Are Foreign Insurance Companies Subject to the PFIC Tax Regime?

Sometimes U.S. investors set up insurance companies offshore for a variety of reasons. Often insurance companies established outside the United States are taxed under the controlled foreign corporation or (“CFC”) rules. However, unknown to the U.S. investor, a foreign insurance corporation or company can be taxed under the extremely punitive foreign investment company (or “PFIC”) tax regime. This article discusses the PFIC tax rules and how a foreign insurance company can be taxed as a PFIC.

In order to understand why PFIC rules were enacted, it is important to take a step-back and understand the historical background as to why these rules were enacted. U.S. investors in domestic mutual funds have always been taxed on the fund’s investment income because a domestic fund must distribute at least 90% of its income each year in order to avoid U.S. corporation taxation. See IRC Section 851 and 852. On the other hand, at one time the U.S. holders of foreign mutual funds were able to avoid U.S. tax as a result of the funds not paying dividends. Congress believed that U.S. owners of foreign mutual funds had an unfair advantage over U.S. owners of domestic mutual funds. This resulted in the enactment of the PFIC tax regime that significantly expanded the reach of the Internal Revenue Code (“IRS”) with respect to passive investment income earned by U.S. persons through foreign corporations.

The objective of the PFIC provisions of the Internal Revenue Code is to deprive a U.S. taxpayer of the economic benefit of deferral of U.S. tax on a taxpayer’s share of the undistributed income of a foreign investment company that has predominantly passive income. Although the PFIC provisions were aimed at U.S. persons holding stock in foreign investment funds, the PFIC provisions have a much broader impact. The PFIC provisions of the Internal Revenue Code may apply to any U.S. person holding stock in any foreign corporation, even one engaged in an active foreign business such as manufacturing, for any tax year in which the corporation derives enough passive income or owns enough passive assets to meet the definition of a PFIC.

Definition of PFIC

A foreign corporation is a PFIC if it satisfies either an income or asset test. Under the income test, a foreign corporation is a PFIC if 75% or more of the corporation’s gross income for the taxable year is defined as “foreign personal holding company” for purposes of Subpart F provisions of the Internal Revenue Code, with certain adjustments. Internal Revenue Code Section 954(c) defines “foreign personal holding company income” to include most types of passive income, such as interest, dividends, rents, annuities, royalties and gains from the sale of stock, securities or other property that produces interest, dividends, rents, annuities or royalties. See IRC Section 954(c)(1)(A) and (c)(1)(B)(i). The adjustments include exclusions for income derived from the active conduct of a banking, insurance, or securities business, as well as any interest, dividends, rents, and royalties received from a related person to the extent such income is properly allocable to nonpassive income of the related person. A “related person” is defined in Internal Revenue Code Section 954(d)(3). An individual, corporation, partnership, trust or estate that controls or is controlled by a controlled foreign corporation (“CFC”) is a “related person.” Control means, in the case of a corporation, direct or indirect ownership of more than 50 percent of the total voting power or value of the stock of the corporation.

For purposes of the income test, passive income is subject to four exceptions. The first two exceptions relate to income from the active conduct of a banking or insurance business. See IRC Section 1297(b)(2)(A) and (B). The third covers interest, dividend, rent or royalty income received from a related person to the extent that such income is properly allocated to income of such related person that is not passive income. See IRC Section 1297(b)(2)(C). The fourth covers certain foreign trade income subject to special treatment under two preferential tax regimes for export sales.

Under the asset test, a foreign corporation is a PFIC if the average market value of the corporation’s passive assets during the taxable year is 50% or more of the corporation’s total assets. An asset is characterized as passive if it has generated (or is reasonably expected to generate) passive income in the hands of the foreign corporation. See IRC Section 1297. Assets that generate both passive and nonpassive income in a tax year are treated as partly passive and partly nonpassive to the proportion to the relative amounts of the two types of income generated by those assets in that year. See IRC Notice 88-22. Both the Internal Revenue Service (“IRS”) and taxpayers may apply a PFIC test using the adjusted bases of its assets (as determined for earnings and profits purposes) in lieu of their value. However, a publicly traded corporation is required to use the value of its assets in applying the asset test. A PFIC that is also a CFC but is not publicly traded is required to use the adjusted bases of its assets in applying the asset test for PFIC status with no option to use the value of its assets.

Look Through Rule

For purposes of the PFIC income and asset tests, a look-through rule applies to foreign corporations that own, directly or indirectly, at least 25 percent by value of the stock of another corporation. Under this rule, a foreign corporation is treated as owning its proportionate share of the other corporation’s assets and as receiving it directly its proportionate share of the other corporation’s income in determining whether the foreign corporation is a PFIC. In addition, in applying the PFIC tests to the foreign corporation, amounts such as dividends and interest received from the 25-percent-or-more-owned subsidiary are eliminated from the foreign corporation’s income for purposes of the income test, and the foreign corporation’s stock or debt investment in the subsidiary is eliminated from the foreign corporation’s assets for purposes of the asset test. See IRC Section 1297(c).

