April 7, 2016 - Haoshen Zhong

Life insurance contracts investing in PFICs

Greetings from Haoshen Zhong.

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Do I report PFICs held in my life insurance policy?

This week’s newsletter topic came by way of a reader I will refer to as Morgan:

In France, the Assurance Vie (life insurance) acts as a tax deferred savings account and is the preferred investment for French residents. The tax practitioners here in France do not have a clear understanding as to whether their US citizen, French resident clients need to report their life insurance investments as PFICs.

I will assume that France has a set of laws governing life insurance that define what life insurance means under French law, and that the taxpayer’s life insurance satisfies the French definition.

Morgan’s question requires us to answer 2 separate questions:

  1. Is the life insurance itself a PFIC?
  2. Does the taxpayer look through the life insurance to report the underlying investments?

PFIC definition

Internal Revenue Code section 1297(a) defines a passive foreign investment company (PFIC) as “any foreign corporation if [it meets an income test or an asset test]”. IRC §1297(a).

To own a PFIC, a taxpayer must first own shares in a foreign corporation. If what the taxpayer owns is not shares of a foreign corporation, then he does not own a PFIC.

But the fact that the policy is life insurance under foreign law is not the end of the story. Treasury Regulation tells us:

The Internal Revenue Code prescribes the classification of various organizations for federal tax purposes. Whether an organization is an entity separate from its owners for federal tax purposes is a matter of federal law and does not depend on whether the organization is recognized as an entity under local law. Reg. §301.7701-1(a)(1).

In short, we need to check what the policy is under US tax law. If it is a corporation under US tax law, then it could be a PFIC.

The foreign life insurance is life insurance under US tax law

Code section 7702(a) gives the tax law definition of a life insurance. The definition looks scary, and it is scary if you are not an insurance actuary. You can ignore that definition, because Code section 7702(g)(3) tells us the following:

If any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance contract under subsection (a), such contract shall, notwithstanding such failure, be treated as an insurance contract for purposes of this title. IRC §7702(g)(3).

This tells us that as long as the policy is life insurance under foreign or State law, it is life insurance under US tax law. In fact, the only consequence of failing the definition of life insurance is that the taxpayer may need to pay tax on income from the policy each year. IRC §7702(g)(1).

We assumed Morgan’s policy is life insurance under French law. Hence, we can conclude that the policy is life insurance under US tax law.

The life insurance is not a PFIC

A corporation is a type of business entity, and a business entity is an entity that is “not otherwise subject to special treatment”. Reg. §301.7701-2(a).

A life insurance policy is probably not an entity under US tax law. But even if it is an entity, it would not be a business entity. Code section 7702 lays out what life insurance means and provides special treatment for life insurance. Thus, life insurance is “otherwise subject to special treatment” and therefore not a business entity.

The policy is not a business entity–and therefore not a foreign corporation. The policy itself cannot be a PFIC.

No lookthrough to underlying PFICs

The Internal Revenue Code contains attribution rules. These rules generally say that even if a taxpayer is not the owner of an asset under local law, US tax law would still treat the taxpayer as the owner of the asset. Under attribution rules, it is possible for a taxpayer to be the owner of a PFIC under US tax law.

No attribution from life insurance under PFIC-specific attribution rules

Section 1298(a) gives us attribution rules specifically for PFICs. These include attribution through corporations, partnerships, estates, trusts, and options. IRC §1298(a). These do not include life insurance, and the implementing Regulations do not mention life insurance. See Reg. §1.1298-1T. The PFIC attribution rules do not directly require attribution through life insurance.

The life insurance should not be treated as a securities account

One argument for attribution is that these policies should be treated as securities accounts. These policies differ from securities accounts in 3 ways:

  1. They do not give the investor direct access to the underlying investments.
  2. They are specifically classified as life insurance under US tax law.
  3. They transform income from investments into ordinary income, even if the underlying investments would have returned long-term capital gains or qualified dividends.

These differences suggest that these policies should be treated differently than accounts. The taxpayer should not look through to the underlying investments merely because securities account holders look through the accounts.

No importation of constructive ownership rules

Another argument argument is that PFIC rules import constructive ownership under section 318. These are generic attribution rules for corporations that the Code and the Regulations generously import into other rules related to corporations.

Section 318, by its own terms, applies to “this subchapter”, meaning sections 301 to 391 of the Internal Revenue Code. PFIC rules are in sections 1291 to 1298. By section 318’s own terms, its constructive ownership rules do not apply to PFICs.

Neither Congress nor the IRS is shy about directly referencing constructive ownership or section 318 when it wishes to import constructive ownership rules. See e.g. IRC §958(b); Reg. §§1.6038-2(c), 1.6046-1(i). By contrast, none of the PFIC rules reference constructive ownership or section 318. IRC §1298(a); Reg. §1.1298-1T. Our conclusion is that the PFIC attribution rules do not import the section 318 ownership rules. The IRS more or less said as much:

When Congress intends constructive ownership rules to apply, it will expressly so state. TAM 200733024.

We can be reasonably confident that the taxpayer does not have to look through his life insurance to any underlying PFICs.

No need to report PFICs held in life insurance

The policy itself is not a PFIC, because it is not a foreign corporation.

The taxpayer does not need to look through the policy, because there is no attribution through life insurance under PFIC attribution rules.

The taxpayer whose life insurance invests in PFICs is safe from PFIC reporting and tax rules, provided that the policy is life insurance under foreign law.

Update:  Is the foreign life insurance really the foreign equivalent of US life insurance?

I have received some feedback on how assurance vie works, specifically that it is not analogous to the US life insurance.

This is directed to what life insurance means in the US outside the context of tax.  And insurance requires “risk shifting” and “risk distribution”.  These concepts are explained most in depth in relation to captive insurance rather than life insurance (see Rev. Rul. 2002-89, 90, 91).  Life insurance simply means that the insurance insures the risk of death.

The feedback indicates that assurance vie does not insure the risk of death at all:  Its payout is tied strictly to the performance of its investment.

Which means the assurance vie would not be a life insurance under US tax law.  But it is important to note that the reason it fails is because it does not insure the risk of death.  The fact that it has investment features is not determinative.

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