On July 10, 2019, the IRS and Treasury issued proposed regulations that clarify when a foreign insurance company is a passive foreign investment company (PFIC).

PFICs Generally

A foreign corporation is a PFIC if 75% or more of its gross income consists of interest, dividends, capital gains, or certain other “passive” income, or if 50% or more of its assets produce passive income.  A U.S. taxpayer that holds PFIC stock generally is required to include in income, on a current basis, its proportionate share of the PFIC’s ordinary earnings and net capital gain, whether or not distributed.  By contrast, a U.S. taxpayer that holds stock in a non-PFIC foreign corporation generally is not taxed on the foreign corporation’s earnings until the foreign corporation distributes the earnings or the U.S. taxpayer sells the stock.  Accordingly, U.S. taxpayers typically would prefer a foreign corporation not to be a PFIC.

Insurance Company Hedge Funds

Historically, some foreign investment funds (which otherwise would be PFICs) have claimed an exception from the PFIC rules on the basis that they are engaged in an “active insurance” business.  Although the investment funds are organized as insurance companies under local law, their insurance activities have been small relative to their investment activities, and their portfolios have consisted of hedge funds or investments in which hedge funds typically invest. 

To curb this perceived abuse, the Tax Cuts and Jobs Act of 2017 amended the “active insurance” exception to treat a foreign insurance company as a PFIC unless (1) it is a “qualifying insurance corporation” and (2) its income is derived in the “active conduct of an insurance business.”

Very generally, a foreign insurance company is a qualifying insurance corporation only if (1) its insurance liabilities exceed 25% of the total assets reported on its applicable financial statements or (2) due to runoff- or ratings-related circumstances, it fails to meet the 25% test but meets an alternative test that requires its insurance liabilities to equal or exceed 10% of its total assets.

The tax code does not define “active conduct of an insurance business.”

Proposed Regulations

Under the proposed regulations, whether a company is in the “active conduct of an insurance business” is based on all facts and circumstances.  However, the company’s officers and employees, or the officers or employees of another entity in the company’s “control group,” must carry out substantial managerial and operational activity.  Moreover, the company’s compensation expenses for the managerial and operational activity related to the production or acquisition of premiums and investment income on assets held to meet its insurance obligations generally must be at least 50% of all of its expenses related to the production or acquisition of premiums and investment income on assets held to meet its insurance obligations.

The company’s control group generally includes entities (1) more than 50% of whose vote and value the company directly or indirectly owns or (2) more than 80% of whose vote and value a common parent directly or indirectly owns.  In each case, the company must exercise regular oversight and supervision over the service providers and pay their compensation or reimburse the service-providing entity for the compensation.

The proposed regulations will not become effective until finalized; however, taxpayers may generally choose to rely on them for taxable years beginning after December 31, 2017, so long as the taxpayers apply the rules consistently.