Special Rules for Start-Up Year and Corporations Changing Businesses

A foreign corporation is not treated as a PFIC during the first year that it has gross income (also known as the “start-up year”) as long as three requirements are satisfied. First, no predecessor of the corporation was a PFIC. Second, the corporation establishes to the satisfaction of the IRS that it will not be a PFIC for either of the first two years after the start-up year. Third, the corporation is not in fact a PFIC for either of the first two years after the start up year. See IRC Section 1298(b)(2). A foreign corporation that is changing businesses is not treated as a PFIC for a tax year if three requirements are satisfied. First, neither the corporation nor any predecessor  was a PFIC. Second, the corporation establishes to the satisfaction of the IRS that i) substantially all of its passive income for the tax year is attributable to the proceeds from disposition of one or more active trades or businesses, and ii) it will not be a PFIC for either of the first two tax years after such tax year. Third, the corporation is not in fact a PFIC for either of these two years. See IRC Section 1298(b)(3).

Taint of PFIC Status

The determination regarding the status of PFIC for a foreign corporation is made on an annual basis. Thus, a corporation may be a PFIC in some years but not others. However, under Section 1298(b)(1), a foreign corporation’s status as a PFIC for even a single tax year may continue to taint the shareholders’ stock even if the corporation does not satisfy the definition of PFIC in any other tax year. Under Section 1298(b)(1), stock held by a taxpayer will be treated as stock in a PFIC if, at any time during the taxpayer’s holding period for such stock, the corporation or any predecessor was a PFIC. There are only two ways that a shareholder can purge the stock of its PFIC taint. First, the shareholder can prevent the application of Section 1298(b)(1) by making a qualified fund election (discussed below). Second, the shareholder can purge the stock of its PFIC taint by electing to recognize gain on the last day of the last year on which the corporation was a PFIC as if the stock had been sold for its fair market value on that day.

Overlap Between CFCs and PFICs

Sometimes a foreign corporation can satisfy the definition of both a CFC under Section 957 and PFIC under Section 1297(a). In these situations, Section 1297(e)(1) provides that a foreign corporation will not be treated as a PFIC with respect to a shareholder during the “qualified portion” of the shareholder’s holding period for the stock in the corporation. The “qualified portion” of the holding period is when the shareholder is a “U.S. Shareholder” as defined in Section 951(b) of the Internal Revenue Code. Thus, a U.S. shareholder that is subject to current inclusions under the Subpart F or GILTI rules with respect to stock in a PFIC is not also subject to the PFIC rules with respect to such stock.However, the PFIC provisions continue to apply to other U.S. persons owning stock in the PFIC who are not U.S. shareholders within the meaning of Section 951(b).

If a shareholder is not subject to the PFIC provisions by reason of Section 1297(e)(1) and then ceases to qualify for such treatment either because the shareholder is no longer a U.S. shareholder under Section 951(b) or because the PFIC is no longer a CFC, the shareholder’s holding period for the stock, for purposes of the PFIC rules, is treated as starting immediately after such cessation. See IRC Section 1297(e)(3)(A).

Taxation of PFICS

A shareholder of a PFIC is subject to the Section 1291 excess distribution rules in which shareholders must allocate excess distributions and gains realized upon the sale of their PFIC shares pro rata to their holding period. See IRC Section 1291(a)(1)(A).

An excess distribution includes the following:

1) A gain realized on the sale of PFIC stock, and

2) Any actual distribution made by the PFIC, but only to the extent the total actual distribution received by the taxpayer for the year exceeds 125 percent of the average actual distribution received by the taxpayer in the preceding three taxable years. The amount of an excess distribution is treated as if it had been realized pro rata over the holding period of the foreign share and, therefore, the tax due on an excess distribution is the sum of the deferred yearly tax amounts. This is computed by using the highest tax rate in effect in the years the income was accumulated, plus interest. Any actual distributions that fall below the 125 percent threshold are treated as dividends. This assumes they represent a distribution of earnings and profits, which are taxable in the year of receipt and are not subject to the special interest charge.

Interest charges are assessed on taxes deemed owed on excess distributions allocated to tax years prior to the tax year in which the excess distribution was received. All capital gains from the sale of PFIC shares are treated as ordinary income for federal tax purposes and thus are not taxed at favorable long-term capital gains rates. See IRC Section 1291(a)(1)(B). In addition, the Proposed Regulations state that shareholders cannot claim capital losses upon the disposition of PFIC shares. See Prop. Regs. Section 1.1291-6(b)(3).

Below, please see Illustration 1. and Illustration 2. which demonstrates a typical sale of PFIC stock.

Illustration 1.

Jim is an engineer and a citizen of Germany. Jim moved to California and became a U.S. green card holder. Jim likes to invest in foreign mutual funds. On the advice of his German broker, on January 1, 2016, Jim buys 1 percent of FORmut, a mutual fund incorporated in a foreign country for $1. FORmut is a PFIC. During the 2016, 2017, and 2018 calendar years, FORmut accumulated earnings and profits. On December 31, 2018, Jim sold his interest in FORmut for $300,001. To determine the PFIC excess distribution, Jim must throw the entire $300,000 gain received over the entire period that he owned the FORmut shares – $100,000 to 2016, $100,000 to 2017, and $100,000 to 2018. For each of those years, Jim will pay tax on the throw-back gain at the highest rate in effect that year with interest.

