Reinsurers Suggest Targeted Changes to Proposed PFIC Regs

September 9, 2019

Internal Revenue Service
Office of the Chief Counsel
AC: PA: LPD: PR (REG-108214-15)
Room 5203
1111 Constitution Avenue, NW
Washington, D.C. 20224-0001

RE: Proposed Regulations on Passive Foreign Investment Companies (REG-105474-18)

The Reinsurance Association of America (RAA), headquartered in Washington, D.C., is the leading trade association of property and casualty reinsurers doing business in the United States. The RAA is committed to promoting a regulatory environment that ensures the industry remains globally competitive and financially robust. RAA membership is diverse, including reinsurance underwriters and intermediaries licensed in the U.S. and those that conduct business on a cross border basis.

A broad range of foreign insurance companies with U.S. shareholders are affected by the 2019 proposed regulations on Passive Foreign Investment Companies (PFIC). While Congress was concerned that investment companies might claim the insurance exception to the PFIC rules inappropriately, changes to the insurance exception in the 2017 tax reform act,¹ commonly called the Tax Cuts and Jobs Act (“TCJA”), have raised the possibility that many bona fide reinsurers, including companies actively writing low frequency/high severity risks, such as natural disasters, municipal bond defaults, or environmental risks, could be treated as PFICs. In particular, the change in TCJA excluding unearned premium reserves from the definition of “applicable insurance liabilities” has created a risk that foreign insurers writing certain lines will be classified as PFICs. The likelihood of an erroneous classification is compounded by the narrow active conduct percentage test, which a number of well established insurers may fail. Moreover, the denial of certain exceptions has the effect of penalizing foreign-parented insurance groups for owning U.S. insurance companies.

We appreciate that the IRS and Treasury have attempted to find a balance that would prevent investment companies from inappropriately claiming the insurance exception of Code §1297(b)(2)(B),² while permitting bona fide insurance companies to continue to provide much needed coverage to U.S. insureds. These comments address sections in the proposed regulations that need revision in order to carry out that goal without risking misclassification of active insurance companies. This balance is critical to maintaining affordable insurance and reinsurance for hard-to-place risks such as hurricanes, wildfires, oil pipelines, or ocean marine risks, coverages that are typically written by foreign insurers and reinsurers.

EXECUTIVE SUMMARY

The items below are listed in the order in which they appear in the regulations; significant issues appear throughout the draft, rather than primarily at the beginning.

• QIC/Ratings Related Exception: A tested foreign corporation (TFC) that fails to meet the 25% liabilities-to-assets test may prove that it is a qualifying insurance company (QIC) by satisfying a 10% liabilities-to-assets test and proving that its failure is due to run-off related or rating-related circumstances. The description of credit rating agencies' ratings requirements does not follow rating agencies' terms and should be revised. The regulation should recognize that the ratings level requirements for being an acceptable insurance counterparty may vary from one line of business to another, depending upon market conditions.

• Deemed Election by Public Company: Prop. Reg. §1.1297-4(d) provides that a U.S. shareholder in a Tested Foreign Corporation (TFC) may elect to treat the TFC's stock as stock in a QIC if the TFC satisfies the 10% threshold for assets/liabilities and other criteria. As a practical matter, it is difficult for individual U.S. shareholders to make the election. A better approach would be to create a deemed election by a publicly traded corporation, applicable to all U.S. shareholders, if the TFC has provided the required information either through a publicly available statement or directly to the shareholder.

• Collateralized Reinsurers: The TCJA and the proposed regulations will have a significant impact on the treatment of collateralized insurers designed to accept catastrophic risk. In recent years collateralized insurers have represented an increasing share of worldwide reinsurance capacity and have become the primary source of retrocessional coverage for reinsurance companies. These insurers are required by insurance law to be fully collateralized, and thus are able to operate without a rating from a credit rating agency. Because they write catastrophe coverage which by nature deals with infrequent events, it may be extremely difficult to meet the 25% and 10% thresholds provided in Code §1297(f). RAA proposes that the regulations should provide that collateralized insurers that are regulated by law and provide full collateralization of insurance limits be treated as meeting a rating-related circumstance. If Treasury and IRS wish to provide for an additional quantitative test, a de minimis investment income to premium earned test or a hypothetical ratings capital requirement test can be developed.

