Emory Corporate Governance and Accountability Review

The PFIC Carve-Out: Hedge Funds and the Tax-Free World of Offshore Reinsurance
Ben Pierce Emory University School of Law, J.D. Candidate, 2017; B.A. English and American Literature, New York University.

Hedge funds that seek the advantages of offshore, tax-free jurisdictions have long been thwarted by § 1297 of the Tax Code, which imposes severe tax consequences on American shareholders of passive foreign investment companies (or “PFIC”). 1Jeffry J. Erney et al., The IRS Turns Up the Heat on Hedge Fund-Backed Reinsurance, Baker Hostetler (June 8, 2015), . Insurance companies, however, enjoy a special carve-out from the rule, allowing them to escape classification as a PFIC as long as they are predominately engaged in the business of insurance, rather than the business of investing. 2I.R.C. § 1297 (2007). Hedge fund managers have utilized the carve-out to establish offshore reinsurance companies that serve as vehicles for both hedge fund-style investment and the assumption of insurance risk. Some regulators have leapt to the conclusion that these offshore corporations are investment funds “disguised” as legitimate reinsurers. 3Richard Rubin et al., IRS Weighs Rules on Hedge Fund Managers’ Use of Reinsurance, Ins. J. (Apr. 24, 2015), ; Erney et al., supra note 1.

A recent bill proposed by Senate Finance Committee Ranking Member Ron Wyden targets such hedge fund-backed reinsurers, but legislators and regulators face the difficult task of discerning “real” reinsurance companies from those that are serving purely as tax sheltering mechanisms. 4See Offshore Reinsurance Tax Fairness Act, S. 1687, 114th Cong. (2015). This paper will argue that the bright-line test proposed by the Wyden Bill is an unworkable solution, as it may inadvertently undermine the public policy concern of policyholder protection and discourage the influx of capital into the reinsurance industry.

The fact that there is a jurisdiction 650 miles off the coast of North Carolina that lacks any income tax obligations poses a lucrative opportunity for many investment firms. 5Bermuda - Taxation, KPMG (Jan. 1, 2014), ; see also Zachary R. Mider, Paulson Leads Funds to Bermuda Tax Dodge Aiding Billionaires, Bloomberg Bus. (Feb. 19, 2013, 6:00 AM), . However, the PFIC rule in § 1297 of the Tax Code mitigates the tax advantages of Bermuda and other no-tax jurisdictions. Section 1297 designates a non-U.S. corporation as a PFIC if during the tax year, “75 percent or more of its gross income is ‘passive income’” or if “50 percent of more of its assets produce passive income or are held for the production of ‘passive income.’” 6I.R.C. § 1297; Treasury Issues Proposed Regulations Concerning the Application of the PFIC Rules to Non-U.S. Reinsurance Companies, Sidley Austin LLP (Apr. 24, 2015), . The rule penalizes a U.S. shareholder in a PFIC in multiple ways, including the imposition of tax and interest charges on the income of the PFIC, whether or not distributed to the shareholder. 7See Instructions for Form 8621, IRS, (last visited Nov. 8, 2015). However, § 1297 contains a special exception for non-U.S. insurance companies, for it excludes from passive income any income “derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business” and which would be subject to normal insurance taxation if it were a domestic corporation. 8I.R.C. § 1297.

This exception creates an opportunity for a hedge fund to establish an offshore reinsurance corporation whose assets it manages. 9Senator Wyden Proposes PFIC Legislation That Targets Certain Hedge Fund/Reinsurance Structures, Sidley Austin LLP (June 29, 2015), . The reinsurer’s income, bolstered by hedge fund-style investment, builds up in a tax-free jurisdiction. When an investor participates in a conventional hedge fund, she pays the ordinary income tax rate on her share of the fund’s income, whether or not distributed. 10Victor Fleischer, Why Hedge Funds Don’t Worry about Carried Interest Tax Rules, N.Y. Times: Dealbook (May 14, 2014, 3:35 PM), ; Taxes and FAQs about your short-term or long-term capital gains and losses, J.P. Morgan Asset Management, (last visited Nov. 8, 2015). In hedge fund-backed reinsurance, the investor has an advantage: she pays the more favorable long-term capital gains tax rate whenever she receives a distribution from the reinsurer or disposes of the reinsurer’s stock. 11See Richard Rubin et al., Hedge Fund-Backed Bermuda Ventures Could Be at Risk From IRS, Ins. J. (Apr. 24, 2015), ; Arthur J. Lynch, Richard L. Reinhold, Treasury Department and IRS Release Proposed Regulations Clarifying Application of PFIC Analysis to Offshore Reinsurers, Willkie Farr & Gallagher LLP (Apr. 24, 2015), .

