Tax reform legislation narrows insurance PFIC exception

By Surjya Mitra, CPA, J.D., LL.M., and Mark Smith, CPA, J.D., LL.M., Washington

Editor: Annette B. Smith, CPA

One change to the Code implemented in the law known as the Tax Cuts and Jobs Act, P.L. 115-97, limits the ability of shareholders of certain foreign insurance companies to avoid being subject to anti-deferral rules that apply to passive foreign investment companies (PFICs). Because the change is effective for tax years beginning after Dec. 31, 2017, shareholders in a foreign insurance company that previously relied on the so-called insurance exception to avoid PFIC status must test the foreign insurance company under the new rules to confirm that they can continue to rely on it.

PFICs in general

Under Sec. 1297(a), a foreign corporation is a PFIC if (1) 75% or more of its gross income is passive income (the income test); or (2) at least 50% of its average percentage of assets is held for the production of passive income (the asset test).

The income test: For purposes of the income test, the term "passive income" means any income that would be foreign personal holding company income (FPHCI) as defined in Sec. 954(c). FPHCI includes, for example, dividends, interest, royalties, rents, annuities, and net gains from the sale of property that gives rise to such income.

An insurance company invests its surplus and reserves in assets, such as bonds, that generally earn FPHCI. Thus, absent the insurance exception, all of the investment earnings of a foreign insurance company generally would be considered passive income.

The asset test: For purposes of the asset test, passive assets are assets that produce passive income. If an asset generates income that qualifies for the insurance exception, it is not a passive asset.

Insurance exception: Pre-TCJA

Under the pre-TCJA insurance exception, a foreign insurance company's income during a tax year is not passive income if (1) it is derived in the active conduct of an insurance business; (2) the insurance company is "predominantly engaged" in that business; (3) the insurance company would be subject to tax under Subchapter L, "Insurance Companies," if it were a domestic corporation; and (4) the insurance company does not maintain reserves in excess of the reasonable needs of its business.

Subchapter L qualification: Secs. 831(c) and 816(a) define an insurance company as any company more than half the business of which during the tax year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. For an arrangement to qualify as insurance, the arrangement must (1) involve an insurance risk; (2) involve both risk shifting and risk distribution; and (3) constitute insurance in the commonly accepted sense.

Predominantly engaged in the insurance business: Before 1984, regulations that defined an insurance company required that a company's primary and predominant business activity be insurance activity. The Code was amended in 1984 to replace the "primary and predominant" standard with the now-familiar "more than half the business" test. If an insurance company meets this standard, it is necessarily "predominantly engaged" in an insurance business (see the preamble to Prop. Regs. Sec. 1.1297-4; the proposed rules are to be effective when finalized).

Active engagement in the insurance business: Until the publication of proposed regulations in 2015, no guidance addressed what constitutes the active conduct of an insurance business. However, Notice 89-81 and Prop. Regs. Sec. 1.1296-4(a) issued in 1995 address a similar exception for income derived from an active banking business. Notice 89-81 states that "[t]he foreign corporation must actively conduct, within the meaning of section 1.367(a)-2T(b)(3) of the temporary regulations, a banking business that is a trade or business within the meaning of section 1.367(a)-2T(b)(2)." Those regulations provide the following criteria to determine whether a trade or business is actively conducted:

  • Whether a trade or business is actively conducted must be determined under all the facts and circumstances. In general, a corporation actively conducts a trade or business only if the officers and employees of the corporation carry out substantial managerial and operational activities.
  • A corporation may be engaged in the active conduct of a trade or business even though incidental activities of the trade or business are carried out on behalf of the corporation by independent contractors. In determining whether the officers and employees of the corporation carry out substantial managerial and operational activities, however, the activities of independent contractors are disregarded.
  • On the other hand, the corporation's officers and employees are considered to include the officers and employees of related entities who are made available to and supervised on a day-to-day basis by, and whose salaries are paid by (or reimbursed to the lending related entity by), the transferee foreign corporation.

Absent other guidance, these rules would support the view that a foreign corporation is engaged in the active conduct of an insurance business if it carries out substantial managerial and operational activities related to that business through its officers and employees and those of related companies. However, in 2015 the IRS proposed regulations that, if adopted, would provide definitions for the previously undefined terms "active conduct" and "insurance business," as used in Sec. 1297(b)(2)(B). Prop. Regs. Sec. 1.1297-4 states that the term "active conduct" has the same definition as in Temp. Regs. Sec. 1.367(a)-2T(b)(3), except that officers and employees are not considered to include the officers and employees of related entities. Although this definition of "active conduct" is otherwise consistent with Prop. Regs. Sec. 1.1296-4, it is unclear why the IRS thought it was necessary to exclude from the definition officers and employees of related entities for insurance companies.

