Insurance company exception from “passive income”

Insurance company exception from “passive income”

The Treasury Department and IRS today released for publication in the Federal Register proposed regulations (REG-108214-15) that would prescribe specific requirements for the insurance company exception from the definition of passive income for purposes of the passive foreign investment company (PFIC) rules.

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The proposed regulations would exclude income only to the extent it is derived from the “active conduct of an insurance business” and would define the “active conduct of an insurance business” for purposes of the insurance company exception from passive income in section 1297(b)(2)(B) to:

  • Require that the business activities of a foreign insurance company be conducted by officers and employees of the foreign insurance company
  • Define “insurance business” to include investment activities and administrative services that are “required to support or are substantially related to insurance and annuity contracts issued or reinsured by the foreign corporation”
  • Define these qualifying investment activities as the company’s investment activities “to the extent that income from the activities is earned from assets held by the foreign corporation to meet obligations under the contracts”

The proposed regulations are scheduled to be published in the Federal Register on April 24, 2015, and are proposed to be effective prospectively on the date that final regulations are published.

The preamble to the proposed regulations requests comments on key issues raised by the proposed regulations, including how to best measure whether investment activities are required to support (or are substantially related to) insurance and annuity contracts.

Read text of the proposed regulations [PDF 207 KB]


Section 1297 defines a PFIC as a foreign corporation that satisfies either the income test of section 1297(a)(1) or the asset test of section 1297(a)(2).

A foreign corporation satisfies the PFIC income test if 75% or more of the gross income of the corporation for the tax year is “passive income.” A foreign corporation satisfies the PFIC asset test if the average percentage of the assets held by the corporation during the tax year which produce passive income, or held for the production of passive income, is at least 50%.“

Passive income” for purposes of the PFIC income and assets tests is defined in section 1297(b)(1) as income of a kind that would be foreign personal holding company income as defined in section 954(c).

Section 954(c)(1) defines passive income as including dividends, interest, royalties, rents, and annuities, as well as certain other types of income from property transactions, commodity transactions, foreign currency transactions, income from notional principal contracts, and similar types of income.

Insurance exception

Section 1297(b)(2) provides several exclusions from the term “passive income.”

Section 1297(b)(2)(B) states that the term “passive income” does not include any income 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 of the Code if it were a domestic corporation.

Proposed regulations

The proposed regulations would provide that income (including income from certain investment activities) will qualify for the insurance exception from passive income only to the extent the income is derived in the active conduct of an insurance business. Investment activities, for this purpose, must support or be substantially related to insurance and annuity contracts issued or reinsured by the foreign corporation, which the proposed regulations interpret to mean that the assets must be held by the foreign corporation to meet obligations under the contracts.

An insurance business is defined by the proposed regulations to mean the business of issuing insurance and 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 foreign corporation.

Active conduct of a business is proposed to be defined under Reg. section 1.367(a)-2T(b)(3), except that officers and employees taken into account are not considered to include officers and employees of related entities.

The proposed regulations do not provide a method for determining the portion of assets held to meet obligations under insurance and annuity contracts, and thus request comments on possible methods to be used in making this determination.

The proposed regulations also do not define the meaning of being “predominantly engaged” in an insurance business; however, the preamble to the proposed regulations states that any company taxable under subchapter L as an insurance company is necessarily predominantly engaged in an insurance business for purposes of section 1297(a)(2)(B).

Potential government concerns

The preamble to the proposed regulations refers to situations when a hedge fund establishes a foreign corporation that purports to be a foreign reinsurance company, with the possible objective of deferring and reducing tax that otherwise would be due on such income. The preamble states that such foreign corporations may be PFICs.

Previously, the IRS issued Notice 2003-34, 2003-23 I.R.B. 990, and alerted taxpayers that it had become aware of arrangements used by taxpayers to avoid the application of the PFIC provisions. The arrangements involved an investment in a purported insurance company that was organized offshore and that invested in hedge funds or investments in which hedge funds typically invest.

The IRS posited that such arrangements typically involved a U.S. stakeholder investing (directly or indirectly) in the equity of a foreign corporation that is organized as an insurance company and that complies with the applicable local laws regulating insurance companies. The relevant foreign corporation issued “insurance or annuity contracts” or contracts to “reinsure” risks underwritten by insurance companies. The IRS asserted that some of the contracts did not cover insurance risks, and others significantly limited the risks assumed by the foreign corporation through the use of retrospective rating arrangements, unrealistically low policy limits, finite risk transactions, or other similar devices.

The IRS notice asserted that the foreign corporation's actual insurance activities were relatively small compared to its investment activities. It purportedly invested its capital and the amounts that it receives as consideration for its "insurance" contracts in, among other things, hedge funds or investments in which hedge funds typically invest. As a result, the foreign corporation's portfolio generated investment returns that substantially exceeded the needs of its "insurance" business and these earnings were not distributed currently to the U.S. stakeholder. If the foreign corporation is not a PFIC, the U.S. stakeholder will recognize capital gain rather than ordinary income upon a disposition of its equity interest in the foreign insurance company.

The notice observed that the business of an insurance company necessarily includes substantial investment activities. Both life and nonlife insurance companies routinely invest their capital and the amounts they receive as premiums. The investment earnings are then used to pay claims, support writing more business, or to fund distributions to the company’s owners.

The notice stated that presence of investment earnings does not, in itself, suggest that an entity does not qualify as an insurance company. However, the notice expressed concern that in certain cases it was inappropriate to claim that the insurance company was an insurance company for Federal income tax purposes and the IRS may challenge such tax treatment.

Today, Senator Ron Wyden (D-OR), ranking member for the Senate Finance Committee, issued a statement in recognition of IRS efforts “to help stop offshore reinsurance tax avoidance” with the proposed regulations. Senator Wyden has repeatedly called upon the IRS over the past year to clarify rules that would prevent hedge funds from operating as offshore insurance companies in order to avoid paying taxes

KPMG observation

Today’s proposed regulations pose a number of issues:

  • These proposed regulations cross-reference Reg. section 1.367(a)-2T(b)(3) for the definition of what constitutes the “active conduct” of a trade or business. This regulation requires that business activities be conducted by officers and employees of the foreign corporation, but allows the activities of officers and employees of related entities to be counted in satisfying this test. The proposed regulations expressly provide that the activities of officers and employees of related entities do not count for purposes of the active conduct determination. The activities of independent contractors, such as insurance managers and captive managers, presumably would not count, either.
  • The proposed regulations do not propose rules to address special situations, including but not limited to, start-up companies, companies in runoff, catastrophe reinsurance, and years in which a company obtains unusually high investment returns. Once comments have been received and reviewed, consideration may be given to these and other special circumstances.
  • The proposed regulations suggest, without prescribing, that a determination of the assets that are held to meet obligations under insurance and annuity contracts (and, thus, do not produce passive income) may be made by treating assets as held for this purpose to the extent that the insurance company’s assets do not exceed a specified percentage of the company’s total insurance liabilities (i.e., insurance reserves) for the year. It is interesting to note that the proposed regulations do not suggest a reserves-to-assets test, or a premium-based test.
  • In practice, an insurance company requires assets to be held as capital; these assets would not cause “passive” status for PFIC purposes.
  • Imposition of a reserves-based test likely would lead to disagreements over foreign company reserve amounts.


For more information, contact a tax professional with KPMG’s Washington National tax:

Craig Pichette | +1 (312) 665-5267 |

Sheryl Flum | +1 (202) 533-3394 |

Lori Robbins | +1 (202) 533-3491 |

Jean Baxley | +1 (202) 533-3008 |

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