• Financial Statement: In computing applicable insurance liabilities, the proposed regulation requires the use of U.S. GAAP statements, IFRS statements, or, if neither is filed, then the local regulatory statement. The regulatory statement is required to discount losses “on an economically reasonable basis,” a requirement that may be satisfied by using U.S. GAAP or IFRS discounting principles. However, U.S. GAAP does not discount loss reserves, with a limited exception. RAA believes that imposing a discounting requirement for purposes of the liabilities-to-assets test is incorrect and will result in the misclassification of active insurance companies as PFICs. A better solution would be to limit the amount of Applicable Insurance Liabilities (excluding unearned premium reserves) to amounts which would be appropriate using U.S. GAAP or IFRS accounting principles.

• Insurance Liabilities: The definition of “applicable insurance liabilities” in Prop. Reg. §1.1297-4(f)(2)(i) as “occurred losses” is incorrect and should be replaced by “unpaid losses,” the term used in U.S. regulatory statements and the Code.

• Active Conduct Test: The Active Conduct requirement purports to use a facts and circumstances test, but immediately narrows it to a percentage test that would measure officer and employee expenses against total expenses. The percentage test places excessive emphasis on the size of staff, while excluding costs of essential functions routinely performed by independent agents, brokers, and investment advisors, and has little bearing on the key metric of an insurance company, which is the assumption of insurance risk. This distorted measurement could result in well established companies being improperly classified as PFICs and should be deleted. The IRS should instead incorporate a facts and circumstances test that recognizes the assumption of risk as the key element and is consistent with the broad test in Notice 2003-34.

• QDIC: RAA commends the Treasury and IRS on the creation of an exception for income of a qualifying domestic insurance corporation (QDIC). However, the exception does not apply for purposes of Code §1298(a)(2). For foreign holding companies and insurers with substantial U.S. insurance subsidiaries, there is a significant risk that the company will be classified as a PFIC for Code §1298(a)(2) purposes if the QDIC exception is unavailable. Compounding this result, the proposed regulations similarly preclude the Code §1298(b)(7) exception for certain domestic subsidiaries from applying for Code §1298(a)(2) purposes. There is no sound policy basis for this negative result. The PFIC rules were not adopted to discourage foreign investment in the U.S. insurance market. RAA recommends that the denial of the QDIC exception in Prop. Reg. §1.1297-5(b)(2) and §1.1297-5(e)(2) for Code §1298(a)(2) attribution purposes, as well as the denial of Code §1298(b)(7) for Code §1298(a)(2) attribution purposes in Prop. Reg. §1.1298-4(e), be removed.

• Treatment of Income and Assets of Certain Look-Through Entities: Questions have been raised whether the references to §1.1291-1(c)(2) and §1.1291-1(d)(3) in Prop. Reg. §1.1297-5(f)(1) could be applied to limit the exclusion in Prop. Reg. §1.1297-5(e) so that assets/ income from less than 25% owned entities would be treated as passive. RAA believes the better interpretation is that Prop. Reg. §1.1297-5(e) would treat all §income / assets of a QIC held to satisfy insurance liabilities as non-passive. Prop. Reg. 1.1297-5(f)(1) should specifically refer to §1.1.291-1(c)(2)(i) and §1.1291-1(d)(3)(i) which would clarify this interpretation. In addition, the regulations should apply a consistent rationale for determining non-passive asset/income status when performing the 50% asset/ 75% income tests for look-through subsidiary and partnership investments. QICs should not be penalized for following GAAP or IFRS accounting treatment.

• Reporting: Several RAA members have asked whether a publicly traded foreign company will be required to report PFIC income to U.S. shareholders. A reporting requirement would place a substantial burden on foreign companies, and could deter U.S. investors from purchasing shares in a foreign company, thereby restricting insurance capacity.

• Applicability Date: The regulation should apply to the taxable year of a U.S. shareholder beginning on or after the later of the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register or after January 1, 2021. In the event that the January 1, 2021 date does not leave the foreign corporation at least one year to comply, that date should be moved to a later calendar year.

PART ONE: DEFINITION OF A QUALIFYING INSURANCE COMPANY

Code §1297(a)³ provides that a foreign corporation (that is not a controlled foreign corporation) will be a PFIC if more than 75% of its gross income is passive income or at least 50% of its assets are held for the production of passive income. Because insurance companies hold substantial investments to satisfy their claims obligations, Code §1297(b)(2)(B) provides an exception to the definition of “passive income” for income derived by a “qualifying insurance company” in the “active conduct of an insurance business.”

