Readers, we are continuing to follow along with the saga between Senator Ron Wyden (former Chair of the Senate Finance Committee) and IRS Commissioner, John Koskinen, regarding hedge fund sponsored reinsurance companies which I’ve written about before here.
Inside of the promised 90-day deadline, on April 23, 2015, the Department of the Treasury issued proposed regulations that address the so-called “insurance exception” from classification as a passive foreign investment company (“PFIC”). The proposed regulations are intended to curtail certain abuses believed to arise when an asset manager forms an offshore reinsurance company that invests in the asset manager’s own funds. However, the application of the proposed regulations is not limited to hedge fund sponsored reinsurance companies. The proposed regulations have no effect until the date on which final regulations are published.
For the uninitiated, hedge fund managers have increasingly begun establishing offshore reinsurance companies. The reinsurance company then writes reinsurance to unrelated third parties, collects premiums for such reinsurance, and then invests its shareholder equity together with the premiums into the funds managed by the asset manager that established the reinsurance company in the first place. The claimed abuse is that the U.S. asset manager and other US investors will defer U.S. tax on the hedge fund income, as it does not flow through the reinsurer, and convert the character of the income from short-term to long-term capital gain.
Within the boundaries of insurance regulatory oversight, insurance and reinsurance companies have a fair amount of discretion as to how they invest their reserve amounts and at what level they maintain such reserves. Of course, many reinsurance companies rely on an independent rating agency (such as A.M. Best) rating in order to keep their business competitive. Such ratings require a high level of high grade reserves or, as the case may be, an even higher level of low grade reserves (hedge fund assets are typically considered lower grade reserves when compared to government securities and corporate bonds due to their higher volatility).
Typically, when a US person is a shareholder of an offshore company, whether or not the passive income of such company flows up onto the U.S. shareholder’s tax return is determined based on the type of foreign entity. If an offshore company is a controlled foreign company or CFC (primarily US owned offshore company) or a PFIC (any offshore company with largely passive assets), the passive income of the company gets reported annually by its U.S. shareholders regardless of whether such income is distributed.
A large and important exception to PFIC classification is the “insurance exception” which is reserved for offshore companies that are predominantly engaged in the active conduct of an insurance business. Well over a decade ago asset managers realized the tax benefits of offshore reinsurance companies. Concomitantly, the IRS recognized the possibility of abuse related to the insurance exception and published guidance via Notice 2003-34. Part of that guidance was the recognition by the Service that there is little difference between a traditional insurance or reinsurance company and a hedge fund. Thus, Notice 2003-34 did not attempt to make bright line rules but rather left a facts and circumstances test in place with a promise to scrutinize questionable arrangements.
As my previous post indicated, there is no wide divide between an insurance (or reinsurance) company and a hedge fund. Both invest money in assets as a core part of their business. The sole distinguishing factor is that one writes insurance and the other does not. However, if a hedge fund begins to write insurance they become largely indistinguishable. The sole question becomes how much insurance does the hedge fund need to write in order to be treated similarly to the insurance company for tax purposes?
Despite Senator Wyden’s obsession with shutting down hedge fund reinsurance, there is nothing insidious with an offshore reinsurance company investing the bulk of its reserves in a single hedge fund. The problem arises when any insurance company, regardless of type or jurisdiction, has reserves in excess of its reasonably anticipated needs considering its insurance liabilities. However, the strength of an insurance company as measured by regulators, rating agencies, customers and counterparties is based on the size and stability of its reserves. If an insurance company is going to invest its reserves in more volatile, assets then the company’s stakeholders will require ever larger amounts of such reserves. Hence, a reinsurance company with reserves totally invested in a single hedge fund manager may appear to have relatively high levels of reserves when compared to another reinsurance company that invests the bulk of its reserves in sovereign debt and high-grade corporate debt.
