Tax News
Prop. Reg. 1.1297-4 Addresses Hedge Fund Reinsurance
May 04, 2015
Treasury is scheduled to release tomorrow the eagerly anticipated hedge fund reinsurance regulations. A pre-release version of the regulations has already been published by the Service and here we explore its most notable elements.  Hedge fund reinsurance has been one of those topics, like carried interest and fee waivers, which has reached the status of “evil” in the mass media. It is one of the topics that journalists or politicians alike grasp for when they want to point out how the rich take advantage of the Tax Code at the expense of the poor.

As it may be, what is hedge fund reinsurance? A hedge fund is usually structured as a flow-through entity and earns short term capital gains typically taxed at top marginal ordinary income rates. Here comes a great idea. The PFIC rules (which apply to foreign passive companies and generally have the adverse consequence of an interest charge and various filing requirements) do not apply to insurance income. Why not establish a reinsurance company ran by the fund? The reinsurance company could invest in the hedge fund, both capital invested by management and LPs and reinsurance premiums collected from reinsuring risk. The investors are happy because they just converted ordinary income into capital gain. They also got a tax free deferral to boot. The managers are happy because they obtain permanent capital funneled into the fund through the reinsurance co.

Apparently, the IRS, many-a-Congressman, and the Media were not happy, however. The IRS first started tackling this issue more than 10 years ago with Notice 2003-34. Then came series of articles pointing out that more and more hedge funds are setting up reinsurance companies and allegedly “exploiting loopholes.” Then came Chairman Wyden harping on the IRS regarding the lack of progress with respect to hedge fund reinsurance. This was followed by a JCT paper titled “Background and Data with Respect to Hedge Fund Reinsurance Arrangements” (the paper is a great reading and could be found here). Lastly, came out various Bills that were going to close the alleged loophole, but as often happens these days in Congress, these Bills went nowhere (we are talking about the Camp and Baucus proposals).

Full circle, the IRS comes out with REG-108214-15 which could be found here. This reg has the potential of causing some tectonic changes in the hedge fund reinsurance set up. The proposed regulation in itself is rather brief. Moreover, the regulation does not address one of the central issues that surround hedge fund reinsurance, i.e. the issue of whether the hedge fund reinsurer is “predominantly engaged” in insurance business. However, the regulation does two things of significant import. First, it ties the definition of an “active” conduct of an insurance business to the definition under Reg. 1.367(a)-2T(b)(3), except that officers and employees are not considered to include the officers and employees of related entities as provided in §1.367(a)-2T(b)(3). This means that the officers and employees of the reinsurer must carry out substantial managerial and operational reinsurance activities. Most importantly, the activities of independent contractors and officers and employees of the hedge fund will be disregarded.

At least on first blush this means that the reinsurer has to have its own managerial team that is dedicated to the reinsurance business and it can’t borrow employees from the hedge fund. What this means is that hedge fund reinsurers that have contracted out the underwriting to a local Bermuda facilitator may have to rethink their arrangements.

The second part of the regulations that merit very close attention is the definition of insurance business. Under that definition, investment activities and administrative services are included in the definition of an insurance business to the extent they are required to support or are substantially related to insurance and annuity contracts issued by the reinsurer. Investment activities are required to support or are substantially related to insurance and annuity contracts issued or reinsured by the reinsurer to the extent that income from the activities is earned from assets held by the reinsurer to meet obligations under the contracts.

And this is where the real rub is. The regulations do not outline a method of determining the portion of a foreign insurance company’s assets that are held to meet obligations under reinsurance contracts. The IRS asks for comments expressly as to this issue. However, the regs hint at what the IRS is looking at. In the words of the IRS:

“… 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”….”)

This appears to be driving at the 35% applicable insurance liability test from the Baucus and Camp Bills. While this is not exactly the test that was proposed in these legislations, it is a test that is based on an asset to liability ratio, which depending on the final ratio, could be problematic for hedge fund reinsurers. The JCT has specified in its paper that suspected hedge fund reinsurers have an asset to liability ratio of 1 to 12%. The Baucus and Camp proposals had a ratio of 35%.

It is too early to say where this is going, but stakeholders ought to get a move on and comment by the deadline of July 23, 2015.
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