Code §1297(f) defines a “qualifying insurance company” (“QIC”) as a foreign corporation (1) which would be subject to tax under Subchapter L if it were a domestic corporation, and (2) whose “applicable insurance liabilities” constitute more than 25 percent of its total assets. Prop. Reg. §1.1297-4(b). If a foreign insurer fails to meet the 25% test, the U.S. shareholder may elect to meet an alternative facts and circumstances test: (1) the QIC's insurance liabilities must constitute at least 10% of its total assets, (2) the QIC is “predominantly engaged in an insurance business,” and (3) its failure to meet the 25% test was due solely to “runoff-related or rating-related circumstances.” Code §1297(f)(2) and Prop. Reg. §1.1297-4(d)(1). The proposed regulation raises several issues, discussed below in the order in which they appear in the proposed regulation:

Alternative Test/ The 10% Test

Rating Related Circumstances : If a foreign corporation fails to meet the 25% test to qualify as a QIC, it may be able to qualify if it has a 10% liabilities-to-asset ratio and the failure is attributable to rating-related or run-off related circumstances. Prop. Reg. §1.1297-4(d)(4) provides that the corporation must comply with the requirements of a credit rating agency “in order to maintain the minimum credit rating required for the corporation to be classified as secure to write new business.” The reference to “secure” doesn't follow rating agency analyses or terminology and should be revised as described below.

A.M. Best, one of the best-known insurance company credit rating agencies, does not use the term “secure” at any point in its ratings. Standard & Poor's refers to “financial security” or “financial strength” in its explanation, but never states that an insurer is “secure.” Both agencies use alphabetical designations (A+ designated “Superior” to D designated “Poor” for A.M. Best; AAA to CC for Standard and Poor's). As the Preamble notes, the rating required may vary by line of business. As a practical matter, a reinsurer must have the equivalent of an A category or better from A.M. Best or Standard and Poor's to be competitive, since the reinsurer's financial strength is the critical factor used by brokers and ceding companies when placing reinsurance. It would be extremely difficult for a reinsurer with a lower rating to compete for new business.

Proposal: A better statement of the rating-related exception would provide:

Deemed Election in Cases Where Public Company Provides Compliance Statement

Prop. Reg. §1.1297-4(d) provides that a U.S. shareholder in a Tested Foreign Corporation (TFC) may elect to treat the TFC's stock as stock in a QIC if the TFC satisfies the 10% threshold for the liabilities-to-assets test, the TFC failed the 25% test solely because of run-off related or rating-related circumstances, and the TFC is predominantly engaged in the insurance business. In order for the U.S. shareholder to make the election, the TFC must provide the U.S. shareholder with a statement that it has satisfied the requirements of Code §1297(f)(2) during the taxable year.

As a practical matter, providing the necessary statement to a U.S. shareholder is extraordinarily difficult, if not impossible, for a publicly traded corporation. The stock of a publicly traded company may be held in street names, by a trust or mutual fund, or through a variety of commingled funds. Many individual U.S. shareholders will be unfamiliar with the election and will not know how to make the election on Form 8621. A better approach would be to create a deemed election by a publicly traded corporation, applicable to all U.S. shareholders, if the TFC has provided the required information either through a publicly available statement or directly to the shareholder.

Collateralized Reinsurance/Ratings Related Exception

Apart from the ways in which the TCJA and the proposed regulations would affect the classification of traditional foreign insurance groups as PFICs, these new rules will also have a significant impact on the treatment of collateralized insurers designed to accept catastrophic risk. In recent years collateralized insurers have represented an increasing share of worldwide reinsurance capacity due to the inherent flexibility and efficiency with which such vehicles operate, resulting in more competitive rates in the market⁴. Collateralized insurers are generally regulated by specific provisions of insurance law⁵ with a cornerstone of these laws being the requirement that insurance limits are fully collateralized. The requirement to fully collateralize insurance limits allows collateralized insurers to transact business without a rating from a credit rating agency because there is no issue of their having the resources to pay claims. These vehicles perform the sole function of assuming significant insurance risk and have become the primary source of retrocessional coverage for reinsurers.

