On 10 July 2019 the US Department of Treasury, Internal Revenue Service, proposed regulations under the Internal Revenue Code on the determination of ownership in a passive foreign investment company (PFIC) for purposes of Code Section 1297(a).
They also address the treatment of certain income received or accrued by a foreign corporation and assets held by a foreign corporation. The proposed regulations furnish guidance on when a foreign corporation is a qualifying insurance corporation (QIC) under Section 1297(f) of the Code and on income and assets that a QIC excludes from passive income and assets pursuant to Code Section 1297(b)(2)(B).
This is referred to as the “PFIC insurance exception”.
The proposed regulations also address the application and scope of certain rules that determine whether a United States person that directly or indirectly holds stock in a PFIC is treated as a shareholder of the PFIC, and whether a foreign corporation is a PFIC.
They affect US persons with direct or indirect ownership interests in certain foreign corporations. The proposed regulations withdraw regulations proposed in 2015 with respect to the PFIC insurance exception.
The proposed regulations were published in the Federal Register on July 11, 2019. Written or electronic comments and requests for a public hearing must be received by the Internal Revenue Service by 9 September 2019.
Background
Before amendment by the Tax Cuts and Jobs Act of 2017, Section 1297(b)(2)(B) of the Code provided that passive income generally did not include investment income derived in the active conduct of an insurance business by a corporation that is predominantly engaged in an insurance business and that would be subject to tax under Subchapter L (insurance companies) of the Code if it were a domestic corporation.
This is commonly referred to as the PFIC insurance exception. However, Congress had concerns about a lack of clarity in the PFIC insurance exception generally and particularly about how much insurance or reinsurance business a company must do to qualify under the exception.
In response, the act modified the PFIC insurance exception to provide that passive income does not include investment income derived in the active conduct of an insurance business by a QIC.
As modified by the act, the PFIC insurance exception provides that a foreign corporation’s income attributable to an insurance business will not be passive income if three requirements are met: (1) the foreign corporation must be a QIC as defined in section 1297(f), (2) the foreign corporation must be engaged in an “insurance business,” and (3) the income must be derived from the “active conduct” of that insurance business.
These standards apply to taxable years beginning after 31 December 2017.
Proposed Regulations
The proposed regulations address the requirements that a foreign corporation must satisfy to qualify for the PFIC insurance exception.
Foreign corporation’s status as a QIC: The proposed regulations address the requirements that a foreign corporation must satisfy to qualify as a QIC. The ‘insurance company’ requirement provides that a foreign corporation would be subject to tax under subchapter L, if it were a domestic corporation, if it is an insurance company as defined in Code Section 816(a).
This Code section generally requires more than 50 percent of the corporation’s business during the taxable year to be the issuing of insurance or annuity contracts, or the reinsuring of risks underwritten by insurance companies.
In addition, a foreign corporation must satisfy the ‘25 percent test’. This generally requires that a foreign corporation’s ‘applicable insurance liabilities must exceed 25 percent of its ‘total assets’. This determination is made on the basis of the foreign corporation’s liabilities and assets as reported on the corporation’s applicable financial statement for the last year ending with or within the taxable year.
If, however, a foreign corporation fails the 25 percent test, the Code permits a US person to elect to treat stock in the corporation as stock of a QIC under certain circumstances. To make the election, the foreign corporation must be predominantly engaged in an insurance business, and its applicable insurance liabilities must constitute 10 percent or more of its total assets. A US person may only make this election if the foreign corporation fails the 25 percent test solely due to runoff-related or rating-related circumstances involving its insurance business.
When applying the 25 percent test to a foreign corporation, the Code provides that the amount of the foreign corporation’s applicable insurance liabilities cannot exceed the lesser of (i) the amount that the foreign corporation reported to its ‘applicable insurance regulatory body,’ (ii) the amount required by applicable law or regulation, or (iii) the amount determined under regulations prescribed by the Treasury Department and the IRS.
The proposed regulations provide additional guidance regarding the limitation on the amount of applicable insurance liabilities for purposes of the 25 percent test and the 10 percent test.
Engaged in an insurance business: For purposes of the PFIC insurance exception, the proposed regulations define an insurance business as the business of issuing insurance and annuity contracts or reinsuring risks underwritten by other insurance companies, or both. Under the proposed regulations, an insurance business also includes the investment activities and administrative services required to support, or that are substantially related to, those insurance, annuity, or reinsurance contracts issued or entered into by the QIC. The proposed regulations provide that investment activities are any activities that generate income from assets that a QIC holds to meet its obligations under insurance and annuity contracts issued or reinsured by the QIC.
Active conduct of insurance business: The proposed regulations provide that ‘active conduct’ is based on all facts and circumstances. Generally, a QIC actively conducts an insurance business only if the QIC’s officers and employees carry out substantial managerial and operational activities. The proposed regulations provide that a QIC’s officers and employees are considered to include the officers and employees of another corporation if the QIC satisfies a control test.
Generally, to satisfy the control test, (i) the QIC must either own, directly or indirectly, more than 50 percent of the vote and value (for a corporation) or capital and profits interest (for a partnership) of the entity whose officers or employees are performing services for the QIC, or (ii) a common parent must own, directly or indirectly, more than 80 percent of the vote and value or capital and profits interest of both the QIC and the entity performing services for the QIC.
In addition, the control test requires that the QIC must exercise regular oversight and supervision over the services performed by the other entity’s officers and employees for the QIC. The QIC must also either (i) pay directly all the compensation of the other entity’s officers and employees attributable to services performed for the QIC for the production or acquisition of premiums and investment income on assets held to meet obligations under insurance, annuity, or reinsurance contracts issued or entered into by the QIC; (ii) reimburse the other entity for the portion of its expenses, including compensation and related expenses and add a profit markup, as appropriate, for these services performed for the QIC by the other entity’s officers and employees; or (iii) otherwise pay arm’s length compensation in accordance with Section 482 on a fee-related basis to the other entity for the services provided to the QIC.
The proposed regulations acknowledge that, for example, it is common to charge for investment advisory or management services via a fee calculated as a percentage of the underlying assets under management, and a fee calculated on this basis may be arm’s length under the principles of Code Section 482.
The proposed regulations provide that a QIC determines the annual amount of its income that is derived in the active conduct of an insurance business and excluded from passive income. To make this determination, the QIC must determine its active conduct percentage.
If the QIC’s active conduct percentage is greater than or equal to 50 percent, all of the QIC’s passive income is excluded from passive income pursuant to the exception for the active conduct of an insurance business.
If the QIC’s active conduct percentage is less than 50 percent, none of its income is excluded from passive income pursuant to the exception for the active conduct of an insurance business.
