International Tax Primer CFCs and PFICs, Currently and Prospectively

42nd Annual Insurance Tax Conference International Tax Primer CFCs and PFICs, Currently and Prospectively Speakers: Daniel Priest, Debevoise & Plimpton LLP Chris Ocasal, Ernst & Young LLP Moderator: Richard Burness, Athene

Agenda • Investing in a potential CFC • Investing in a potential PFIC • Options on discovering a PFIC

CFCs and PFICs in a Territorial World • The CFC and PFIC regimes prevent U.S. taxpayers from deferring U.S. tax by earning income through non-U.S. corporations. • A territorial tax system generally permits foreign subsidiaries to earn and repatriate their business earnings to U.S. parents free of U.S. tax • Will the CFC and PFIC rules be relevant in a territorial system? • The Framework provided by the Trump administration and the leaders of the Congressional tax writing committees is silent on both PFICs and CFCs. Foreign profits of U.S. multinationals will be taxed on a global basis at a reduced rate. • The prior House GOP Reform Blueprint for tax reform would streamline the CFC rules but not get rid of them – they will still apply to passive income such as dividends and insurance premiums for U.S. risks, and may apply to premiums for non-U.S. risks • The PFIC rules, which generally apply to investment income, not business income, will likely remain • The Framework’s exemption from foreign dividends only applies where the U.S. parent owns at least 10% of the equity

Hypothetical A • You work for a U.S.-based insurer, which is considering a minority equity investment in a non-U.S. insurance group (“Target”) • The Target group primarily issues reinsurance, but some subsidiaries directly write life and annuity contracts in non-U.S. jurisdictions • Your business team sees Target as a great opportunity for a tax-deferred investment • What questions do you need to look into?

Is Target a CFC? • The “controlled foreign corporation” rules of Subpart F seek to prevent U.S. taxpayers from deferring U.S. tax on certain kinds of movable income, such as dividends, interest, rents and royalties, by earning such income through foreign corporations • If Target is a CFC, certain U.S. owners will be taxed currently on their pro rata share of its “Subpart F income” • If Target is a CFC, U.S. owners may have reporting obligations on Form 5471, potentially annually. • If CFC status is not discovered upfront, the evaluation will need to be made before returns are filed.

What is a CFC? • A foreign corporation is a CFC for a particular year if on any day during such year “U.S. shareholders” own • More than 50% of the total combined voting power of all classes of the corporation’s stock entitled to vote, or • More than 50% of the total value of all classes of the corporation’s stock • For purposes of taking into account insurance income of a CFC, the thresholds are reduced to 25% • What do you know about the other owners of Target? • How is the board appointed? • Does target have a “voting cutback” or other structural arrangement in place to mitigate CFC issues?

Are You a U.S. Shareholder? • A “U.S. shareholder” is a U.S. person who owns 10% or more of the combined voting power of all classes of stock entitled to vote of such foreign corporation • U.S. person means a U.S. citizen/resident, domestic partnership, domestic corporation, or non-foreign trust or estate • How big a stake is your group planning to buy? • Complex attribution rules apply to the 10% test, including attribution to and from corporations, trusts and partnerships • Is anyone related to your buying entity that might acquire a direct or indirect interest in Target? • Increasingly common to see shareholder agreements include contractual representations and restrictions on actual and constructive ownership

Subpart F Income • The Subpart F rules treat a U.S. shareholder of a CFC as if the U.S. shareholder actually received its proportionate share of certain categories of the corporation’s current earnings and profits, whether or not cash is distributed • Income subject to inclusion under this regime includes, among other things, insurance income and foreign base company income • Foreign base company income includes, among other things, dividends, interest, rents, royalties and gains from assets that give rise to such income • Subpart F insurance income includes any income of a CFC attributable to the issuing or reinsuring of any insurance or annuity contract unless the contract qualifies for special “same country” rules. • The rules are exceedingly complex and contain numerous special rules, definitions, exceptions, exclusions and limitations

Related Person Insurance Income • Special rules apply when a foreign corporation earns subpart F insurance income from insurance contracts that directly or indirectly insure a U.S. person who directly or indirectly owns any stock in the corporation (“RPII”) • Also applies where the U.S. owner is related (common control standard) to the insured • If U.S. direct and indirect shareholders own 25% or more of the voting power of the corporation, all U.S. shareholders generally will include their share of RPII in income (no 10% thresholds!) • Significant de minimis exceptions apply, based on ownership and income. Insurers often rely on the exceptions because of the difficulty of determining the relationships between owners and insured parties • Beware affiliate reinsurance arrangements with a controlling U.S. owner

Is Target a PFIC? • The passive foreign investment company (“PFIC”) rules are intended to prevent U.S. taxpayers from deferring tax by holding passive investments through foreign corporations (e.g., investing in non-U.S. mutual funds) • In general, a foreign corporation is treated as a PFIC if: • At least 75 percent of its gross income is “passive income” (such as interest or dividends), or • At least 50 percent of its assets are held for the production of passive income • Do you need to worry about subsidiary PFICs?