Because fully collateralized reinsurance vehicles write catastrophe coverage and may not have significant insurance reserves each year, it may be extremely difficult to meet the 25% and 10% thresholds provided in Code §1297(f). RAA recognizes that these thresholds cannot be changed by regulation. However, we believe it is essential that Treasury and IRS are aware of the impact the TCJA and the PFIC proposed regulations will have upon the capacity these insurers bring to the market, particularly in reinsuring catastrophe risks. RAA asks that IRS/ Treasury consider rules specifically designed for such vehicles when interpreting the rating-related circumstance requirement (in situations when the 10% test is met).

RAA proposes that collateralized insurers that are required by regulators to provide for the full collateralization of insurance limits be treated as meeting a rating-related circumstance. If there is a desire by Treasury and IRS to provide for an additional quantitative test to meet a rating-related circumstance for these vehicles, a de minimis investment income to premium earned test or a hypothetical ratings capital requirement test could be developed.

Applicable Financial Statements/Local Regulatory Statement

In computing applicable insurance liabilities, the proposed regulation requires the use of U.S. GAAP statements, IFRS statements, or, if neither is filed, then the local regulatory statement. If the local regulatory statement is the basis for determining applicable insurance liabilities, the proposed regulation requires discounting applicable insurance liabilities “on an economically reasonable basis,” a requirement that may be satisfied by using U.S. GAAP or IFRS discounting principles. Prop. Reg. §1.1297-4(e)(3)(1).

However, U.S. GAAP does not require discounting of loss reserves; it permits discounting only for loss payment arrangements that are fixed and determinable, which in practice, is limited to structured settlements arising from workers compensation coverage. IFRS uses discounting in its measurement model but applies it differently to long duration and short duration contracts. For both, in the calculation of reserves, IFRS adds back a risk adjustment, and for long-duration contracts, adds back a contract service margin, that, in effect, substantially offset the discounted amounts for all insurance contracts.

RAA believes that imposing a discounting requirement for purposes of the liabilities-to-assets test is incorrect and will result in the misclassification of active insurance companies as PFICs. Discounting is applied for U.S. tax purposes to determine the impact of the time value of money on taxable income. The measurement of income and deductions to provide a clear reflection of income for tax purposes relies upon different principles from those used to value assets and liabilities on a balance sheet. Moreover, U.S. GAAP does not provide a full economic balance sheet for insurance companies i.e., all assets and liabilities measured at fair value, so discounting one portion of the balance sheet i.e., insurance reserves, while not measuring all other assets and liabilities on an economic basis (and also excluding the liabilities for unearned premium reserves) is not theoretically consistent. Instead, Applicable Insurance Liabilities should be limited to amounts that would have been appropriate if calculated following U.S. GAAP or IFRS accounting principles. Finally, we agree that imposing U.S. tax discounting on foreign reserves shown in a regulatory statement would be extremely burdensome, as the Preamble noted. It would also increase the likelihood that bona fide reinsurers would be treated as PFICs, an outcome that would be harmful to U.S. insureds.

RAA proposes that the regulation should limit the amount of Applicable Insurance Liabilities (excluding unearned premium reserves) to amounts that would be appropriate if calculated using U.S. GAAP or IFRS accounting principles.

Definition of Applicable Insurance Liabilities

The definition of “applicable insurance liabilities” in Prop. Reg. §1.1297-4(f)(2)(i) uses an unconventional and novel term. It refers to “occurred losses,” instead of “unpaid losses,” the term used in U.S. regulatory financial statements and the Code. It is not clear what the term “occurred losses” means, since it is not used in insurance regulation, financial accounting, or the Code. It raises questions whether estimated losses and loss adjustment expenses are allowed or losses are limited to those paid, contrary to state regulation and U.S. tax accounting.

Proposal: A better definition of Applicable Insurance Liabilities in Section 1.1297-4(f)(2) would provide:

The reference to “occurred losses” is incorrect and should be replaced by the term used in regulatory financial statements and the Code — “unpaid losses.”

PART TWO: ACTIVE CONDUCT OF AN INSURANCE BUSINESS

To exclude insurance income from passive income, a foreign corporation must be a Qualifying Insurance Company (“QIC”) and must demonstrate that its income is derived from the active conduct of an insurance business. Code §1297(b)(2)(B). Even though it has satisfied the QIC tests, a foreign company has a lot at stake in meeting the second test: all of the QIC's insurance related income will be excluded from passive income if the active conduct percentage is 50% or greater, but none of its income will be excluded if the active conduct percentage is less than 50%, so that it will fail to qualify for the insurance exception. Prop. Reg. §1.1297-5(c)(1). The proposed regulation provides that the active conduct percentage is “based on all the facts and circumstances,” but then immediately imposes a narrow percentage test that compares the expenses of officers and employees “related to the production or acquisition of premiums and investment income” to total expenses for the production of “premiums and investment income.”⁶

In the active conduct percentage test, the numerator includes expenses of officers and employees,⁷ while the denominator consists of total expenses. The denominator includes brokerage fees and agents' commissions, as well as investment management fees, three common expenses that may far exceed employee expenses. Adding those substantial costs creates a risk that large, well established insurance companies may be classified as PFICs.

