On December 4, 2020, the U.S. Internal Revenue Service and Department of the Treasury released final and proposed regulations relating to passive foreign investment companies (PFICs) relevant to foreign insurance companies and their investors, insurance-linked securities (ILS) funds, and other participants in transactions involving foreign insurers.1 The 246-page final regulations retain the basic approach and structure of prior proposed regulations published on July 11, 2019, with certain significant revisions, and the 116-page proposed regulations include further proposed rules and important modifications.
The final and proposed regulations provide guidance on a variety of technical issues under the PFIC rules, most importantly related to the exception from “passive income” for income derived in the active conduct of an insurance business by a qualifying insurance corporation (QIC), as modified by the 2017 Tax Cuts and Jobs Act (the Insurance Exception). In general, a QIC is a foreign corporation that would be subject to tax under subchapter L if it were domestic and the “applicable insurance liabilities” (AIL) of which constitute more than 25% of its total assets (the 25% Test).
Among other revisions, in respect of the Insurance Exception, the regulations:
- Withdraw, revise, and re-propose the controversial “active conduct percentage test” of the prior proposed regulations and introduce a new, alternative “factual requirements test.”
- Satisfaction of either test is sufficient to meet the active conduct requirement. The re-proposed 50% “active conduct percentage test,” which still compares internal costs to total costs, now excludes costs attributable to investment activities.
- However, securitization vehicles (e.g., cat bond issuers, sidecars, collateralized reinsurance vehicles) and ILS funds that invest in securitization vehicles generally are deemed not to be engaged in the active conduct of an insurance business.
- In addition, QICs that have no employees (or a nominal number of employees) and rely on independent contractors to perform core functions generally are deemed not to be engaged in the active conduct of an insurance business.
- Clarify that the “runoff-related circumstances” exception to the 25% Test is meant to apply to a company that is exiting the insurance business.
- Provide that the “rating-related circumstances” exception to the 25% Test applies only if (i) the foreign corporation exclusively provides mortgage insurance; (ii) more than half of the foreign corporation’s net written premiums for the annual reporting period (or a 3-year average) are from insurance coverage against the risk of loss from a catastrophic loss event; or (iii) the foreign corporation is a financial guaranty insurance company.
- Provide further details regarding which balance-sheet liabilities are included in the calculation of AIL, particularly in the case of balance sheets prepared in accordance with GAAP or IFRS.
The regulations generally apply (or are proposed to apply) only prospectively. However, taxpayers may choose to apply various provisions to certain prior years, subject to consistency requirements.
Sidley expects to publish a supplemental analysis once we have completed a more in-depth review of the new regulations.
1 The final and proposed regulations include rules applicable to all industries; this Sidley Update focuses on certain aspects most relevant to the insurance industry.
