Cash-Rich U.S.-Owned Foreign Insurance Companies Targeted in Proposed IRS Regulations

The IRS issued proposed regulations that could limit the ability of hedge funds from operating insurance companies to diminish their tax base.

In Notice 2003-34, the IRS described arrangements in which U.S. taxpayers organize non-U.S. companies to engage in insurance or reinsurance businesses. The insurance companies invest their capital and premiums in high-risk, high-reward investments, whose returns would exceed what would be needed to repay insurance claims. These companies engage in the "active conduct" of insurance businesses (rather than making passive investments), so they are not passive foreign investment companies ("PFIC") subject to adverse tax rules. In effect, these arrangements allow U.S. taxpayers (including various hedge funds) to defer recognition of income by converting their investment returns to capital gains upon a sale of their interest in the insurance companies.

The proposed regulations, as a whole, would limit the situations in which foreign insurers organized under these arrangements would be treated as actively conducting an insurance business and outside the scope of the PFIC rules. The proposed regulations would limit an "insurance business" to issuing insurance or reinsurance, and the related investment activities would be limited to those that are "required to support or are substantially related" to the insurance or reinsurance being offered. Investment activities would meet this standard "to the extent" that the income generated by the investments is earned from assets held by the foreign insurer to satisfy its obligations under its insurance or reinsurance contracts. The IRS did not specify how this determination would be made but requested comments on this point. In addition, the proposed regulations would generally prevent foreign insurers that are managed by the officers and employees of related entities from benefiting from the favorable tax rules applicable to insurance companies.

See: Proposed Regulations (80 FR 22954); Notice 2003-34; Joint Committee on Taxation: "Background and Data with Respect to Hedge Fund Arrangements."See also: FATCA Specialty Page (available to Cabinet subscribers only).