• Brokerage Fees and Agents' Commissions: Unlike some U.S. direct writing companies, most reinsurers simply do not have employees who are licensed brokers. Foreign reinsurers writing in both U.S. and foreign markets rely upon independent agents and brokers to sell their products. For reinsurers, brokers' fees are a substantial expense. Adding brokerage fees to other expenses can often tip the balance so that it is impossible for the reinsurer to meet the 50% test.

• Independent Investment Advisors: Although insurance companies have the necessary underwriting and claims expertise, even the largest companies typically hire an independent advisor to manage their investments.⁸ In practice, a company's investment advisory fees may dramatically change the ratio of expenses for officers and employees (the numerator) to total expenses (the denominator) and cause the QIC to fail the active conduct percentage. This is especially true if the insurance company writes long-tail lines of business, e.g., medical malpractice, product liability, or workers' compensation. In applying the active conduct test, an approach which concluded that an insurance company did not have substantial managerial and operational activities merely because it hired outside investment advisors would be unrealistic and inconsistent with standard practice in the insurance industry.

Industry professionals are concerned that the regulation's emphasis on a headcount of employees in the active conduct percentage test will lead to the disqualification of many entities long recognized as bona fide insurance companies, as well as jeopardizing the insurance company status of Alternate Risk Transfer mechanisms, such as catastrophe bonds,⁹ sidecars,¹⁰ and collateralized reinsurance. In contrast to primary insurers, reinsurers generally manage large policies that require substantial investments with a comparatively small staff of underwriters and administrative personnel.

If the regulation adopted a broad facts and circumstances approach, as was done in IRS Notice 2003-34,¹¹ it would give better guidance to industry professionals, U.S. shareholders, and IRS examiners. Notice 2003-34 recognized that the company's status as an insurance company turned on whether the predominant business activity is issuing insurance or reinsurance contracts, but took a broad view of all of the relevant facts to be considered, including “the size of its staff, whether it engages in other trades or businesses, and its sources of income.” It also cited numerous cases which had determined insurance company status, thereby making it clear that an insurer must “use its capital and efforts primarily in earning income from the issuance of contracts of insurance.”¹² Quite simply, underwriting insurance risk should be the principal factor in the “facts and circumstances” test. The importance of underwriting is addressed already by the explicit requirement that the liabilities-to-assets ratio must meet the 25% or 10% thresholds of Code §1297(f). Companies that clear that hurdle have already demonstrated that they are engaged in the active conduct of an insurance business.

The active conduct percentage test is not necessary to distinguish investment companies from bona fide insurance companies. Neither the statute nor the legislative history requires the adoption of this test. To qualify for the insurance exception, a company must satisfy numerous tests:

• It would be “taxable under Subchapter L” if it were a domestic company, which incorporates the standards of Code §816(a), which generally requires that more than half of the company's business during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.

• Applicable insurance liabilities must be 25% of total assets, and applicable insurance liabilities are subject to a cap and strict standards for acceptable financial statements,

• If the foreign company seeks to qualify under the 10% test, it must prove that it is “predominantly engaged in the insurance business,” which, in addition to the requirement that more than half the corporation's business must be the issuing of insurance contracts, requires that the facts and circumstances of the foreign corporation are “comparable to commercial insurance arrangements providing similar lines of coverage to unrelated parties in arm's length transactions.”

• The TCJA's legislative history and the “Bluebook” provide a list of factors indicating that a company is not engaged in the insurance business for purposes of a facts and circumstances test, including workers focused to a greater degree on investment activities than underwriting activities and low loss exposure.

While we understand the Service's desire to provide U.S. shareholders and IRS field agents with a “bright line” test, the narrow expense ratio is a flawed tool. It places excessive emphasis on the size of staff, but excludes costs of essential functions routinely performed by independent agents, brokers, and investment advisors. Moreover, this distorted measurement will result in well established companies being improperly classified as PFICs.