The advantages afforded by the insurance carve-out have not gone unnoticed by Congress. In June 2015, Senate Finance Committee Ranking Member Ron Wyden addressed the carve-out by introducing “The Offshore Reinsurance Tax Fairness Act” (the “Wyden Bill”). 12Senator Wyden Proposes PFIC Legislation That Targets Certain Hedge Fund/Reinsurance Structures, supra note 9. The Wyden Bill amends the insurance carve-out in § 1297 to exclude from passive income any income “derived in the active conduct of an insurance business by a qualifying insurance corporation.” 13Bermuda - Taxation, supra note 4. The amendments define a “qualifying insurance corporation” as one that would be subject to normal insurance taxation if it were a domestic corporation, and whose insurance liabilities constitute more than 25 percent of its total assets for the prior tax year. 14Id. This ratio is intended to be a “bright-line test” for distinguishing legitimate offshore reinsurers from hedge fund-backed reinsurers. 15Staff of S. Comm. on Fin., 114th Cong., The Offshore Reinsurance Tax Fairness Act, available at . It also provides an “alternative facts and circumstances” test for those corporations that do not meet the 25% ratio. 16S. 1687. 114th Cong. (2015). Under this narrow safe harbor provision, the reinsurer is still exempted from PFIC designation as long as its insurance liabilities constitute at least 10 percent of its total assets and its failure to meet the bright-line test is due to “temporary circumstances” involving its insurance business. 17Id.

Although the Wyden Bill provides a clear standard by which to differentiate offshore corporations, its reach is over-inclusive. A reinsurer may be unable to underwrite enough risk to meet either the 10% or 25% test in its first few years of life, and only later be able to reach the capacity necessary to hold the requisite assets and liabilities. 18See How Are Insurance Company Reserve Amounts Determined?, Fin. Web, (last visited Nov. 8, 2015). The amendments also hinder the ability of reinsurers to respond to market fluctuations, as reinsurers may be unable to take on the mandatory amount of insurance liability during downswings in the market. 19Id.

A hedge fund-backed reinsurer may hold far more assets than insurance liabilities, but that does not mean that the reinsurer is engaged in a “sham” insurance business. As major players in the capital markets, hedge funds are a powerful source of capital for the reinsurance industry. An overly capitalized reinsurer, although it may do little underwriting, is in a better position to protect its policyholders since it holds more capital to pay future claims. 20See id. Placing restrictions on the balance sheet of an offshore reinsurer runs counter to the public policy of requiring insurers to hold adequate capital to deal with the uncertainty of future losses.

A bright-line test cannot reasonably be applied to an industry with such varied products and business lines, and whose products and business lines change over time. The capital profile of an annuity company is completely different from that of a hurricane reinsurer. The “temporary circumstances” provision suggests that lawmakers are open to applying a test that analyzes a reinsurer’s activities over a longer timeline. To more effectively discern legitimate reinsurers from pure tax sheltering mechanisms, regulators could analyze the individual facts and circumstances of a corporation beyond a given tax year. Over a longer range of time, disguised hedge funds would appear to underwrite such an insignificant amount of reinsurance as to have no economic substance as a reinsurer. Those are the entities that Congress should focus on.

Footnotes

1Jeffry J. Erney et al., The IRS Turns Up the Heat on Hedge Fund-Backed Reinsurance, Baker Hostetler (June 8, 2015), .

2I.R.C. § 1297 (2007).

3Richard Rubin et al., IRS Weighs Rules on Hedge Fund Managers’ Use of Reinsurance, Ins. J. (Apr. 24, 2015), ; Erney et al., supra note 1.

4See Offshore Reinsurance Tax Fairness Act, S. 1687, 114th Cong. (2015).

5Bermuda - Taxation, KPMG (Jan. 1, 2014), ; see also Zachary R. Mider, Paulson Leads Funds to Bermuda Tax Dodge Aiding Billionaires, Bloomberg Bus. (Feb. 19, 2013, 6:00 AM), .

6I.R.C. § 1297; Treasury Issues Proposed Regulations Concerning the Application of the PFIC Rules to Non-U.S. Reinsurance Companies, Sidley Austin LLP (Apr. 24, 2015), .

7See Instructions for Form 8621, IRS, (last visited Nov. 8, 2015).

8I.R.C. § 1297.

9Senator Wyden Proposes PFIC Legislation That Targets Certain Hedge Fund/Reinsurance Structures, Sidley Austin LLP (June 29, 2015), .

10Victor Fleischer, Why Hedge Funds Don’t Worry about Carried Interest Tax Rules, N.Y. Times: Dealbook (May 14, 2014, 3:35 PM), ; Taxes and FAQs about your short-term or long-term capital gains and losses, J.P. Morgan Asset Management, (last visited Nov. 8, 2015).

11See Richard Rubin et al., Hedge Fund-Backed Bermuda Ventures Could Be at Risk From IRS, Ins. J. (Apr. 24, 2015), ; Arthur J. Lynch, Richard L. Reinhold, Treasury Department and IRS Release Proposed Regulations Clarifying Application of PFIC Analysis to Offshore Reinsurers, Willkie Farr & Gallagher LLP (Apr. 24, 2015), .

12Senator Wyden Proposes PFIC Legislation That Targets Certain Hedge Fund/Reinsurance Structures, supra note 9.

13Bermuda - Taxation, supra note 4.

14Id.

15Staff of S. Comm. on Fin., 114th Cong., The Offshore Reinsurance Tax Fairness Act, available at .

16S. 1687. 114th Cong. (2015).

17Id.

18See How Are Insurance Company Reserve Amounts Determined?, Fin. Web, (last visited Nov. 8, 2015).

19Id.

20See id.

Emory University School of Law, J.D. Candidate, 2017; B.A. English and American Literature, New York University.