Senate Finance Committee ranking member Ron Wyden, D-Ore., has introduced legislation aimed at preventing offshore tax avoidance by some U.S. hedge fund “reinsurers.” 

The bill, “The Offshore Reinsurance Tax Fairness Act,” would close a tax break that allows hedge fund reinsurers to take advantage of an exception to the tax code’s passive foreign investment company rules

“We need a fair tax code that doesn’t allow for winners and losers,” Wyden said in a statement. “For over 10 years now this loophole has allowed some hedge fund investors to avoid paying hundreds of millions of tax dollars. It’s time we shut it down for good.”

The passive foreign investment company rules of U.S. tax law are supposed to prevent U.S. taxpayers from delaying U.S. tax on investment income by holding investments through offshore corporations, Wyden’s office noted. The PFIC rules provide an exception for income derived from the active conduct of an insurance business. The exception applies to income derived from the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business and which would be subject to tax under Subchapter L if it were a domestic corporation.

Current law does not prescribe how much insurance or reinsurance business the company must do to be considered predominantly engaged in an insurance business. Investigative efforts by staff members on the Democratic side of the Senate Finance Committee have found some companies that are not legitimate insurance companies are taking advantage of this favorable tax treatment.

The Offshore Reinsurance Tax Fairness Act would provide a bright-line test for determining whether a company is truly an insurance company for purposes of the exception to the PFIC rules. Under the new rule, to be considered an insurance company, the company’s insurance liabilities must exceed 25 percent of its assets. If the company fails to qualify because it has 25 percent or less (but not less than 10 percent) in insurance liability assets, the company may still be predominantly engaged in the insurance business based on facts and circumstances.

A company with less than 10 percent of insurance liability assets would not be considered an insurance company and, therefore, would be ineligible for the PFIC exception and subject to current taxation. Legitimate insurance companies, however, would be able to meet the 25 percent test. Those that do not meet the test and are truly involved in the insurance business will be eligible for the PFIC exception based on a facts and circumstances determination.

Wyden’s office believes the rule disqualifying companies with less than 10 percent of insurance liability assets should target most of the hedge fund reinsurance companies that are taking advantage of the current law loophole, making them ineligible for the PFIC exception and stopping this abuse.

The legislation builds on requests over the past year by Wyden to the Treasury Department and IRS to issue guidance to help end this abuse. In April, the agencies proposed regulations that provided a first step in addressing the issue. The Offshore Reinsurance Tax Fairness Act goes further in fully ending this long-standing tax break by creating a bright-line test for determining whether a company is an insurance company for purposes of the exception.

Hedge funds with reinsurance companies based in Bermuda and the Cayman Islands could find themselves losing tax breaks if the legislation passed. The IRS and the Treasury Department have been weighing new rules to crack down on the tax break in recent months (see Third Point Re Says It’s a Real Insurer as IRS Eyes Tax Rule and Hedge Funds Get More Time from IRS for Reinsurance Tax Savings).

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