Bermuda Insurance Group Comments on Final, Proposed PFIC Regs

April 14, 2021

Room 5203
Internal Revenue Service
PO Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Insurance Exception to the Passive Foreign Investment Company Rules and Related Rules

Ladies and Gentlemen:

The Association of Bermuda Insurers & Reinsurers (ABIR) represents Bermuda's leading property and casualty insurers and reinsurers. Bermuda is the center of global expertise on underwriting for catastrophe risk transfer products and other specialty insurance and reinsurance. ABIR and Bermuda (re)insurers provide as much as 60% of hurricane reinsurance in some US states, keeping insurance accessible and affordable for Americans. In the past 20 years, ABIR and Bermuda (re)insurers have paid US policyholders and ceding companies more than $208 billion in claim payments. For more information, visit www.abir.bm

We write today providing comments on Internal Revenue Service ("IRS"), Treasury, Notice of Proposed Rulemaking, 26 CFR Part 1, REG-111950-20, Document ID IRS-2021-0003-0001, Federal Register Number 2020-27003 (the "Notice"), that provides:

proposed regulations regarding the determination of whether a foreign corporation is treated as a passive foreign investment company ("PFIC") for purposes of the Internal Revenue Code ("Code"). The proposed regulations also provide guidance regarding the treatment of income and assets of a qualifying insurance corporation ("QIC") that is engaged in the active conduct of an insurance business

(the "Proposed Regulations"). In addition, we are requesting certain clarifications with respect to the final PFIC regulations promulgated contemporaneously with the Proposed Regulations on January 14, 2021 in TD 9936 (the "Final Regulations").

Our comments relate to the exception to the PFIC rules for insurance companies (the "Insurance Exception"), generally, and the qualifying insurance corporation ("QIC") rules, specifically, as well as the interaction of these rules with other parts of the Final Regulations, and are from the perspective of property casualty insurance companies.

Especially in connection with some of the rules discussed below, it is important to note that PFIC characterization does not impact the non-US insurance companies characterized as PFICs, but impacts US persons owning stock in such non-US insurance companies. Many insurance groups have non-US parent companies, many are publicly traded and many also have significant US operations. US investors investing in legitimate insurance companies should not be harmed as a result of the adoption of regulations that inappropriately characterize such legitimate insurance companies as investment companies. In addition, inappropriate PFIC characterizations potentially harm US persons purchasing insurance by causing disruption to the availability and expense of capital for US and non-US insurance companies.

EXECUTIVE SUMMARY

Set forth below is a summary of comments with respect to the Insurance Exception provisions in the Proposed Regulations (items 1, 2 and 4) and a request for clarification and guidance with respect to certain provisions in the Final Regulations with respect to which the Proposed Regulations are silent (items 3, and 5 through 8).¹

DISCUSSION

I. Brief Overview of the PFIC Statutory Rules

A. Statutory Definition of a PFIC

In general, a non-US corporation will be a PFIC during a given year if: (1) 75% or more of its gross income constitutes "passive income;" (the "75% Test") or (2) 50% or more of its assets produce (or are held for the production of) passive income (the "50% Test"). For the above purposes, passive income is income characterized as foreign personal holding company income as defined under section 954(c), which generally includes interest, dividends, annuities, certain royalties and rents, and other investment income. Under this definition, almost all non-US insurance companies would be characterized as PFICs absent an exception.

B. Overview of the Insurance Exception to the PFIC Rules

The Insurance Exception as modified by "An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018" (commonly referred to as "the Tax Cuts and Jobs Act") (the "TCJA") requires that an insurance company be characterized as a qualifying insurance corporation (the "QIC Test") and that its income be derived in the active conduct of an insurance business.³ Any income so derived by a QIC will not be treated as passive for purposes of the 75% Test and 50% Test. In addition, pursuant to the look-through rule of section 1297(c) such income will also be treated as non-passive when the QIC's income and assets are deemed received by and held by any corporation that holds 25% of the value of the QIC's stock directly or indirectly.⁴ As most non-US insurance companies are part of affiliated groups with a holding company as the ultimate parent, testing for PFIC status is typically done at the holding company level and the insurance company income and assets are treated as non-passive for purposes of the 75% Test and 50% Test at the holding company level. If the holding company is not a PFIC, it is not necessary to test the insurance companies in the group for PFIC status because section 1298(a)(2)(A) limits the attribution of ownership in lower tier subsidiaries of non-US corporations that are not PFICs only to those persons that own at least 50 percent of such corporation.

