Insurers Win, Non-Bank Lenders Lose in Passive Investment Rules

Dec. 10, 2020, 9:45 AM

Insurance companies will have an easier time avoiding higher taxes aimed at passive investments, while for other industries, it may become more difficult.

The industry, which relies on passive income to support reserves in case of claims from catastrophic events, had been pushing for relief from the 2017 tax overhaul that would prevent insurance companies from being classified as passive foreign investment companies, known as PFICs.

Treasury listened to those concerns in final rules (T.D. 9936, RIN: 1545-BO59) released Dec. 4, helping the industry avoid new compliance costs.

But the rules added new complications for other industries, including non-bank lenders who could now see higher taxes and penalty charges on their passive offshore investments under a separate set of proposed rules (REG-111950-20, RIN: 1545-BP91).

“It is a mixed bag—the Treasury Department and the IRS made some useful additions and clarifications in the final regulations and have kept the door open for further refinements,” said Irina Pisareva, partner at Sullivan & Worcester LLP.

The 2017 tax overhaul narrowed rules that allowed investors to defer U.S. taxation until earnings were distributed or the investment was sold, at which time the gains would be treated as capital gains. The change was intended to close a loophole that allowed taxpayers to use offshore hedge funds and other investment vehicles to shelter money overseas.

The final rules tax the U.S. investors of companies that derive some income from “passive” streams of income, including money collected from property rent, royalties, and dividends.


Treasury eased some of the hurdles the insurance industry faced when qualifying for a PFIC exemption by issuing safe harbors.

“The most significant change in the newly proposed regulations is the determination of whether income is derived in the active conduct of an insurance business,” said Josh Fieldstone, a manager at Deloitte Tax LLP in Chicago.

An earlier proposed version of the rules would have required companies to see if at least 50% of their activities were “active” by calculating their insurance-related expenses they pay to their own employees over their total expenses. If they were deemed active, they wouldn’t be subject to higher taxes under the PFIC rules.

Insurance industry groups, including the American Property Casualty Insurance Association, told Treasury in comment letters that the proposed test doesn’t reflect the active role such investments play in their business models.

“Congress established the insurance exception to the PFIC rules in order to avoid unwarranted and excessive taxation of bona fide insurance companies and we are pleased important clarifications are included in the final and proposed PFIC regulations,” David Pearce, the association’s vice president and director of tax policy, said in a statement.

That test was difficult because it was very common for those insurance companies to hire external brokers and investment managers—expenses that would have pushed the company to PFIC status, said Peter Furci, co-chair of Debevoise & Plimpton LLP’s global tax practice.

The new rules give offshore insurance companies two paths to being active: a modified version of the 50% expense test, or a facts and circumstances test that allows companies to show that their internal employees are providing active and substantial management functions over underwriting and the other core functions of the business, Furci said.

Non-Bank Lenders

Proposed rules could have an outsized effect on non-bank lenders—financing companies that use their own money to lend to customers instead of using deposits.

Companies that offer their own credit, like automakers with vehicle financing units or non-bank mortgage lenders, are engaging in active financing activities, but they are not banks as traditionally defined, said Adam Chesman a senior director for international M&A tax services in RSM US LLP’s Washington office.

To be named a PFIC, a foreign corporation has to earn at least 75% of its income from passive sources, or hold an average of 50% of its assets that produce passive income as defined in tax code Section 954(c), with certain exceptions. One of those exceptions is for banks whose passive assets are necessary to support its core business.

But in the new proposal, the IRS makes it clear that the banking exception only applies to traditional banks—those that take deposits, potentially including a class of non-bank financial institutions that may get the PFIC designation, Chesman said.

“We really only have one rule, and that’s the PFIC active bank exception. And that’s really going to become difficult for these companies that don’t participate in traditional banking activities that aren’t licensed and regulated as banks in the U.S. or in a foreign country that fall within this exception,” Chesman said.

Foreign Banks

While non-bank lenders took a hit under final rules, Treasury listened to concerns from foreign banks and allowed them to choose from three sets of regulations in the proposed rules.

It’s too early to tell what impact, if any, the new proposal will have on banks because they have to analyze their books asset by asset, which will take time. And each bank has to decide for itself which to choose from, Jonathan Gifford, counsel at Cleary Gottlieb Steen & Hamilton LLP said.

If banks apply the new proposed regulations, they have to apply those for all future years until the regulations are finalized, Gifford said.

“Saying you can rely on any of the three sounds helpful, but it’s unclear whether or not that last restriction—that, if you apply the new proposed regulations, you have to stick with them for all future years—in practice is going to turn out to be too restrictive for investors,” he said.

To contact the reporters on this story: David Hood at dhood@bloomberglaw.com; Siri Bulusu in Washington at sbulusu@bloombergtax.com

To contact the editors responsible for this story: Patrick Ambrosio at pambrosio@bloombergtax.com; Meg Shreve at mshreve@bloombergtax.com

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