December 1, 2016 - Haoshen Zhong

PFIC Wrapper Miniseries #2: Participating Life Insurance

This week’s topic is the second of a series of posts that will talk about how various “wrappers” affect the US taxation of PFICs. The last post discussed Canadian RESP.

This post discusses a participating life insurance policy I have seen in China and Southeast Asia. It is called a participating life insurance because the policy contains a cash value that is tied to returns on investments made using the premiums–in this way, the policyholder “participates” in the profits from the investments.

This post discusses the implications of this type of life insurance wrapper around a PFIC.

PFIC defined

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

  1. Income test: At least 75% of the corporation’s gross income is passive income.
  2. Asset test: At least 50% of the corporation’s assets are passive assets.

Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad. It would be useful if the life insurance wrapper could cut off PFIC tax liability.

How this type of participating life insurance works

This type of life insurance is called a participating life insurance, in that the policy owner participates in the profits of the investments that the insurance company makes. The life insurance contains a death benefit component and an investment component.

The death benefit component functions like a normal life insurance: When the insured person dies, the policy beneficiary receives a death benefit. The death benefit is typically the greater of the cash surrender value of the policy or a sum specified in the policy.

The investment component contains a cash surrender value. If the policy owner surrenders the policy before the insured dies, the policy owner (or a specified beneficiary) receives the cash surrender value. Unlike US policies, these policies only specify a net surrender value. They do not specify the surrender charges.

Most commonly, the policy owner pays high premiums for the first 5 years, during which the cash surrender value is low. At the end of the 5 year period, the cash surrender value becomes slightly less than the total premiums paid. At this time, the policy owner stops paying premiums out of pocket, and future premiums are deducted from the cash surrender value. Each year, earnings from investments that the life insurance company makes is credited to to the cash surrender value of the policy–minus fees and premiums.

Generally, these plans will describe the expected cash surrender values of the policy, depending on the level of initial premium payments and the age of the insured. These are not policy values guarantees. They merely reflect the typical growth of the cash surrender value.

Insurance cuts off PFIC liability

One question that you might ask is, “Is this a life insurance policy under US tax law?” This question is important in the context of PFICs because of lookthrough rules.

Section 1298(a) specifies the conditions under which PFIC ownership can be attributed to a US person, even when the US person does not own the PFIC directly. They can be attributed through corporations, partnerships, estates, trusts, or options. IRC §1298(a)(2), (3), (4). There is no rule for attributing PFICs through an insurance policy.

Similarly, section 1298(a) does not import any attribution rules. For example, section 1298(a) does not contain any reference section 267 (related party rules) or section 318 (constructive ownership of stock), so it does not import those attribution rules.

We can say that section 1298(a) and the underlying regulations form a closed set of attribution rules. Under the special rules applicable to PFICs, there is no attribution through an insurance policy.

Having determined that there is no special rule for PFICs that causes a PFIC to be attributed to a policyholder of an insurance policy, we still need to look at the normal rules of indirect ownership. For example, suppose we have merely a normal stock in this type of life insurance policy; would the policyholder be considered an indirect owner of that normal stock?

For this answer, we turn to the rules that normally apply to life insurance policies.

Is this life insurance policy a life insurance policy under US tax law?

Code section 7702(a) defines a life insurance contract as:

[A]ny contract which is a life insurance contract under the applicable law, but only if such contract [(1) meets the cash value accumulation test or (2) meets the guideline premium requirements and falls within the cash value corridor]. IRC §7702(a).

There are in fact 2 requirements:

    1. It must be a life insurance contract under “the applicable law”


  1. It must satisfy 1 of 2 sets of tests based on actuarial calculations described in section 7702(a).

We only care if the insurance policy is a life insurance policy under applicable law

Before we delve into any actuarial tests, let us see what happens if the policy fails both sets of actuarial tests. In fact, Congress told us what happens:

If at any time any contract which is a life insurance contract under the applicable law does not meet the definition of life insurance under subsection (a), the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during such year. IRC §7702(g)(1)(A).

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).

If the policy fails both tests, these are the consequences:

  • The policy is an insurance policy other than life insurance, so it does not benefit from special life insurance provisions (like the death benefits being excluded from income); and
  • The policyholder must recognize the growth in the cash value of the policy (presumably attributed to income from the policy) as ordinary income.

Failing both sets of actuarial tests does not convert the policy into an ordinary investment account. In fact, the tax consequences say the exact opposite, because section 7702(g) converts the income of the policy to ordinary income–there is no passthrough of income.

If all we cared about is whether the policyholder must look through the policy to underlying PFICs, then we do not care about the 2 sets of actuarial tests. Once we have determined that the policy is a life insurance contract “under applicable law”, we know that the policyholder does not need to look through the policy (though he can have a number of other problems).

The policy is a life insurance contract under the applicable law

Neither the Code nor the regulations define what “the applicable law” means.

One possibility is that it is a life insurance contract under the foreign law that governs the contract. Let us assume that the policy in question satisfies the definition of a life insurance contract as defined under the foreign law that governs the contract.

Another requirement that can arise is that the foreign law’s definition of life insurance must correspond to the US concept of life insurance–though not necessarily the section 7702 definition. This issue arises mostly in the context of captive insurance companies–an arrangement where a parent company creates a subsidiary for the purpose of insuring the parent company–, where the captive might offer “insurance” that is not insurance under the ordinary understanding of insurance in the US.

The IRS summarized the meaning of insurance under the US understanding in Revenue Ruling 2005-40. An insurance arrangement must contain 2 elements:

  1. There must be a shift of risk of financial loss from a fortuitous event from the insured to the insurance company; and
  2. The insurance company must distribute its risk of loss by acquiring a sufficiently large pool of insured, so each insured person is not simply paying for the risk directly.

In our scenario, there is a shift of risk of financial loss: Suppose the insured buys the policy at age 30 and dies at age 36, the death benefit is the same as if he died at age 100. The fortuitous event is the death of the insured at an early age, and the risk of loss from an early death has been shifted from the insured to the insurance company.

In our scenario, there is most likely a distribution of risk: The insurance company sells the same type of policy to a large pool of buyers, so the risk of financial loss from an early death is distributed among the large pool of insured: Some might die at an age where the death benefit is more than premiums and earnings, and some might die after premiums and earnings total more than death benefits.

These participating life insurance policies generally correspond to the US idea of life insurance–they just add an investment company. They should be life insurance contracts under “the applicable law”.

No PFIC lookthrough

We know that there is no special PFIC rule that requires the policyholder to look through an insurance policy, and we know that under normal rules, an insurance policy of a type similar to this type of participating life insurance does not require a policyholder to look through to the underlying investments. The policyholder should not need to look through the policy.

Thank you

Disclaimer: This post is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.