In order to be a qualifying insurance corporation ("QIC") for a taxable year the following requirements must be met: (i) the corporation would be subject to tax under subchapter L if it were a US domestic corporation; and (ii) its "applicable insurance liabilities" as reported on the corporation's "applicable financial statements"⁵ constitute more than 25% of its total assets (or meet an alternative facts and circumstances test).⁶ For these purposes, "applicable insurance liabilities" include: loss and loss adjustment expenses, and reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance risks.⁷

The alternate facts and circumstances test allows a corporation that does not meet the 25% test to otherwise qualify for the exception if: (i) the corporation is predominantly engaged in an insurance business; (ii) at least 10% of its total assets comprise "applicable insurance liabilities;" and (iii) the reason for the failure to meet the 25% test is solely due to run-off or ratings-related circumstances. In order to utilize the exception, however, an election must be made by the US person who would be subject to the PFIC consequences as a result of owning stock in the insurance company.

For purposes of subchapter L, a property casualty company is characterized as an insurance company if more than half of its business during each taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.

C. Consequences of PFIC Characterization Apply at Shareholder Level

In general and subject to certain exceptions, if a non-US corporation is characterized as a PFIC during a given year, each US Person⁸ owning shares (directly and in certain cases indirectly) of the non-US corporation would be subject to a penalty tax⁹ at the time of the sale at a gain or receipt of an "excess distribution"¹⁰ with respect to the shares of the non-US corporation owned by the US Person.¹¹

If a US Person owns stock in a non-US corporation that is a PFIC, that stock will continue to be treated as PFIC stock even if the non-US corporation ceases to be a PFIC, in which case an election may be made to "purge" the PFIC taint from such stock, under which a US Person would recognize gain (but not loss) as if the stock were sold at fair market value.¹² Such gain generally should be taxable as an excess distribution as described above.¹³

II. Discussion of Certain Provisions of the Proposed Regulations and Comments

A. Clarification of Consolidated Financial Statement Assets for QIC Testing.

1. Overview of Proposed Regulations section 1.1297-4(f) and the Definition of Applicable Financial Statement

Proposed Regulations section 1.1297-4(f)(1) defines an applicable financial statement as a financial statement prepared for financial reporting purposes and then provides a waterfall priority list of potential financial statements indicating that the highest priority (i.e., closest to the top of the list) available financial statement will be a QIC testing entity's Applicable Financial Statement. Proposed Regulations section 1.1297-4(f)(1)(iv) provides additional priority rules for a non-consolidated statement over a consolidated statement. For example, GAAP financial statements have the highest priority and among GAAP statements those prepared in connection with Forms 10-K filed with the US Securities and Exchange Commission have the highest priority.

For purposes of QIC testing (i.e., comparing AIL to total assets), the general rule found in Final Regulations section 1.1297-4(c) is that AIL and total assets as reported on the applicable financial statement are compared. When a single company financial statement is the applicable financial statement (as per the preference noted above) only that company's AIL and assets will be considered. However, when a consolidated financial statement is the applicable financial statement, only single company AIL will be considered, while total gross assets for all consolidated entities will be considered. Although Proposed Regulations section 1.1297-4(e) provides for certain reductions to total assets (i.e., for (i) AIL of other entities included on the applicable financial statement (determined by not taking into account the rules of Final Regulations section 1.1297-4(e)(2) (capping AIL) and (f)(2)(i)(D)(2) (limiting AIL to the testing QIC's AIL)), and (ii) reinsurance recoverables), no other reductions to assets are provided for.

2. Comment

The priority rules for applicable financial statements create anomalous results in the context of consolidated financials and penalize non-US insurance companies for complying with the provisions of GAAP or IFRS requiring consolidated financial statements. The result is that similarly situated groups that choose to hold insurance company subsidiaries which have non-AIL liabilities (e.g., unearned premium reserves) in a tiered structure rather than in a flat brother-sister structure could be treated differently under the PFIC regime. As a result, Proposed Regulations section 1.1297-4(e)(4) should be amended to provide that the amount of total assets may be reduced for all liabilities other than those of the QIC testing entity, so that the testing entity is not required to compare its AIL to a quantum of assets that includes the gross assets of other group members. Alternatively, in the context of GAAP or IFRS consolidated financial statements, it should be permissible for purposes of determining a QIC testing entity's total assets, to utilize the testing entity's underlying single company trial balance that is incorporated into the consolidated financial statement.