Prop. Regs. Sec. 1.1297-4 would further define the term "insurance business" as the business activity of issuing insurance and annuity contracts and reinsuring of risks underwritten by insurance companies, together with investment activities and administrative services that are required to support or are substantially related to insurance contracts issued or reinsured. An investment activity is defined as any activity that would produce income of a kind that would be FPHCI as defined in Sec. 954(c), such as dividends and interest. Investment activities are required to support or be substantially related to insurance or annuity contracts issued or reinsured by the foreign corporation to the extent that income from the activities is earned from assets the foreign corporation holds to meet obligations under the contracts. These regulations have not yet been finalized.

Assets used for reasonable needs of the insurance business: When the insurance exception was adopted in 1986, legislative history explained that the insurance exception is intended to cover "bona fide" insurance companies (H.R. Conf. Rep't No. 99-841, 99th Congress, 2d Sess. II-644 (Sept. 18, 1986)). The General Explanation of the Tax Reform Act of 1986 (1986 Blue Book) explains that the IRS has authority to restrict the insurance exception when necessary to prevent U.S. persons from earning what is essentially investment income in a tax-deferred entity. The 1986 Blue Book further states that it was intended that entities engaged in the business of providing insurance may derive passive income and, thus, be treated as PFICs, in the event the entities maintain financial reserves in excess of the "reasonable needs" of the business (Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-87), p. 1025 (May 4, 1987)). The 1986 Blue Book adds that an offshore captive insurance corporation could be a PFIC if no risk was shifted to the foreign corporation, observing that, in that case, the foreign corporation would not be a true insurance company.

Changes made by the TCJA

Under the TCJA, passive income for PFIC purposes does not include income derived in the active conduct of an insurance business by a "qualifying insurance corporation" (QIC). A QIC is a company (1) that would be subject to tax under Subchapter L if it were a domestic corporation; and (2) the applicable insurance liabilities of which constitute more than 25% of its total assets as reported on the company's applicable financial statement for the last year ending with or within the tax year.

After the TCJA, the insurance exception still requires that the income of the foreign insurance company be derived in the active conduct of an insurance business, and that the foreign insurance company would be subject to tax under Subchapter L if it were a domestic corporation.

The limitation of the insurance exception to QICs is new. The QIC definition incorporates a numerical test that compares the ratio of applicable insurance liabilities to assets, based on the applicable financial statement. For this purpose, applicable insurance liabilities generally include insurance reserves but exclude deficiency, contingency, and unearned premium reserves. Companies that engage in lines of business that tend to have contingency reserves, such as those that assume catastrophic risk, mortgage, or financial guarantee risks, may have difficulty meeting this test. Companies that write multiyear insurance policies, which tend to have significant unearned premium reserves, may have similar difficulties.

An applicable financial statement is a statement for financial reporting purposes that (1) is made on the basis of generally accepted accounting principles (GAAP); (2) is made on the basis of international financial reporting standards (IFRS) if there are no GAAP financial statements; or (3) is filed with the applicable insurance regulatory body, if there are neither GAAP nor IFRS financial statements.

If a corporation is not a QIC solely because its applicable insurance liabilities constitute 25% or less of its total assets, an elective alternative test may apply if (1) the corporation's applicable insurance liabilities constitute at least 10% of its total assets; and (2) based on the applicable facts and circumstances, the corporation is predominantly engaged in an insurance business, and its failure to qualify under the 25% threshold is due solely to runoff-related or rating-related causes. This election is made by the U.S. shareholder, not the company.

Interestingly, the QIC definition suggests that in addition to meeting the more-than-half-the-business test, if the alternative test is applied, it also must be shown that the insurance company is predominantly engaged in the insurance business. The conference committee report on the TCJA enumerates facts and circumstances that may show a company is not predominantly engaged in an insurance business. Those facts include a small number of insured risks with low likelihood but large potential costs, workers focused to a greater degree on investment activities than underwriting activities, and low loss exposure. Additional relevant facts include claims payment patterns for the current and prior years, loss exposure, the percentage of gross receipts constituting premiums for the current and prior years, and the number and size of insurance contracts issued or reinsured. The fact that a firm has held itself out as an insurer for a long period is not determinative (H.R. Conf. Rep't No. 115-466, 115th Cong., 1st Sess. 669 (Dec. 15, 2017)).

The conference committee report also identifies runoff-related or rating-related circumstances, such as the failure to take on new insurance business (resulting in little or no premium income) and the use of remaining assets to pay claims with respect to preexisting insurance risks on the company's books. Those circumstances also include the imposition of specific capital and surplus requirements by a rating agency as a condition of obtaining a rating necessary to write new insurance business for the current year (id., p. 671).

Analyze effects of changes

Many U.S. shareholders of foreign insurance companies rely upon the insurance exception to avoid the PFIC regime. Those shareholders should analyze the relationship between a company's applicable insurance liabilities and total assets shown on its GAAP, IFRS, or regulatory financial statements to determine whether the exception still applies or whether, instead, the company is now a PFIC as a result of the recent changes.


Annette B. Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.

For additional information about these items, contact Ms. Smith at 202-414-1048 or

Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.

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