the activities under favorable consideration only to officers and employees, but implies they also could include the activities of shareholders of the corporation.

Accordingly, we believe that if the final Section 1297 regulations consider the activities of individuals 'inside' the corporation for purposes of the active conduct test, the language in those regulations either should align with the language contained in Treas. Reg. sec. 1.367(a)-2(d)(3), or align with the language contained in Treas. Reg. sec. 1.355-3(b)(2)(iii) but drop the term 'officers or employees,' or expand the current language contained in Treas. Reg. sec. 1.1297-5(c) to include the shareholders of the corporation (particularly if closely held) for purposes of the factual requirements test.

Level of specificity

We are concerned by the level of specificity contained in Prop. Reg. sec. 1.1297-5(c) which discusses the facts and circumstances surrounding the requirements associated with meeting the definition of an active conduct of an insurance business. Previous attempts to define an active trade or business were broad-based, looking to general parameters and taking a holistic approach. In our view, the 2021 proposed regulations are extremely prescriptive, and we are concerned that they would narrow the eligibility of foreign corporations that otherwise would qualify under Section 1297(b)(2)(B). We note that Congress intended these regulations to “provide regulatory authority to restrict the exception for income derived by bona fide banks and insurance companies where it is necessary to prevent U.S. persons from earning what is essentially investment income in a tax deferred entity”. It did not empower the IRS to establish narrow guidelines regarding how to run an insurance or reinsurance business.

We suggest the 2021 proposed regulations be amended by removing the prescriptive nature of the language around how an insurance company should function through a more conceptual test. In that regard, we suggest by rewording Prop. Reg. sec. 1.1297-5(c)(1) as follows:

(c) Factual Requirements Test — (1) In general. A QIC satisfies the factual requirements test of paragraph (b)(1)(i) of this section if all the following are met

(i) The officers, employees or closely held shareholders of the QIC carry out substantial managerial and operational activities on a regular and continuous basis with respect to its core functions as described in paragraph (f)(4) of this section. DELETE THE BALANCE OF Prop. Reg. sec. 1.1297-5(c).

Preference for large insurers and reinsurers

In our view, the 2021 proposed regulations inadvertently exclude small and midsize foreign insurance companies which might not need multiple full time employees to perform their core functions from the active insurance exception because of the requirements under the 2021 Proposed Regulations for 1) full or nearly full time officers and employees under Prop. Reg. sec 1.1297-5(c)(2)(F) and Prop. Reg. sec 1.1297-5(c)(4), and 2) the exception under Prop. Reg. sec 1.1297-5(b)(2)(i) which requires a company to employ in excess of a nominal number of employees.

We are concerned with the impact of the exclusionary language contained in the 2021 proposed regulations. We note Prop. Reg. sec. 1.1297-5(c)(2)(F), which requires employees and officers who conduct substantial managerial and operational activities with respect to core functions required under Prop. Reg. sec. 1.1297-5(c)(2) to “devote all or virtually all of their work to those activities and similar activities for related entities”. Prop. Reg. sec. 1.1297-5(c)(4), states that “the number of officers and employees actively engaged in each core function is a relevant factor in determining whether the factual requirements in paragraph (c)(1) of this section have been satisfied.” Prop. Reg. sec. 1.1297-5(b)(2)(i) excludes from 'active conduct' a company with “only a nominal number of employees.” All of these sections imply that a foreign insurance company must employ multiple individuals, and thus effectively establishes a minimum size requirement on insurers and reinsurers with respect to qualification for the active insurance exception. In other words, this language creates a preference for large insurers and reinsurers and potentially would exclude certain small and midsize insurers and reinsurers that do not need numerous full-time employees to perform each of the core functions with respect to qualifying for the active insurance exception. As an example, a single individual may function in multiple roles, such as chief financial officer and actuary, for a smaller insurance business. The 2021 proposed regulations seem to indicate that such an individual does not count toward the insurance business meeting the active conduct requirement because certain activities related to those roles would not be considered a 'core activity' for active conduct test purposes.

We do not believe that it was the intent of Congress in enacting Section 1297(b)(2)(B) under the TRA of 1986 or its modification under the TCJA to establish size limits on insurance company eligibility. Accordingly, we suggest removing any reference to number of employees in the 2021 proposed regulations that might create the unintended preference against small and midsized insurers and reinsurers that may not employ a significant number of employees or whose closely held shareholders are significantly involved in running the business, or avoiding any reference to a number of employees required to meet the active conduct test. In our view, the number of employees does not differentiate a business as an insurance company as opposed to an investment company but rather the activities of the business should make this determination (as it does in meeting the definition of an insurance company under Subchapter L).

Definition of core activities is incomplete

We believe that Prop. Reg. sec. 1.1297-5(f)(4), which defines the term 'core functions' of a QIC, is incomplete. The proposed regulations include only “underwriting, investment, contract and claims management, and sales.” Insurance and reinsurance companies are subject to regulation in their country of incorporation and often elsewhere. We believe that regulatory compliance, balance sheet reserving, and compliance with statutory regulations also should be considered a core activity given that these factors are requirements of conducting an active insurance business.

We provide this comment in support of our view that the language in the 2021 proposed regulations is overly prescriptive as to how an insurance company must operate to meet the requirements of the active insurance exception and does not consider the various types of insurance companies with differing business needs. As such, we recommend the 'core functions' of a QIC language be updated to a more conceptual test.

Inconsistency in application of the QIC test

We further believe that the prescriptive nature of the 2021 proposed regulations does not adequately consider the various types of insurance businesses and their related operations. For example, Section 1297(f)(2)(B)(ii) recognizes that insurance companies that are in runoff should be given special consideration. The 'active conduct' test language does not appear to confer this same consideration to an insurance company in runoff (e.g., the proposed regulations focus heavily on underwriting when a company in runoff generally performs no underwriting activities) and may result in a company in runoff being a PFIC due to the limited activities that an insurance company in runoff is required to perform. This is just one example of the prescriptive language in the 2021 proposed regulations having a preference towards a large, multi-line foreign insurer with multiple employees as opposed to more bespoke insurance vehicles whose facts do not indicate it operates as an investment company and thus should not be a PFIC. In light of this, we believe that the 2021 proposed regulations should be updated to incorporate more general concepts that allow foreign insurance companies to be assessed based on their purpose and individual facts, as opposed to their size.

In summary, PricewaterhouseCoopers Tax Services Limited believes that if the 'active conduct' tests contained in the 2021 proposed regulations were adopted as currently drafted, they would exceed the Congressional intent of the TRA of 1986 (as clarified by the TCJA) by inappropriately limiting which insurance and reinsurance companies are eligible for the active insurance exception under Section 1297(b)(2)(B). Accordingly, we believe the language should be modified to:

• align with Congressional intent so that the 'active insurance exception' precludes incorporated investment vehicles but allows eligibility for bona fide insurance and reinsurance companies;

• recognize the regulatory precedent of an existing definition of the term 'active conduct' by looking not only to the activities of officers and directors but also shareholders of the corporation, particularly if closely held;

• avoid a preference for large insurance and reinsurance companies by not mandating the size of the company's workforce to perform core functions;

• limit providing significant operational direction to foreign insurance companies regarding how they should run their specific trade or business; and

• avoid inconsistencies between the statute and regulations, specifically as they relate to Section 1297(f)(2)(B)(ii).

Thank you in advance for considering our comments. If you have questions about this comment letter, please contact Scott D. Slater at +1 (441) 299-7178 or scott.slater@pwc.com.

Sincerely,

Scott D. Slater
Partner
PricewaterhouseCoopers Tax Services Limited
Hamilton, Bermuda