Given the limitation in Final Regulation section 1.1297-6(d)(2) with respect to the application of the 1297(c) look through rule for active QICs, such that the income and assets of 25% or more owned subsidiaries and partnerships are only deemed non-passive to the extent of their net equity value (discussed below in section F.), it does not appear necessary to require a QIC testing company to compare its single company AIL to the group's gross assets in order to mitigate concerns about leverage.

B. Removal of Limitation on Non-Passive Assets of Qualifying Domestic Insurance Corporations.

1. Overview of the Proposed Regulations sections 1.1297-6(e)(2) limitation

Proposed Regulations sections 1.1297-6(e)(2) provides for a limitation on the amount of income and assets of a QDIC that are treated as non-passive for purposes of determining whether a non-US corporation is treated as a PFIC. The limitation is either 200% (for life companies) or 400% (for property and casualty ("P&C") companies) of total insurance liabilities. Total insurance liabilities is defined more broadly than AIL and includes unearned premium of P&C companies.

2. Comment

The limitation in Proposed Regulations sections 1.1297-6(e)(2) should be removed. It is unclear why an insurance company group should be penalized for retaining business and assets in the US. In addition, as has been noted in prior comments, for a variety of reasons some types of insurance companies generally will not have total insurance liabilities on their applicable financial statements despite that they are legitimate insurance companies and have significant paid losses.

If the non-passive asset limitation in Proposed Regulations section 1.1297-6(e)(2)(iii) is not removed, guidance should be provided to clarify (i) whether the limitation is on a gross or net basis and (ii) that any amount of assets that is excluded from non-passive characterization as a result of the limitation is excluded from the calculation of PFIC status. In other words, that such assets over the limitation are not treated as passive assets deemed held under section 1297(c) by the top tier non-US corporation testing for PFIC status.

C. Clarification of the Interaction of the QDIC Rule and the Precedence Rule of Section 1298(b)(7) over Section 1297(c)

1. Overview of the QDIC Rule and the Section 1298(b)(7) Precedence Rule

Final Regulation section 1.1297-6(a) and (e) provide that the income and assets of a QDIC look-through subsidiary are non-passive for purposes of determining whether a non-US corporation is treated as a PFIC. However, Final Regulation section 1.1297-7-2(b)(2)(iii) provides that if a US domestic corporation meets the requirements of section 1298(b)(7) its income and assets are not treated as non-passive for purposes of determining whether a non-US corporation is treated as a PFIC.

2. Comment

Final Regulation section 1.1297-6(a) and (e) and Final Regulation section 1.1297-7-2(b)(2)(iii) are contradictory and it should be made clear that the special rule for QDICs overrides the general section 1298(b)(7) precedence rule in Final Regulation section 1.1297-7-2(b)(2)(iii). The precedence rule if applied to an insurance company would treat that insurance company differently than any other company that may generally chose its entity classification status, because insurance companies are per se corporations. In addition, insurance group corporate structures may be mandated by US insurance regulatory concerns. The application of the precedence rule to insurance companies may result in treating similarly situated taxpayers differently depending on their corporate structures (e.g., whether the QDIC is a stand-alone entity or part of a consolidated group with a top tier US holding company).

D. Modification of the Active Test

1. Brief Overview of the Active Conduct Rules in Proposed Regulations 1.1297-5

In general, Proposed Regulations section 1.1297-5 requires, in order for a QIC to be characterized as in the active conduct of its insurance business, either (i) that a QIC's officers and employees carry out substantial managerial and operational activity including specific operational activities, or (ii) that an active conduct percentage test be met.

2. Comment

Proposed Regulations section 1.1297-5 should be modified to provide for a facts and circumstances test that allows a non-US insurance company to determine the scope of its operational activities and to not have such activities mandated in detail.

