Passive foreign investment company regs affect insurance companies

| 1/7/2021
Passive foreign investment company regs affect insurance companies

On Dec. 4, the IRS released informal drafts of final and proposed regulations for passive foreign investment companies (PFICs), which include rules for offshore insurance entities.

The draft regulations generally would be applicable after publication in the Federal Register. However, the regulations likely will be subject to the new administration’s regulatory freeze and might not be published in the near term.

Regardless, the draft regulations provide insight into the IRS’ current thinking about PFICs. Following is a summary of the draft final and proposed regulations, particularly as they relate to insurance. 

PFIC insurance exception

Under IRC Section1296(a), a foreign corporation is a PFIC if it meets either a passive income test or a passive assets test. Generally, U.S. shareholders of a PFIC are subject to U.S. tax on PFIC distributions and gains realized from disposition of PFIC stock unless an election is made to tax PFIC earnings in the current period. 

A foreign insurance corporation is excepted from the PFIC rules for passive income earned or passive assets held in the conduct of an active insurance business. It is considered engaged in an active insurance business if it meets the following three tests:

  • It is a qualifying insurance corporation (QIC) under IRC Section 1297(f).
  • It is engaged in an insurance business.
  • The foreign corporation’s otherwise passive income is derived from the active conduct of the insurance business under IRC Section 1297(b)(2)(b).

Under IRC Section 1297(f), a foreign corporation is a QIC if it would be subject to tax if it were a domestic corporation and if its applicable insurance liabilities (AIL) constitute more than 25% of its total assets as reported on the corporation’s applicable financial statement. A 10% AIL alternative facts and circumstances test (AFCT) election is available for companies experiencing a runoff or credit agency ratings-related situation.

Draft final regulations: Applicable insurance liabilities

The 2019 proposed regulations provided an initial definition of what liabilities constituted AIL. However, taxpayers requested that the final regulations include a more detailed definition of related insurance liabilities.

The draft final regulations modify and clarify the definition of AIL, including eliminating the term “occurred losses” and clarifying that incurred losses – both reported and unreported – and attendant loss adjustment expenses qualify as AIL. Certain liabilities such as deposit liabilities that are not insurance liabilities are excluded from AIL. The draft final regulations also provide that a foreign entity can use only certain permitted financial statement methods for purposes of determining the appropriate AIL amount for the 25% test.

Similar to the proposed regulations, the draft final regulations clarify that runoff-qualified situations are limited to when an insurance company is exiting the insurance business, as opposed to ordinary insurance business runoff. In a change from the 2019 proposed regulations, the final regulations simplify the reporting for companies in runoff but tighten the scope of insurance companies that qualify for credit agency ratings-related circumstances.

The final regulations follow the proposed regulations in allowing only the U.S. shareholder to make the AFCT election on Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund,” and by requiring the foreign insurance corporation to provide certain eligibility information to the U.S. shareholder.

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2020 proposed regulations: Active conduct of an insurance business test

The 2019 proposed regulations contain an active conduct percentage test to determine whether a foreign corporation meets the active conduct test under IRC Section 1297(b)(2)(b). These rules were significantly changed in the draft 2020 proposed regulations, including adding a new alternative factual requirements test and modifying the active conduct percentage test.

Under the draft proposed regulations, an insurance company that has no or nominal employees and relies on contractors to perform core functions would fail the active conduct test.

Under the new factual requirements test, regular and continuous substantial managerial and operational activities related to core insurance functions must be performed by the corporation’s officers and employees, who would be required to perform all decision-making activities related to the underwriting business.

To satisfy the modified active conduct percentage test, the draft proposed regulations provide that the corporation’s total officer and employee costs related to core insurance functions need to be at least 50% of total costs related to core insurance functions. Investment activity costs do not need to be considered, which is a favorable change from the 2019 proposed regulations. To qualify under the active conduct percentage test, the corporation’s officers and employees are required to provide qualified oversight activity if core functions are performed by third parties.

Favorably, under the draft proposed regulations, officers and employees of related parties may be considered employees and officers of the tested foreign corporation if strict ownership and oversight requirements are met.

Actions to consider

Companies should revisit their AIL calculations and consider any appropriate changes to improve their AIL-to-assets ratio.

Companies in insurance runoff- or ratings-related situations that wish to qualify for the AFCT should carefully analyze the requirements for qualification, notification of U.S. shareholders, and the U.S. shareholder’s Form 8621 reporting.

Although it is unclear when the welcomed new active conduct provisions in the draft proposed regulations will be effective (if at all), companies should consider re-examining their facts and circumstances in light of these draft rules and evaluate what operational changes would be required to enable the company to meet one of the alternative active insurance business tests in the draft regulations.

In addition, because it is uncertain when and whether these rules will be finalized, U.S. shareholders of foreign insurance companies should consult with their tax advisers to evaluate whether filing protective PFIC elections is appropriate.

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