To avoid the erroneous results of this narrow test, the active conduct percentage test should be deleted. Instead, IRS/Treasury should provide guidance about the facts and circumstances test that recognizes the assumption of risk as the key element and is consistent with the broader facts and circumstances test in Notice 2003-34.

Qualifying Domestic Insurance Corporation Exception

The proposed regulations provide an exception to the passive income and passive asset tests for a Tested Foreign Corporation (TFC) for income and assets of a Qualifying Domestic Insurance Corporation (QDIC) Prop. Reg. §§1.1297-5(b)(2) and (e)(2). A domestic corporation is a QDIC if it is subject to tax under Subchapter L and to Federal income tax on its net income. Prop. Reg. §1.1297-5(d). The QDIC exception is welcome and appropriate.

However, Prop. Reg. §§1.1297-5(b)(2) and (e)(2) provide that the QDIC exception does not apply for purposes of Code §1298(a)(2). Consequently, for purposes of attributing ownership in lower-tier PFICs to U.S. persons that are shareholders of the TFC, the TFC must apply the income and asset tests without applying the QDIC exception.

Foreign insurance groups commonly have a holding company parent, frequently one that is publicly traded, and insurance company subsidiaries in various countries, including the U.S. The U.S. insurance group typically is held by a U.S. holding company positioned below the foreign holding company. Historically, such multinational insurance groups have not been PFICs and accordingly U.S. minority stockholders have not been attributed ownership in any lower-tier PFICs held by the foreign parent (if any) pursuant to the 50% ownership threshold in §1298(a)(2)(A).

For foreign holding companies and insurers with substantial U.S. insurance subsidiaries, there is a significant risk that the company will be classified as a PFIC for Code §1298(a)(2) attribution purposes if the QDIC exception is unavailable. The policy reason supporting such a result is unclear. The PFIC rules were not meant to penalize foreign companies for participating in the U.S. market. Denying the QDIC exception to a foreign corporation with a U.S. insurance subsidiary will make U.S. shareholders indirect owners of PFICs held by the TFC (that are often part of a foreign insurer's investment portfolio to support its active insurance business), imposing a significant and unexpected administrative burden on such shareholders, which will deter U.S. investment in foreign insurance groups. Foreign-parented insurance groups will be incentivized to exit the U.S. insurance market and operate a pure non-U.S. insurance business (which would still be afforded non-passive treatment under the proposed regulations to the extent such foreign insurance businesses qualify as QICs). Consequently, denying the QDIC exception to a foreign corporation with a U.S. insurance subsidiary will also significantly disrupt the U.S. insurance market and reduce insurance availability for U.S. policyholders.

The Preamble states that the QDIC exception is intended to address situations where a TFC owns a domestic insurance corporation through a structure to which the Code §1298(b)(7) exception from passive income and asset treatment for certain stock of domestic subsidiaries does not apply.¹³ Yet, Prop. Reg. §1.1298-4(e) also denies Code §1298(b)(7) for Code §1298(a) attribution purposes. The denial of both the QDIC exception and Code §1298(b)(7) for Code §1298(a)(2) attribution purposes has a disproportionately harsh result for multinational insurance groups with significant U.S. insurance operations, and does not appear to further Congress' intent of the PFIC regime to encourage investments in U.S. assets.¹⁴

RAA recommends that the denial of the QDIC exception in Prop. Reg. §1.1297-5(b)(2) and §1.1297-5(e)(2) for Code §1298(a)(2) attribution purposes, as well as the denial of Code §1298(b)(7) for Code §1298(a)(2) attribution purposes in Prop. Reg. §1.1298-4(e), be removed.

Treatment of Income and Assets of Certain Look-Through Subsidiaries/Look-Through Partnerships

Insurance company investments have evolved since the original PFIC statute was enacted in 1986. Insurance companies still hold bonds and stocks directly, but now they also invest in partnerships or corporations structured to target specific segments, e.g., real estate or oil and gas, or to follow certain strategies, e.g., value or growth. It is very common for insurance companies —

• domestic and foreign — to own interests in funds structured as partnerships or corporations whose activities are limited to the trading of securities for their own account (as defined in Section 864(b)(2)), many of which are publicly traded.

