A new set of guidance on the treatment of passive foreign investment companies (PFICs) published at the end of last week by the U.S. Internal Revenue Service and Department of the Treasury has been modified so that the active conduct test excludes insurance-linked securities (ILS) funds, as well as other ILS and reinsurance securitization structures.
Proposed changes to tax regulations have threatened the treatment of ILS structures for some years now, as the Tax Cuts and Jobs Act (TCJA) rolled on into specific guidance on Passive Foreign Investment Companies (PFIC).
These regulations have led to uncertainty in both the reinsurance and insurance-linked securities (ILS) market over tax treatment of offshore structures, securitization vehicles and earnings from ILS funds.
The latest guidance and proposed rules from the IRS clarify one of the main concerns though, as ILS operations are set as excluded under the active conduct test.
Law firms had previously highlighted concerns that some of the tax reforms enacted and planned in the United States could have seen insurance-linked securities (ILS) structures classified as a controlled foreign corporation (CFC) and others classified as a passive foreign investment company (PFIC).
Concern had emerged over how ILS structures and other offshore reinsurance operations would far under the so-called active conduct test, as they needed to qualify for an exception and this was uncertain under previous versions of the rules.
But feedback from ILS market participants and legal experts has seemingly swayed this and the latest proposed regulations from the IRS explicitly exclude ILS funds and structures under this important test.
The latest proposed rules on active conduct of an insurance business have the following listed under exclusions:
The active conduct test excludes securitization vehicles (such as vehicles used to issue catastrophe bonds, sidecars, or collateralized reinsurance vehicles) and insurance linked securities funds that invest in securitization vehicles. These vehicles are excluded because they are designed to provide a passive investment return tied to insurance risk rather than participation in the earnings of an active insurance business.
Further, the rules also clarify that “a qualifying insurance company (QIC) is not engaged in the active conduct of an insurance business” if:
It is a vehicle that has the effect of securitizing or collateralizing insurance risks underwritten by other insurance or reinsurance companies or is an insurance linked securities fund that invests in securitization vehicles, and its stock (or a financial instrument, note, or security that is treated as equity for U.S. tax purposes) is designed to provide an investment return that is tied to the occurrence of a fixed or pre-determined portfolio of insured risks, events, or indices related to insured risks.
These are fairly significant revisions to the rules and make the situation a lot clearer for ILS investment structures and fund strategies.
They make it clear that insurance-linked securities (ILS) investment funds, as well as structures such as catastrophe bonds, reinsurance sidecars and collateralized reinsurance structures, will not always be considered in active conduct of an insurance business.
These new rules are proposed to take over from a controversial percentage test, that would have tried to establish how active a company was.
By excluding ILS, it will make clearer how they will be treated for taxation, rather than leaving the active conduct test open to potential interpretation on a case-by-case basis.