Why Does it Matter? • If Target is a PFIC, then distributions from Target, and gain from the disposition of Target stock, are taxed as ordinary income for any U.S. shareholder, and subjected to an interest charge (intended to remove the benefit of tax deferral) • “Once a PFIC, always a PFIC” • These consequences can be avoided by making a Qualified Electing Fund (“QEF”) election • Election causes the U.S. shareholder to be currently taxed on Target’s income and gain • PFIC income is taxed at ordinary rates; long-term gains flow up as such • Losses generated by Target do not flow up to the U.S. shareholder • The rules also impose recordkeeping and reporting obligations

Target Owns a Lot of Stocks and Bonds… • Insurance companies own large amounts of passive assets in order to support their reserves and to maintain required capital levels • The PFIC rules are not intended to pick up legitimate banking and insurance businesses that must hold investment assets • Passive income does not include income derived in the active conduct of an insurance business by a corporation predominantly engaged in an insurance business that would be taxed under Subchapter L if it were a U.S. corporation

Does Target Qualify for the Active Insurance Exception? • To be taxed under Subchapter L, more than half of Target’s business must be issuing insurance or annuity contracts or reinsuring risks underwritten by insurance companies • Case law generally requires gross premium income to exceed investment income • Are Target’s products “insurance or annuity contracts” under U.S. tax principles, or financial products? • Does Target hold financial reserves beyond the reasonable needs of its insurance business? • How many employees does Target have? How do they write business?

Proposed Regulations • On April 23, 2015, the Service published proposed regulations concerning the PFIC status of non-U.S. insurance companies • Intended to curb “Hedge Fund Re” structures • Requires non-U.S. insurers to be actively managed by their own employees and officers • Assets held to meet obligations under insurance contracts treated as nonpassive • The Service requested input on criteria for determining when assets are held under insurance contracts

Hypothetical B US Company • A portfolio investment is made in a foreign corporation without considering whether the FC is a PFIC at the time • Three years later you realize that the FC is a PFIC (“PFIC A”) • You also subsequently realize that PFIC A owns an a portfolio position in another PFIC (“PFIC B”) • What are the relevant PFIC considerations at this point with respect to PFIC A and PFIC B? PFIC A PFIC B

Direct and Indirect PFIC Shareholder Status USCo • USCo treated as both direct shareholder of PFIC A and indirect shareholder of PFIC B, and may recognize PFIC tax consequences with respect to both • If no elections are made, both PFICs are “Section 1291 Funds” subject to the Section 1291 excess distribution regime • Distribution from PFIC B to PFIC A treated as an indirect distribution to USCo • Disposition of PFIC B shares by PFIC A treated as an indirect disposition by USCo • Disposition of PFIC A shares by USCo also results in an indirect disposition of PFIC B shares • Basis of PFIC A shares adjusted to reflect indirect distributions from and dispositions of PFIC B shares • To what extent indirect “hopscotching” PFIC consequences with respect to PFIC B arise in the absence of final regulations? • Excess distribution amounts (including gains treated as an excess distribution) result in a “deferred tax amount” • The sum of aggregate increases of prior year taxes on amounts allocated to such prior PFIC years, and aggregate amount of interest on those increases in tax • Is an addition to tax that generally cannot be offset or otherwise reduced by other tax attributes (e.g., NOLs and tax credits) PFIC A PFIC B

Direct and Indirect PFIC Shareholder Status (Cont’d) • USCo generally required by Section 1298(f) and Reg. 1.1298-1 to report (on Form 8621) ownership of both PFIC A and PFIC B, even if no distributions or dispositions are recognized during the year • Effective for years beginning on or after December 31, 2013 • Failure to report PFIC ownership results in suspense of statute of limitations on entire return under Section 6501(c)(8) • Reasonable cause for failure to report will limit suspended statute of limitations to just PFIC items required to be reported • What about the practical reality that USCo as portfolio shareholder may never know of lower-tier PFICs?