Pursuant to the U.S. tax code, a foreign corporation is a PFIC only if either 75 percent or more of its gross income for the tax year is passive income or, on average, 50 percent or more of its assets for the tax year produce passive income or are held for the production of passive income. For this purposes, Section 1297(b)(2)(B) of the code provides that, except as provided in regulations, the term “passive income” does not include any income that is derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business and which would be subject to tax under subchapter L (relating to the taxation of U.S. insurance companies) as an insurance company if the non-U.S. corporation were a U.S. corporation (the before mentioned “insurance exception”). Prior to the new proposed regulations, there was no guidance as to the proper interpretation of the insurance exception. The proposed regulations shed some light on a few of the definitional terms within the insurance exception but the key issue of the appropriate size of reserves is left unanswered and comments are requested. The guidance provided by the new proposed regulations is as follows:
• The Proposed Regulations refer to Temporary Treasury Regulation Section 1.367(a)-2T(b)(3), for the definition of “active conduct” of an insurance business. The Section 367 regulations maintain that a corporation actively conducts a trade or business only if the officers and employees of the corporation carry out substantial managerial and operational activities. A corporation may be engaged in the active conduct of a trade or business even though incidental activities of the trade or business are carried out on behalf of the corporation by independent contractors. The new proposed regulations defining the PFIC insurance exception make an important (and in the author’s view, misguided) alteration to the cross-referenced Section 367 regulations by disregarding officers and employees of related entities. The drafters of the regulations were obviously targeting certain hedge fund reinsurance companies that were identified in an earlier Joint Committee on Taxation report as companies having no employees of their own. Rather, the companies utilized officers and employees of a related entity. Should these proposed regulations become final in their current form it would create an inconvenience for certain hedge fund reinsurance companies but will also create a major issue for mainstream insurance and reinsurance companies. Many mainstream entities operate as subsidiaries or cell companies of a larger insurance company and they utilize employees and officers of the related entity. Moreover, most offshore captive insurance companies have no employees of their own. I suspect many comment letters are forthcoming from the mainstream insurance companies and industry groups.
For many hedge fund reinsurance companies, this change in the law would not be meaningful since they already have a full staff of officers and employees focused on their insurance business. For others, compliance would require migrating employees of affiliated entities to be direct employees of the hedge fund reinsurance entity. And note, the cross-referenced Section 367 regulations would continue to permit the outsourcing of asset management to a single hedge fund. Albeit, the activities of the independent hedge fund and its employees would be excluded in determining if the reinsurance company’s officers and employees are actively conducting an insurance business.
• “Insurance business” is defined by the proposed regulations to mean the business activities of issuing insurance and annuity contracts and reinsuring of risks underwritten by insurance companies, together with investment activities and administrative services that are required to support or are substantially related to the insurance contracts issued or reinsured by the non-U.S. insurance company. Again, this new guidance is not an impediment for hedge fund reinsurance companies provided they have their own officers and employees dedicated to the insurance function.
• “Investment activities” are any activities that produce income of a kind that would be “subpart F income” within the meaning of Section 954(c) (i.e., interest, dividends, capital gains from bonds and stocks, etc).
• Investment activities will “support” or be “substantially related” to the insurance business only to the extent that income from such investment activities is earned from investment assets held by the non-U.S. corporation to meet its obligations under the insurance or reinsurance contracts. This definitional component is likely too restrictive for mainstream reinsurance companies in that it may ignore some of their tangential asset activities that have become normal in recent years. Nevertheless, the guidance should not interfere with hedge fund reinsurance companies from qualifying for the PFIC insurance exception.
Closely related to this definition is the subject of what investment assets are needed to support the writen insurance and reinsurance obligations (i.e., adequate reserves) and which assets are not (i.e., excess reserves). This is the primary issue and Treasury has provided no guidance. Rather, Treasury has chosen to ask for comments on the subject.
• The term “predominantly engaged” is defined by reference to Section 831(c) (i.e., the definition of an insurance company) because the insurance exception requires that the non-U.S. corporation would be subject to Subchapter L if it were a U.S. corporation. Accordingly, in order to be “predominantly engaged” in an insurance business within the meaning of the insurance exception, more than half of a non-U.S. corporation’s business during a tax year must consist of the issuance of insurance or annuity contracts or the reinsuring of risk underwritten by insurance companies.
The primary takeaway from the proposed regulations is that hedge fund reinsurance is still viable and is likely to remain so. There is nothing in the proposed regulations that point to a desire to disallow the PFIC insurance exception where the reinsurance company invests substantially all of its assets in a single hedge fund.
The second observation is that the proposed regulations apply to all non-U.S. insurance and reinsurance companies, not just hedge fund reinsurance. Multiple provisions of the proposed regulations will be troubling to the mainstream insurance industry, most notably the “active conduct” which ignores employees of affiliated entities.
The primary issue of excess reserves is yet to come. Comments will likely pour in from mainstream insurance / reinsurance companies, industry groups, trade organizations and the like. We can expect many of those comments to argue for high reserve levels. Many comments will point to regulatory and constituent concerns such as A.M. Best ratings, Solvency II Directive, insurance regulators and others.
Senator Wyden has forced this guidance into existence to close what he calls a “loophole” but, in reality, it will likely increase the occurrence of hedge fund reinsurance firms. It does not look like the ultimate guidance will target or restrict the existence of hedge fund reinsurance and the added guidance will now add tax comfort for those firms that experienced trepidation over the tax uncertainty. Ironically, Senator Wyden may end up pushing hedge fund reinsurance into the mainstream.
The proposed regulations have no effect until final regulations are published. We will continue to follow this issue. If you have any questions regarding this or any other tax issues, please contact your normal WithumSmith+Brown partner.