United States: U.S. PFIC Taxation Exemption To Be Narrowed?

The last 15 years have seen the advent of a new reinsurance platform, where hedge funds have sponsored non-U.S. reinsurers, who in turn invest their capital in the sponsoring hedge funds. While there are business rationales for this platform, and it does provide an additional source of capital for the reinsurance market, it can also have the effect of sheltering hedge fund investment income from U.S. taxation.

This tax break has caught the attention of the U.S. Treasury Department and legislators, who last year proposed narrowing a key tax exemption underpinning the hedge fund reinsurance platform. Their broad proposals could also ensnare many non-hedge-fund reinsurers as well, and have met substantial resistance from the insurance industry. Recently, presidential candidate Hillary Clinton joined the conversation, promising to immediately close this "Bermuda reinsurance loophole," if elected.

As a result, non-U.S. reinsurers with U.S. shareholders need to pay attention to this area. This briefing explains the hedge fund reinsurance concept, the tax break in question, and the proposals to clarify and potentially narrow its scope, and then looks ahead to how reinsurers should prepare for any new rules.

The Hedge-Fund Reinsurance Platform

Reinsurers hold and invest substantial amounts of capital to back their potential loss payouts. A hedge fund may sponsor a reinsurer with the expectation that the reinsurer will invest with the hedge fund, providing the hedge fund with a stable investor. Much of the capital invested in the reinsurer may come from the hedge fund's own U.S. owners and executives.

The U.S. tax break lies in U.S. investors indirectly investing in the hedge fund through the reinsurer. If they were to invest directly in the hedge fund, they would be subject to U.S. tax on their hedge fund profits as those profits are realized, at potentially high ordinary and short-term capital gains rates. But by investing instead in the stock of the reinsurer, they are only taxed if and when they receive dividends or sell their stock, with stock gains being taxed at lower long-term capital gains rates. Meanwhile, the reinsurer, being organized in a foreign, low-tax jurisdiction, such as Bermuda, is not taxed on its investment income derived through the hedge fund. All in all, not a bad tax result, if it works.

Of course, by investing in the reinsurer, investors are subject to the underwriting risks of the reinsurer's reinsurance business, as well as the usual investment risks from the reinsurer investing in the hedge fund. But those underwriting risks can be managed and minimized, and could even provide an additional source of gains.

The tax break for U.S. investors hinges on, among other things, the reinsurer not being a "passive foreign investment company" (PFIC) under U.S. tax laws. If it were, its U.S. shareholders would be subject to very undesirable U.S. tax treatment. A PFIC is generally a foreign corporation with substantial "passive income," such as interest and dividends. However, under the key exception at issue here, passive income does not include 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 [taxable as an insurance company] if it were a domestic corporation." See I.R.C. §1297(b)(2)(B).

This standard is actually quite vague and has not been authoritatively interpreted. Observers have expressed concern that some reinsurers have claimed exemption under it, even though they are essentially investment companies investing in hedge funds, with their reinsurance operations not being substantial enough to merit exemption from the PFIC rule.

Proposals to Clarify PFIC Exemption

Addressing the concern noted above, in April of last year, the U.S. Treasury, at Sen. Ron Wyden's urging, proposed regulation §1.1297-4 to define the scope of the active-conduct-of-an-insurance-business exemption from the PFIC rules.

Prop. Reg. §1.1297-4 would define "active conduct" by reference to Treas. Reg. §1.367(a)-2T(b)(3). Treas. Reg. §1.367(a)-2T(b)(3) provides that the determination of whether a company actively conducts a trade or business is based on all the facts and circumstances, and generally requires the company's officers and employees to carry out substantial managerial and operational activities. For this purpose, Treas. Reg. §1.367(a)-2T(b)(3) disregards the activities of independent contractors, but treats the company's officers and employees as including officers and employees of related entities who are made available to and supervised on a day-to-day basis by, and whose salaries are paid or reimbursed by, the company (Shared Employee Attribution). However, Prop. Reg. §1.1297-4 would deny this Shared Employee Attribution for purposes of the PFIC exemption, requiring a foreign insurer to conduct business through its own officers and employees to satisfy the active conduct requirement.

Prop. Reg. §1.1297-4 would also treat investment activities as part of an active insurance business to the extent income from the activities is earned from assets held by the foreign insurance company to meet obligations under its insurance contracts. However, no method to determine the portion of assets held to meet obligations under insurance contracts is stated, and Treasury requested comments on appropriate methodologies for doing so.

Prop. Reg. §1.1297-4 has met substantial resistance from the insurance industry. A key objection is the denial of Shared Employee Attribution, as such arrangements are common in the industry and consistent with a foreign insurer's taking on substantial insurance risks, a truer gauge of its business.

Shortly after Prop. Reg. §1.1297-4 was proposed, Sen. Wyden introduced a bill, the Offshore Reinsurance Tax Fairness Act, to establish "a bright-line test for determining whether a company is truly an insurance company for purposes of the exception to the PFIC rules." Under the test, companies whose insurance liabilities exceed 25 percent of their assets would qualify for the exception, while companies whose insurance liabilities are less than 10 percent of assets could not. A company whose insurance liabilities are between 10 percent and 25 percent of its assets could qualify as an insurance business by showing "applicable facts and circumstances" establishing that (i) it is predominantly engaged in an insurance business, and (ii) the failure to meet the 25 percent test is due to "temporary circumstances involving such insurance business."

Insurance industry concerns with Sen. Wyden's proposal are principally that his definition of insurance liabilities is too narrow, and that the 25 percent liabilities-to-asset test is too high and should be reduced to 15 percent; and also the ability to qualify on a facts and circumstances basis should be available to companies below 10 percent and not be limited to temporary relief. One concern is that some insurers may require additional surplus due to potential severity of claims or to cover catastrophic claims that might occur in the future and are not reserved for presently.

As noted, presidential candidate Clinton has also promised to close the "Bermuda reinsurance loophole" if elected, although it is not clear exactly what she would do.

Looking Ahead

Neither Prop. Reg. §1.1297-4 nor Sen. Wyden's proposal have been adopted or enacted, and it is difficult to say exactly how the PFIC exemption for active insurance businesses will be clarified, if at all. Any action could depend on the outcome of the next election.

However, there is substantial likelihood that some action will be taken, and foreign insurers with U.S. shareholders should be prepared. Foreign reinsurers that would qualify under both Prop. Reg. §1.1297-4 and Sen. Wyden's proposal, in their current forms, are seemingly well positioned as they currently stand. They may also want to monitor any proposals made by presidential candidates as well. Foreign insurers that would not qualify under the proposals in their current form may, nonetheless, believe that any final rule will be crafted in such a way that they will qualify for PFIC exemption. In any case, foreign insurers should consider structuring their operations to be as well positioned as possible, contemplate engagement with rulemakers to help shape appropriate rules, and be prepared to act quickly if need be.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions