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model did not depend simply on its investment returns but on the ability of its underwriters to price the residual risks borne by its insureds adequately. In so ruling, the Tax Court also relied on a consensus of insurance regulators, insurance auditors and the insurance marketplace that the contract was insurance. The Tax Court rejected as having no basis in law IRS arguments that insurance risk could only involve “pure” risk (that is, a situation where the only possible outcome was loss or no loss) and the residual value contracts were analogous to put options that only involved investment risk.
C. 2015 Inversion Developments
As discussed in the 2014 Year in Review, the Treasury Department and the IRS issued Notice 2014-52 (the “2014 Notice”) as a result of congressional inactivity on inversions in an effort to rein in inversion transactions by expanding the universe of cross-border transactions that would be subject to the anti-inversion rules. For example, the 2014 Notice attempted to expand the cases where the acquisition of a domestic target (“DT”) by a foreign acquirer (“FA”) would result in the application of the anti-inversion rules by introducing the “cash box” rule, which applies in cases where more than 50% of the assets of the FA group are passive assets. In any such case, the “cash box” rule would exclude shares of FA from the denominator of the inversion ownership fraction to the extent attributable to the FA group’s existing passive assets, which would result in a corresponding increase in (1) the ownership of the combined entity by the former shareholders of DT and (2) the likelihood that the anti-inversion rules would apply. The 2014 Notice, acknowledging that banks and insurers had large passive asset portfolios, carved out exceptions to the definition of passive assets for banks and insurers— however, while the exceptions for foreign banks referenced the passive foreign investment company (“PFIC”) and controlled foreign corporation (“CFC”) rules, the carve- out for non-U.S. insurers was limited to the CFC rules that effectively require an FA insurer to write 50% home country risks and also treat all of the assets held by U.S. affiliates of FA as passive. This seemingly inexplicable disparate treatment of non-U.S. banks and non-U.S. insurers was brought to the attention of Treasury and the IRS and was addressed in Notice 2015-79 (the “2015 Notice”).
The 2015 Notice acknowledges that the 2014 Notice could lead to inappropriate results and extended the exclusion from passive assets of an FA insurer to (1) assets that would not be considered passive for purposes of the PFIC rules and (2) assets of any U.S. affiliate that is subject to tax as an insurance company, provided the assets are used to support, or are substantially related to, the active conduct of an insurance company. The 2015 Notice certainly is a step in the right direction—however, the 2015 Notice makes reference to the PFIC Insurance Company Exception rules proposed earlier this year (discussed below), which have been widely criticized and create substantial uncertainty as to whether assets of a non-U.S. insurer would be considered non-passive for purposes of the Insurance Company Exception to the PFIC rules. For example, the proposed PFIC regulations provide that a non-U.S. insurer would be treated as engaged in the active conduct of an insurance business (which is needed to qualify for the Insurance Company Exception) only if its officers and employees carry out substantial managerial and operational activities. As some foreign reinsurers house their underwriting personnel and others in related services companies, it is not clear that these companies would qualify for the PFIC Insurance Company Exception. In addition, the IRS and Treasury are trying to develop a methodology for determining whether assets held by a foreign insurer are held to meet its obligations under insurance and annuity contracts and limiting the PFIC insurance company exception to such assets, and it is unclear what form this methodology will ultimately take. Certain legislative proposals (with the latest, as of the date of this writing, being the proposal by Senator Wyden, which is discussed below) have looked to the ratio of insurance reserves to assets. Although these efforts have been aimed at the hedge fund reinsurers, they do cast a wider net and can be a trap for the unwary. Although the expectation is that new PFIC Insurance Company Exception regulations will be proposed in place of the regulations proposed earlier this year, there can be no assurance that Treasury and the IRS will act in accordance with the expectations of the industry.
Developments and Trends in Insurance Transactions and Regulation 2015 Year in Review
VII.Tax