Clarification Needed on Treatment of Assets/Income of a QIC — §1.1297-5(f)(1)

Generally, Prop. Reg. §1.1297-5(b) provides that passive income does not include income that a QIC derives in the active conduct of an insurance business. Prop. Reg. §1.1297-5(c) adds the requirement that such income must be “earned with respect to assets of a QIC that are available to satisfy liabilities of the QIC related to its insurance business.” Prop. Reg. §1.1297-5(e) also excludes from the general definition of passive assets in Prop. Reg. §1.1291-1 the assets of a QIC “available to satisfy liabilities of the QIC related to its insurance business,” an exclusion that appears to most readers to be broad and inclusive. However, there have been questions whether the references to §1.1291-1(c)(2) and §1.1291-1(d)(3) in Prop. Reg. §1.1297-5(f)(1) could be applied to limit the exclusion in Prop. Reg. §1.1297-5(e) so that assets/ income from less than 25% owned entities would be treated as passive. It is difficult to imagine a policy reason that would cause the income and assets from such a commingled investment product to be treated differently from trading in securities performed directly by the insurance company (for instance, via a managed account).

RAA believes the better interpretation is that Prop. Reg. §1.1297-5(e) would treat all income/assets of a QIC held to satisfy insurance liabilities as non-passive. Prop. Reg. 1.1297-5(f)(1) should specifically refer to §1.1.297-1(c)(2)(i) and §1.1297-1(d)(3)(i) to clarify the operation of this provision.

Non-Passive Income/Asset Treatment for Amounts Reflected on an Applicable Financial Statement — §1.1297-5(f)(2)

Prop. Reg. §1.1297-5(f)(2) provides that the income and assets of look-through partnerships and subsidiaries held by a QIC are only treated as items of income and assets of the QIC (provided they are reflected on the QIC's applicable financial statement). This rule penalizes non-U.S. insurance companies for complying with the requirements of GAAP or IFRS. RAA believes this requirement should be modified so that the income/ assets on the AFS are treated as

non-passive for purposes of the 50% asset/ 75% income tests. Because the statute expresses a clear preference for GAAP or IFRS in determining applicable insurance liabilities,¹⁵ we believe the regulations should apply a consistent rationale for determining non-passive asset status when performing the 50% asset/ 75% income tests for look-through subsidiary and partnership investments. QICs should not be penalized for following GAAP or IFRS accounting treatment.

Proposed Regulation §1.1297-5(f)(2) should provide:

that an item of passive income or passive asset in the hands of an entity other than a QIC (subsidiary entity) shall be treated as an item of income or an asset used in the active conduct of an insurance business by a QIC to the extent included on the applicable financial statement used to test the QIC status of the non-U.S. corporation, whether the income and assets of the subsidiary entity are directly included or whether the value of the investment in the subsidiary entity is included. Any such amount included to test for QIC status should reduce the amount of income and assets treated as passive in the hands of the subsidiary entity for purposes of section 1297(c) and Proposed Regulation sections 1.1297-2(b)(2) and 1.1297-1(c)(2)(i). In addition, the cross reference in Proposed Regulation section 1.1297-5(f)(1) is unclear and it should be clarified that the provision only applies to look through partnerships.

Reporting of Passive Income

Several publicly traded companies with subsidiaries that may be PFICs have asked whether a holding company, which is not a PFIC, would be required to report passive income received from PFICs in the group. RAA is opposed to a reporting requirement for publicly traded companies because of the substantial burden it places on the foreign corporation and its U.S. shareholders. RAA members are also concerned that treating some part of a shareholder dividend as PFIC income will deter investment in foreign insurance groups by U.S. shareholders.

Applicability Dates

According to the Preamble, the regulations will apply to taxable years of a U.S. shareholder beginning on or after the date of publication in the Federal Register.

RAA recommends that a later date should be adopted, so that insurers and foreign holding companies will have adequate time to make any changes necessary for compliance with the final regulations. Accordingly, the regulations should apply to the taxable year of a U.S. shareholder beginning on or after the later of the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register or after January 1, 2021. In the event that the January 1, 2021 date does not leave the foreign corporation at least one year to comply, that date should be moved to a later calendar year. The applicability date should allow the foreign corporation adequate time to comply with the final regulation and to gather information required to report to U.S. shareholders on its status.

Contact Information

RAA would be pleased to answer any questions about these comments. Please contact Joseph Sieverling (202-783-8312 or sieverling@reinsurance.org) or Brenda Viehe-Naess (202-841-3902 or bvns@att.net ).

Sincerely,

Joseph B. Sieverling
Senior Vice President and
Director of Financial Services