It is easy to envision significantly more complex scenarios. Such a scenario is described in Illustration 2 which is based on an example in Staff of Joint Comm. On Tax’n, 100 Cong., 1st Sess., General Explanation of Tax Reform of 1986, at 1027-28(1987).

Illustration 2.

On January 1 of year 1, Samatha, a U.S citizen, acquired 1,000 shares in FC, a foreign corporation that is a PFIC. She acquired another 1,000 shares of FC stock on January 1 of year 2. During years 1 through 5, Samatha receives the following dividend distribution from FC:

Date of Distribution                                               Amount of Distribution

Dec. 31 of year 1                                                     $500
Dec. 31 of year 2                                                     $1,000
Dec. 31 of year 3                                                     $1,000
Dec. 31 of year 4                                                     $1,000
Apr. 1 of year 5                                                         $1,500
Oct. 1 of year 5                                                         $500

Under Internal Revenue Code Section 1291, none of the distributions received before year 5, are excess distributions since the amount of each distribution with respect to a share is 50 cents. However, with respect to distributions during year 5, the total distribution to each share is 37.5 cents ($1 minus 62.5 cents (1.25 times 50 cents)).

Accordingly, the total excess distribution for FC’s tax year ending December 31 of year 5 is $750 (37.5 per share times 2,000 shares). This excess distribution must be allocated ratably between the two distributions during year 5. Thus, $562.50 (75 percent of the excess distribution, i.e., $750 times $1,500/$2,000) is allocated to the April 1 distribution and $187.50 (the remaining 25 percent of the excess distribution, i.e. $750 $500/$2,000) is allocated to the October 1 distribution. These amounts are then ratably allocated to each block of stock outstanding on the relevant distribution date. For the distribution on April 1 of year 5, $281.25 of the excess distribution is allocated to the block of stock acquired on January 1 of year 1 and $281.25 is allocated to the block of stock acquired on January 1 of year 2 and $281.25 is allocated to the block of stock acquired on January 1 of year 3. The $187.50 excess distribution on October 1 of year 5 is also allocated evenly between the two blocks of stock outstanding on the date of the distribution. Finally, the excess distribution for each block of stock is in accordance with Internal Revenue Code Section 1291(a)(1).

The federal tax due in the year of disposition (or year of receipt of an excess distribution) is the sum of 1) U.S. tax computed using the highest rate of U.S. tax for the shareholder (without regard to other income or expenses the shareholder may have) on income attributed to prior years (called “the aggregate increase in taxes” in Section 1291(c)(1)), plus 2) U.S. tax on the gain attributed to the year of disposition (or year of receipt of the distribution) and to years in which the foreign corporation was not a PFIC (for which no interest is due). Items (1) and (2) together are called the “deferred tax amount” in Section 1291. Item (2), the interest charge on the deferred tax, is computed for the period starting on the due date for the prior year to which the gain on distribution or disposition is attributed and ending on the due date for the current year in which the distribution or disposition occurs.

As indicated above, not only are the PFIC taxing rules complex, these rules can generate significant tax liabilities which, in curtain cases, exceed the value of the foreign stock

Special PFIC Rules for Foreign Insurance Companies

If a foreign insurance corporation is wholly owned or owned in part by United States investors and if the foreign insurance company is not taxed under the CFC rules, if the insurance company can be classified as a PFIC under the above discussed rules, the U.S. investor can be subject to the PFIC tax regime. This is the case regardless of the percentage of ownership the U.S. investor in the insurance company.

However, even if the foreign insurance company can be treated as a PFIC under the applicable provisions of the Internal Revenue Code, a foreign insurance corporation can be exempt from the PFIC rules if it meets certain criteria related to being a “qualified insurance corporation” (“QIC”) and engaging in the “active conduct of an insurance business.” The Tax Cuts and Jobs Act of 2017 modified the PFIC insurance exception, making it more specific and requiring foreign insurance corporations to meet certain requirements to qualify. A foreign insurance corporation’s income attributable to an insurance business will not be considered passive income if three requirements are met:

1. The foreign corporation is a QIC if more than 50% of the corporation’s business is the issuing of or reinsuring insurance or annuity contracts;
2.  The foreign insurance corporation is engaging in an “insurance business,” which includes the business of issuing and reissuing contracts, as well as related investment activities and administrative services.
3. The income is derived from the “active conduct” of that insurance business, which generally means the foreign corporation’s officers and employees carry out substantial managerial and operational activities.

If a foreign insurance corporation satisfies the aforementioned three requirements, the U.S. investor can avoid the punitive PFIC tax regime.

If you are considering establishing or investing in an insurance company located offshore, you should consult with a qualified international tax attorney. We have substantial experience in cross-border tax planning involving insurance companies.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.