Electing QEF Treatment • QEF elections may be made for PFIC A and PFIC B • Election made by the first U.S. person that is a direct or indirect shareholder in the PFIC (USCo) • PFIC B remains a Sections 1291 Fund if QEF election only made for PFIC A • QEF elections can be made for any year, but must be made on or before the shareholder’s return due date for that year, as extended (even if on amended return) • PFICs A and B will be “unpedigreed QEFs” if election is made in year 3 because of the “once a PFIC, always a PFIC” rule in absence of a “purging election” • Requires PFICs A and B to provide USCo with an annual statement sufficient to let USCo calculate its share of income and gain • Consequences of unpedigreed QEF • Both Section 1291 excess distribution regime and QEF regime applies (with adjustments to basis for QEF inclusions and accounting for distributions of previously taxed E&P (PTI)) • Any gain recognized from the disposition of shares still treated as an excess distribution • Instances in which retroactive QEF elections for year 1 may be made are very limited • Protective QEF election • Qualified shareholder late election • Late election based on IRS consent

Electing QEF Treatment (cont’d) • If retroactive QEF election cannot be made, PFIC taint may be eliminated by a deemed sale “purging election” (Reg. 1.1291-10) • Requires recognizing gain treated as an excess distribution as of the start of year 3 as if USCo disposed of the PFIC shares • Alternative deemed dividend purging election available if PFIC is also a CFC (with respect to other US shareholders) (Reg. 1.1291-9) • Purging election made on an amended return must be filed within three years of the due date of the original return, as extended, for the first QEF year • QEF election in year 3 with a purging election will start new holding period in the PFIC as a “pedigreed QEF” as of the start of year 3 • Pedigreed QEF advantages include • No longer subject to Section 1291 excess distribution • QEF inclusions required only for years in which foreign corporation is a PFIC • Capital gain on sale of PFIC stock • Note, however, QEF inclusions from indirectly held pedigreed QEF (e.g., PFIC B) still hopscotches (with appropriate basis adjustments and PTI distributions taken into account)

Electing Section 1296 Mark-to-Market Treatment • Section 1296 mark-to-market (MTM) election may be made for PFIC A shares if “marketable” • Marketable stock generally includes stock regularly traded on qualified exchange or is redeemable in manner similar to a mutual fund • Gain equals FMV of stock (end of year) less adjusted basis; loss limited to net amount of prior-year MTM gains over losses (“unreversed inclusions”) • Inclusions (and losses to the extent of unreversed inclusions) are ordinary • Section 1296 MTM election must be made with original return (or amended return) filed on or before the return due date, as extended, for first taxable year to which the election applies • If PFIC not a pedigreed QEF prior to Section 1296 MTM election then gain in year of election taxed as an excess distribution (i.e., a toll charge) • However, statute and regulations generally do not allow a Section 1296 MTM to be made to a PFIC indirectly owned through another PFIC (here PFIC B) (see Section 1296(g) and Reg. 1.1296-1(e). • Presumably USCo remains subject to Section 1291 excess distribution regime on an indirect basis with respect to PFIC B even if it makes the Section 1296 MTM election for PFIC A • Compare with Sections 475 and 817 MTM accounting and special Section 1296(e)(2) MTM election for RICs with respect to all PFICs directly and indirectly held

Other Purging Elections USCo • Assume, in the alternative, USCo in year 3 acquires sufficient amount of shares in PFIC A such that PFIC A becomes a CFC and USCo is a section 951(b) US shareholder of the CFC, then • CFC/PFIC overlap rule of Section 1297(d) applies and PFIC A will be treated as a CFC with respect to USCo • However, because of the “once a PFIC, always a PFIC” rule USCo may make a purging election for year 3 under Reg. 1.1297-3 to purge the PFIC taint from the CFC • CFC, in turn, may make a Section 1296 MTM election with respect PFIC B to the extent “marketable” and subsequent MTM gains will be taxed to USCo under subpart F (Reg. 1.1296-1(g)(2)) • Otherwise proposed regulations provide that USCo remains an indirect PFIC shareholder of PFIC B and subject to the PFIC regime with respect to PFIC B on a hop-scotch basis (Prop. Reg. 1.1291-3(f)(3) and -3(e)(4)(ii)) • Assume also in year 3 that PFIC B ceases to be a PFIC under the PFIC income and asset tests • Nonetheless PFIC B remains a PFIC in those subsequent years because of the “once a PFIC, always a PFIC” rule • USCo may make a purging election for year 3 under Reg. 1.1298-3 to cleanse PFIC B of the PFIC taint CFC Former PFIC

Variable life insurance and annuity contracts – PFIC considerations • Section 817 mark-to-market accounting • Policyholders of variable insurance and annuity contracts may be treated as owners of underlying investment assets to the extent investor control is not limited (Sections 7702, 72, and 817) • Policyholders may find themselves owning PFICs in such instances to the extent investment assets underlying those policies include PFICs • Note that life insurance and annuity contracts issued by a CFC are determined under Section 953(e)(5) without regard to the requirements of Sections 7702, 72(s), 101(f), and 817(h) so long as the contract is • regulated as a life insurance or annuity contract by the CFC’s home country; and • no policyholder (or beneficiary) of the contract is a U.S. person

International Tax Primer CFCs and PFICs, Currently and Prospectively