In addition, the factual requirements test of Proposed Regulations section 1.1297-5 should be modified to allow for flexibility and a facts and circumstances analysis when an insurance company appropriately outsources certain function to persons not meeting the definition of a modified qualified affiliate. In this regard, provided that the outsourcing requirements set forth in Proposed Regulation section 1.1297-5(d)(2) are met, an insurance company should be able to be considered engaged in the active conduct of its business and it should be acceptable for an insurance company to choose how it wants to conduct that business, whether through outsourcing or not. Because a major concern in the original Insurance Exception legislative history (as discussed in prior comments) as well as in the TCJA (defined below) was overcapitalization and excess investment risk/earnings, the allowance of such flexibility could be connected to conservative investing so that it is clear that the insurance company's focus is insurance risk.

The active conduct percentage in Proposed Regulations section 1.1297-5(d) should be modified so that insurance brokerage (e.g., MGA) fees are excluded, similarly to reinsurance brokerage fees, from the definition of total costs as defined in Proposed Regulations section 1.1297-5(f)(8). This should be the case especially in any situation where the entity receiving the fees is affiliated. For this purpose a broader view of affiliated, such as the section 954 related party concept, should be adopted rather than the more stringent modified qualified affiliate rules of Proposed Regulations section 1.1297-5(e)(1).

In any event, the definition of modified qualified affiliate in Proposed Regulations section 1.1297-5(e)(1) should be modified for all purposes. A modified qualified affiliate should be defined by replacing "at least 80 percent" in section 1504(a)(2)(A) with "at least 50 percent," instead of "more than 50 percent," and should include section 1563 brother sister groups in the definition. In addition it is unclear why for purposes of the Insurance Exception active conduct requirement it is necessary to require that both a voting power and a value test be met in order to be considered related.

Finally, the Proposed Regulations should be modified to provide for flexibility in the event that a QIC is prohibited from having employees by external rules and regulations. For example, Proposed Regulations section 1.1297-5(b)(2)(i) should be modified to allow for an exception to the exception that nominal or no employees create a per-se PFIC. At the very least, there should be a grandfather rule for any non-US insurance companies in this situation prior to the date final regulations are promulgated.

E. Clarification of Alternative Facts and Circumstances Test — Election Process

1. Brief Overview of Deemed Election Requirement

As noted above, the alternate facts and circumstances test allows a corporation that does not meet the 25% test to otherwise qualify as a QIC if: (i) the corporation is predominantly engaged in an insurance business; (ii) at least 10% of its total assets comprise "applicable insurance liabilities;" and (iii) the reason for the failure to meet the 25% test is solely due to run-off or ratings-related circumstances. In order to utilize the exception, an election must be made by the US person who would be subject to the PFIC consequences and who owns stock in the insurance company.

Final Regulations section 1.1297-4(d)(5)(iv) provides for a deemed election for certain publicly traded company shareholders with respect to the election that must be made to utilize the alternative facts and circumstances QIC test. US shareholders owning stock valued at $25,000 or less of a publicly traded non-US insurance company group, that otherwise meets the requirements for using the alternative QIC test, benefit from this deemed election.

2. Comment

Clarification is requested with respect to how the $25,000 maximum shareholding requirement applies. For example, the $25,000 maximum shareholding requirement should be applied on a beneficial owner basis and not at the brokerage firm or mutual fund level. Also, guidance is requested with respect to how the requirement and election should be treated under circumstances where a shareholder's share value fluctuates. Many shareholders may not have timely detail about fluctuations in value and monitoring is potentially burdensome depending on the factual ownership situation. Some of these concerns could be alleviated by increasing the maximum value threshold to a more meaningful amount.¹⁴

F. QIC Alternative Facts and Circumstances Test in the Context of Rating Related Circumstances and Collateralized Reinsurers

1. Brief Overview of Final Regulations section 1.1297-4(d)(4)

As noted in the prior section, the alternate facts and circumstances test allows a corporation that does not meet the 25% test to otherwise qualify as a QIC if: (i) the corporation is predominantly engaged in an insurance business; (ii) at least 10% of its total assets comprise "applicable insurance liabilities;" and (iii) the reason for the failure to meet the 25% test is solely due to run-off or ratings-related circumstances. The Final Regulations provide that a QIC testing entity must be a mortgage insurer, a financial guaranty company or a "catastrophe company" in order to avail itself of the alternative facts and circumstances test in the rating related circumstances context (the "Alternative QIC Test").

