U.S. IRS proposes hedge fund reinsurer tax regs, requests comments

The U.S. Treasury Internal Revenue Service has now published a draft rule (link to the draft at the bottom) on the perceived tax issue associated with hedge fund reinsurance strategies, but is asking for comments and feedback to help it ensure it accurately identifies those taking advantage of any loophole.

The IRS has been encouraged to clamp down on the perceived hedge fund reinsurance tax loophole, which some see as a way for hedge funds to avoid tax on income by using offshore reinsurance operations and for their investors to avoid U.S. tax laws too.

The IRS said it would come out with guidance within 90 days back in February and true to its word, and ahead of its schedule, the IRS published a draft of a ruling that seeks to address “passive income” issues in offshore reinsurance vehicles operated by onshore hedge fund managers.

Essentially any ruling will seek to identify those hedge fund reinsurers which are not putting capital to work in underwriting risks, or that are simply providing themselves and investors with a way to access hedge fund investment strategies while avoiding taxation on earnings.

The IRS’ draft explains:

The Department of Treasury (Treasury) and the IRS are aware of situations in which a hedge fund establishes a purported foreign reinsurance company in order to defer and reduce the tax that otherwise would be due with respect to investment income. Such foreign corporations may be Passive Foreign Investment Companies (PFICs).

It is how the IRS and Treasury identify what is a passive income and who is a true reinsurance company that has always been the issue. It’s vital that the final rules use a robust methodology to identify any offending hedge funds or reinsurers, and with reinsurance strategies often so unique to the company creating a one-size-fits-all set of rules has always been feared by not just hedge fund sponsored reinsurers.

The concern has been that the IRS would seek to address this using some ratio of capital put to work in underwriting, versus capital invested in assets. However the ratio between those two uses of capital can depend on many factors, including how new a company is (it takes time to build the relationships to put capital to work), what business it underwrites (the length of the tail risk can dictate how much capital needs to be held as assets), and also individual business strategies which can diverge significantly.

Of course the hedge fund sponsored reinsurer strategy goes well beyond being a tax play for the majority of participants, at least all Artemis deals with. The attraction is the reinsurance underwriting to gain access to the premium float, which is considered a more permanent source of capital that can be put to work in hedge fund investment strategies.

The target then is to deliver a total return, across lower volatility, longer tailed underwriting combined with the high performing hedge fund investment strategy. When it works such a strategy can deliver very attractive returns to its investors or shareholders, while also boosting a hedge fund managers asset base significantly with the float.

So now the IRS has published some guidance, which suggests it will look at how to define the passive income in insurers and reinsurers, in order to identify who is simply trying to benefit from more attractive tax regimes and who is really underwriting reinsurance business.

Encouragingly the IRS now wants to take comments and suggestions, particularly to help it establish a robust way to identify any rogue reinsurance vehicles that are simply being used to enable a hedge fund manager to avoid taxation.

A key paragraph of the proposed regs are below:

In 1984, Congress enacted a definition of an “insurance company” that applied only to life insurance companies, and in 2004, a conforming amendment was made to apply the same definition to non-life insurance companies. See sections 816(a) and 831(c). Under this definition, in order for a corporation to be subject to tax as an insurance company under subchapter L, more than half of its business during the taxable year is required to be the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. By requiring that more than half of the company’s business activity, rather than its predominant business activity, be insurance activity, the current subchapter L statutory rules adopt a stricter and more precise standard than the “primary and predominant” regulatory standard under prior law.2 Thus, 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).

As with any proposed regulations the reinsurance industry and interested or concerned hedge fund managers need to ensure their voices are heard.

The IRS is giving just such an opportunity, by requesting comments for a 90 day period after the draft regulations are published in the Federal Register, which is expected to be tomorrow. That gives 90 days to assess whether the regs will affect your current business plan, or perhaps your future one.

The IRS explains exactly what it wants to receive assistance and input on:

Comments specifically are requested with regard to how to determine the portion of a foreign insurance company’s assets that are held to meet obligations under insurance contracts issued or reinsured by the company. For example, assets could be considered as held to meet obligations under insurance or annuity contracts issued or reinsured by the corporation to the extent the corporation’s assets in the calendar year do not exceed a specified percentage of the corporation’s total insurance liabilities for the year (for example, the sum of the corporation’s “total reserves” (as defined in section 816(c)) plus (to the extent not included in total reserves) the items referred to in paragraphs (3), (4), (5), and (6) of section 807(c)). Comments are requested with regard to what percentage would be appropriate. Also, comments are requested with regard to whether other methods would be more appropriate to determine the portion of assets that are held to meet obligations under insurance and annuity contracts.

It’s vital to be heard on this issue and not just for reinsurers sponsored by hedge funds. Given the current state of the reinsurance market, where companies are developing new business models which seek to take advantage of the investment oriented reinsurer, or hedge fund reinsurer, strategy (think ABR Re and Fidelis Insurance as just two), any ruling could affect future innovations, not just current hedge fund sponsored reinsurers.

So it’s vital to think ahead, about how companies may want to operate a reinsurance vehicle in the future, which has an asset-side strategy to it. If companies are thinking about doing something novel, that stretches the boundaries of the traditional model by pulling in elements of the hedge fund backed model, it’s pretty important to be sure this proposed ruling won’t scupper those plans.

You can access a copy of the proposed regulatory ruling here.