The last 15 years have seen the advent of a new reinsurance platform, where hedge funds have sponsored non-U.S. reinsurers, who in turn invest their capital in the sponsoring hedge funds. While there are business rationales for this platform, and it does provide an additional source of capital for the reinsurance market, it can also have the effect of sheltering hedge fund investment income from U.S. taxation. This tax break has caught the attention of the U.S. Treasury Department and legislators, who last year proposed to shut it down. Their broad proposals could also ensnare many non-hedge-fund reinsurers as well, and have met substantial resistance from the insurance industry.

As a result, non-U.S. reinsurers with U.S. shareholders need to pay attention to this area. This briefing explains the hedge fund reinsurance concept, the tax break in question, and the proposals to crack down on it, and then looks ahead to how reinsurers should prepare for any crackdown.

The Hedge-Fund Reinsurance Platform

Reinsurers hold and invest substantial amounts of capital to back their potential loss payouts. A hedge fund may sponsor a reinsurer with the expectation that the reinsurer will invest with the hedge fund, providing the hedge fund with a stable investor. Much of the capital invested in the reinsurer may come from the hedge fund’s own U.S. owners and executives.

The U.S. tax break lies in U.S. investors’ indirectly investing in the hedge fund through the reinsurer. If they were to invest directly in the hedge fund, they would be subject to U.S. tax on their hedge fund profits as those profits are realized, at potentially high ordinary and short-term capital gains rates. But by investing instead in the stock of the reinsurer, they are only taxed if and when they receive dividends or sell their stock, with stock gains being taxed at lower long-term capital gains rates. Meanwhile, the reinsurer, being organized in a foreign, low-tax jurisdiction, such as Bermuda, is not taxed on its investment income derived through the hedge fund. All in all, not a bad tax result, if it works.

Of course, by investing in the reinsurer, investors are subject to the underwriting risks of the reinsurer’s reinsurance business, as well as the usual investment risks from the reinsurer investing in the hedge fund. But those underwriting risks can be managed and minimized, and could even provide an additional source of gains.

The tax break for U.S. investors hinges on, among other things, the reinsurer not being a “passive foreign investment company” (PFIC) under U.S. tax laws. If it were, its U.S. shareholders would be subject to very undesirable U.S. tax treatment. A PFIC is generally a foreign corporation with substantial “passive income,” such as interest and dividends. However, under the key exception at issue here, passive income does not include 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 [taxable as an insurance company] if it were a domestic corporation.” See I.R.C. §1297(b)(2)(B).

This standard is actually quite vague and has not been authoritatively interpreted. Some regulators and elected officials have expressed a view that some reinsurers have claimed exemption under it, even though they are essentially investment companies investing in hedge funds, with their reinsurance operations not being substantial enough to merit exemption from the PFIC rule.

Proposals to Clarify PFIC Exemption

Addressing the concern noted above, in April of last year, the U.S. Treasury, at Sen. Ron Wyden’s urging, proposed regulation §1.1297-4 to better define the scope of the active-conduct-of-an-insurance-business exemption from the PFIC rules.

Prop. Reg. §1.1297-4 would define “active conduct” by reference to Treas. Reg. §1.367(a)-2T(b)(3). Treas. Reg. §1.367(a)-2T(b)(3) provides that the determination of whether a company actively conducts a trade or business is based on all the facts and circumstances, and generally requires the company’s officers and employees to carry out substantial managerial and operational activities. For this purpose, Treas. Reg. §1.367(a)-2T(b)(3) disregards the activities of independent contractors, but treats the company’s officers and employees as including officers and employees of related entities who are made available to and supervised on a day-to-day basis by, and whose salaries are paid or reimbursed by, the company (the Shared Employee Attribution). However, Prop. Reg. §1.1297-4 would deny this Shared Employee Attribution for purposes of the PFIC exemption, requiring a foreign insurer to conduct business through its own officers and employees to satisfy the active conduct requirement.

Prop. Reg. §1.1297-4 would also treat investment activities as part of an active insurance business to the extent income from the activities is earned from assets held by the foreign insurance company to meet obligations under its insurance contracts. However, no method to determine the portion of assets held to meet obligations under insurance contracts is stated, and Treasury requested comments on appropriate methodologies for doing so.

Prop. Reg. §1.1297-4 has met substantial resistance from the insurance industry. A key objection is the denial of Shared Employee Attribution, as such arrangements are common in the industry and consistent with a foreign insurer’s taking on substantial insurance risks, a truer gauge of its business.

Shortly after Prop. Reg. §1.1297-4 was proposed, Sen. Wyden introduced a bill, the Offshore Reinsurance Tax Fairness Act, to establish “a bright-line test for determining whether a company is truly an insurance company for purposes of the exception to the PFIC rules.” Under the test, companies whose insurance liabilities exceed 25 percent of their assets would qualify for the exception, while companies whose insurance liabilities are less than 10 percent of assets could not. A company whose insurance liabilities are between 10 percent and 25 percent of its assets could qualify as an insurance business by showing “applicable facts and circumstances” establishing that (i) it is predominantly engaged in an insurance business, and (ii) the failure to meet the 25 percent test is due to “temporary circumstances involving such insurance business.”

Insurance industry concerns with Sen. Wyden’s proposal are principally that his definition of insurance liabilities is too narrow, that the 25 percent liabilities-to-asset test is too high and should be reduced to 15 percent; also the ability to qualify on a facts and circumstances basis should be available to companies below 10 percent and not be limited to temporary relief. One concern is that some insurers may require additional surplus due to potential severity of claims or to cover catastrophic claims that might occur in the future and are not reserved for presently.

Looking Ahead

Neither Prop. Reg. §1.1297-4 nor Sen. Wyden’s proposal have been adopted or enacted, and it is difficult to say exactly how the PFIC exemption for active insurance businesses will be clarified, if at all. Any action could depend on the outcome of the next election.

However, there is a substantial likelihood that some action will be taken, and foreign insurers with U.S. shareholders should be prepared. Foreign reinsurers that would qualify under both Prop. Reg. §1.1297-4 and Sen. Wyden’s proposal, in their current forms, are seemingly well positioned as they currently stand. Foreign insurers that would not qualify under the proposals in their current form may, nonetheless, believe that any final rule will be crafted in such a way that they will qualify for PFIC exemption, although they may also want to think about structuring their operations to be as well positioned as possible. In any case, foreign insurers should monitor developments in this area and be prepared to act quickly, if need be.