1. Comment

The preamble to the Final Regulations indicates that the Final Regulations do not provide a coordination rule with respect to rating related circumstances and collateralized reinsurers that are "catastrophe companies," because such collateralized reinsurers do not have credit ratings from a company that provides such ratings. The Proposed Regulations are silent with respect to this topic. As the final Regulations have narrowed the availability of the statutory Alternative QIC Test (section 1297(f)(2)) to only certain insurance companies (as noted above), it may be prudent to facilitate the use of the Alternative QIC Test by collateralized reinsurers that are "catastrophe companies." Such companies provide important reinsurance support for US insurance companies with catastrophe risk, such as Florida companies that write homeowner's coverage. The coverage they provide to the US market is important, in part, because it is fully collateralized, and, thus, minimizes credit risk for the US carriers. As previously noted the market requires full collateralization because of the need for such an alternative form of credit rating. Full collateralization is akin to a rating by a company (i.e., a rating agency). In addition, unlike traditional rated companies, the investments of collateralized reinsurers are typically very conservative and designed primarily for capital preservation. As a result, there should not be a concern that such collateralized reinsurers are overcapitalized and structured to generate excess investment earnings. Such collateralized catastrophe companies with limited investment earnings should not be excluded from having rating related circumstances merely because it is the marketplace that gives them their rating instead of one of the rating companies.

G. Clarification of the Exclusion of Certain Life Insurance/Annuity Reserves from (AIL)

1. Overview of Exclusion

Final Regulations section 1.1297-4(f)(2)(ii) provides for an exclusion to the definition of AIL for:

the amount of any reserve for a life insurance or annuity contract the payments of which do not depend on the life or life expectancy of one or more individuals.

2. Comment

It is not clear what is intended to be excluded and guidance is requested.

H. Clarification with respect to the Interaction of Final Regulations Section 1.1297-6(d) and Final Regulations Section 1.1297-2(b)(2)

1. Brief Overview of Final Regulations Section 1.1297-6(d) and 1.1297-2(b)(2)

Final Regulations section 1.1297-2(b)(2) provides that the income and assets of 25% or more owned (by value) direct/indirect subsidiaries and partnerships are proportionately deemed earned/held by the tested corporation, and are passive for purposes of testing PFIC status if they are passive in the hands of the look through entity. The regulation states:

[E]xceptions to passive income in section 1297(b)(2) and the relevant exceptions *** in section 954(c) that are based on whether income is derived in the active conduct of a business or whether a corporation is engaged in the active conduct of a business apply to such income only if the exception would have applied *** in the hands of the subsidiary, determined by taking into account only the activities of the ***.

The section 954(c) active insurance business exception does not apply. As a result, under Final Regulations section 1.1297-2(b)(2) all lower tier entity income and assets in the context of an insurance group would generally be treated as passive for purposes of the section 1297(c) look through rule, if they were so treated in the lower tier entity's hands.

Section 1.1297-6(d), however, provides that for purposes of the active insurance exception the income and assets of 25% or more owned (by value) direct/indirect subsidiaries and partnerships are proportionately deemed earned/held by the tested corporation and are non-passive to the extent of their net equity value (assuming the basis asset valuation method is not used).

2. Comment

Clarification is requested to confirm that the special section 1297(c) look through rule for active QICs in Final Regulations section 1.1297-6(d) overrides the general look through rule in Final Regulations section 1.1297-2(b)(2), to the extent the income and assets of the look through entity would not be non-passive under the special rule, when section 1297(c) is applied to deem the income and assets of such lower tier entity as held by the ultimate tested corporation parent.

In addition, guidance is needed with respect to (i) how to calculate the amount of such a look-through entity's passive income and assets when the entity's net equity value is treated as non-passive under Final Regulations section 1.1297-6(d), and (ii) how to calculate the passive income of look-through entities that are lower tier to the entity whose net equity value is considered non-passive.

III. Contact Information

We would be pleased to answer any questions about these comments. Please contact Saren Goldner (212-389-5063; sarengoldner@eversheds-sutherland.us).

Very truly yours,

Association of Bermuda Insurers and Reinsurers
Hamilton, Bermuda