Reforms under the new Tax Cuts and Jobs Act (TCJA), adopted in the U.S. in December 2017, means that some insurance-linked securities (ILS) structures could be classified as a controlled foreign corporation (CFC) and others could be classified as a passive foreign investment company (PFIC), according to Mayer Brown’s Global Insurance Industry Year in Review, 2017.
Mayer Brown has identified some impacts to the ILS market as a result of the recent tax reforms in the U.S., highlighting that the change in the definition of ‘United States shareholder’ for CFC purposes, “will have an impact” on both sidecar and catastrophe bond transactions, and on the formation of new insurers.
Most offshore insurance companies include a provision that limits the voting power of a single shareholder to 10% of the voting power of the company. These by-law provisions were originally designed to keep large U.S. shareholders of an offshore insurance company from being treated as a ‘United States shareholder,’ for CFC purposes.
If it occurred that ‘United States shareholders’ owned more than 25% of the shares of a foreign insurer by either vote or value, then the foreign entity would be classified as a CFC.
Mayer Brown explains that any “United States shareholders of that CFC were required to include in their current taxable income the Subpart F income of the CFC regardless of whether the CFC distributed that Subpart F income as a dividend to its shareholders or retained that income in the foreign insurance company.”
As a result, and given that insurance income is classified as a type of Subpart F income, Mayer Brown explains that avoiding CFC status was necessary in order for major U.S. shareholders to have a chance at achieving deferral of tax on their share of the foreign company’s insurance income.
Mayer Brown, expands on this; “If the company’s by-laws provided no shareholder could cast more than 9.9% of the votes in any shareholder vote, no United States person could be treated as a United States shareholder, no matter if the United States person owned 10% or more of the economic interest in the company. Without 10% voting United States Shareholders, the foreign insurance company could not be CFC, and no shareholder had to report currently his share of the company’s insurance income or other Subpart F income.”
Under the new tax reform, the definition of United States shareholder has been changed, with the addition of the words, “or 10 percent or more of the total value of all shares,” to the Section 951(b) definition of United States shareholder.
As a result, Mayer Brown explains in its comprehensive report that following this change the voting cutback provisions now fail to achieve the goal of keeping a major U.S. shareholder from being a United States shareholder for CFC purposes.
The change is unlikely to impact existing, large public companies, explains Mayer Brown, but “the change will make it harder for new offshore insurance companies to be formed by small groups of U.S.-based private equity or other investors without being treated as CFC’s during at least the early part of their existence.”
Issuers of both sidecars and catastrophe bonds are likely to be viewed as insurance companies for tax reasons, and, as result, must be treated as corporations and not “pass-through entities.”
The report explains the fundamentals of a sidecar, noting that it is typically structured as a segregated cell of a Bermudian or Cayman segregated cell company, the core of which is typically owned by an insurer which in turn cedes risks incurred to a cell of the segregated cell company in the form of a reinsurance transaction.
“The cell then uses the proceeds of the offering to collateralize its reinsurance obligation. The core exercises control over the cell, but it has no economic interest in the cell,” explains Mayer Brown.
As highlighted by Mayer Brown, offering documents note that uncertainty remains about whether the segregated cell is treated as a separate entity from the actual core, which in turn leads to uncertainty as to whether the shares purchased by an investor is of the core or the cell.
“But the change in definition of United States shareholder to be a 10% vote or value test will be relevant to either view of the issuer. If a US person acquires enough stock in the offering to equal or exceed 10% of the value of the issuer, that investor will be a United States shareholder of the issuer for purpose of the CFC rules,” says Mayer Brown.
Regarding catastrophe bond transactions, the impact remains, although the structure of such a risk transfer mechanism differs.
An insurer or reinsurer establishes a special purpose insurer (SPI), again this is common in Bermuda and Cayman, that is the issuer of the catastrophe bond and, as a result the issuer typically having de minimis equity, the cat bond is treated as equity for tax reasons.
“The tax disclosure typically advises that the cat bonds could be treated as voting stock for CFC purposes. The change in the definition of United States shareholder to adopt a 10% of vote or value test makes clear that a U.S. investor who owns 10% of an issuer’s cat bond will be treated as a United States shareholder for CFC purposes,” explains Mayer Brown.
In addition to changes that impact CFC status, Mayer Brown also notes that under the reform it is even less likely that a catastrophe bond SPI would qualify for the PFIC exception.
The change in the PFIC provision has been widely viewed as targeting the hedge fund-style reinsurance business model, which critics have questioned in recent times stating that many were too close to hedge funds, and were barely undertaking enough insurance activity to qualify for the PFIC exception.
Under the PFIC provision, issuers must qualify for the ‘active insurance’ exception, but the recent tax reform has seen a further requirement added to the PFIC exception. Under the new tax laws, issuers must satisfy the ‘active insurance’ exception, and must also be a ‘qualifying insurance corporation.’
Mayer Brown explains what this means and also provides some insight on what this means for catastrophe bond transactions; “A qualifying insurance corporation is a foreign corporation which would qualify for taxation as an insurance company if it were a domestic corporation and its applicable insurance liabilities constitute more than 25% (or 10% in certain cases to be provided in Treasury regulations) of the corporation’s total assets.
“This change will make it harder for the hedge fund re type companies to qualify for the PFIC exception.
“Although cat bond disclosures generally expressed skepticism that the cat bond income would qualify as income from the active conduct of an insurance business for the prior-law PFIC exception, the addition of the qualifying insurance corporation 25% test made it even less likely that a cat bond special purposes reinsurer would qualify for the PFIC exception.”
It’s also worth noting that as a result of uncertainty surrounding the above mentioned changes, further clarification from the U.S. Treasury or further legislation would be helpful to determine the impact of the legislation in the ILS space.