Locke Lord QuickStudy: Proposed Regulations Issued On Hedge Fund Reinsurance Transactions

Locke Lord LLP
April 29, 2015
The Internal Revenue Service (IRS) recently issued proposed regulations addressing what constitutes the “active conduct of an insurance business” for purposes of the passive foreign investment company (PFIC) rules (the Proposed Regulations).  The regulations were issued in response to the perceived problem of hedge funds using offshore reinsurance companies to defer U.S. taxation of investment income earned on hedge fund investments.  The Proposed Regulations would be effective when finalized.

U.S. shareholders in a PFIC generally are currently taxable on the “passive income” it earns, regardless of whether such income is distributed (unless they opt to pay an interest charge penalty).  Passive income for this purpose, however, does not include income derived from 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 if it were a domestic corporation.  Existing authorities and guidance do not provide a precise definition of an “active conduct of an insurance business.”

Reliance on the “active conduct” exception by hedge funds and other taxpayers has attracted significant legislative attention recently.  In a typical transaction, a hedge fund (or hedge fund investors) capitalizes an offshore reinsurance company.  The reinsurer, in turn, invests the capital and premiums it subsequently receives in the hedge fund.  Investment earnings of the reinsurer attributable to its investment in the hedge fund are treated as earned in the active conduct of the reinsurer’s business and thus exempt from the PFIC rules.  Critics have questioned whether such reinsurers are bona fide insurance companies and whether their hedge fund earnings are excessive relative to the insurance business. The Proposed Regulations seek to address these concerns.

The Proposed Regulations
The Proposed Regulations consist of two definitions: (1) the meaning of an “active conduct” of an insurance business, and (2) the meaning of an “insurance business.” 

Active Conduct: Relying on the regulations under section 367 of the Internal Revenue Code (which contains a similar active business requirement), the Proposed Regulations provide that whether a corporation is actively conducting an insurance business is determined under all of the facts and circumstances.   To be considered active, the officers and employees of the corporation must carry out substantial managerial and operational activities.  Incidental activities of the business may be carried out on behalf of the corporation by independent contractors.  However, for this purpose, officers and employees do not include officers and employees of related entities.

Insurance Business:  The Proposed Regulations define an “insurance business” as the business of issuing insurance or annuity contracts and the reinsuring of risks underwritten by insurance companies, together with those investment activities and administrative services that are required to support or are substantially related to insurance and annuity contracts issued or reinsured by the corporation.  An investment activity is required to support, or substantially related to, insurance or reinsurance contracts to the extent that the income from such activity is earned from assets held to meet obligations under insurance or reinsurance contracts.

The Proposed Regulations provide a definitional framework for applying the “active conduct” exception of the PFIC rules.  One significant development is that the Proposed Regulations require the insurer or reinsurer to have its own officers and employees, and they must carry out substantial managerial and operational activities.  Some reinsurers may need to modify the way they operate to meet this standard.  
The Proposed Regulations also limit the “active conduct” exception to income earned on assets held to meet insurance obligations.  However, the Proposed Regulations provide no guidance on how to determine the extent to which assets are held for this purpose.  Instead, the Proposed Regulations request comments on this issue.

Although the Proposed Regulations will not be effective until the date they are finalized, offshore insurers and reinsurers with U.S. shareholders that rely on the “active conduct” exception should evaluate their business operations to ensure they can comply with the standard set forth in the Proposed Regulations.

The Proposed Regulations were published in the Federal Register on April 24, 2015, and the IRS is accepting comments until July 23, 2015.

For more information on the matters discussed in this Locke Lord QuickStudy, please contact the authors.