December 15, 2016 - Haoshen Zhong

PFIC Wrapper Miniseries #3: Products That Sound Like Life Insurance

PFIC wrapped in a continental life insurance

This week’s topic is the third of a series of posts that will talk about how various “wrappers” affect the US taxation of PFICs. The last post discussed participating life insurance I have seen in China and Southeast Asia.

This post discusses a few types of financial products that sound like they are life insurance but may in fact be something else. It is inspired by the French assurance vie and a life assurance product I have seen in the Isle of Man.

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 policy works

In this type of policy, the policyholder pays a premium. The premium is used to buy investments. In the country of issue, the income from the investment is tax-deferred until the policyholder cashes out the policy.

If the policyholder holds the policy until death, then the cash value of the investments is paid to the policyholder’s heirs–possibly tax-free in the country of issue.

They are probably not insurance

These policies are not like the US concept of insurance at all.

There is a robust cottage industry in the US creating captive insurance companies–where an operating business creates a subsidiary for the purpose of issuing insurance with good terms to the parent. In response, the IRS and the courts have had many opportunities to describe what insurance means in the US context.

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 policies like the assurance vie and the life assurance, there is no risk shifting of any kind: The policyholder is simply entitled to the value of the investment (minus taxes and fees). It is almost certain that these policies are not insurance policies under the US concept.

They are not life insurance under 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).

To be life insurance, the policy must first be a life insurance contract “under applicable law”, but 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.

But it is unlikely that the US would recognize the policy as life insurance merely because the words used in the country of issue are “life insurance”, words that directly translate to life insurance, or a similar term. Most likely, another requirement is that the foreign law’s definition of life insurance must correspond to the general US concept of life insurance.

We have already seen that this type of life insurance does not correspond to the US concept of insurance at all. They are probably not life insurance under applicable law. Hence, they are not life insurance under tax law.

They are probably just plain investment accounts

What is really happening with these policies is this: You put cash into an account, and that cash is used to buy investments. You can cash out the investments, though the cash-out may be subject to more restrictions than a normal investment account.

There are some provisions in the Code for wrappers for investment accounts that convert the investment into some other type of income, for example variable annuities, pensions, IRAs, and certain life insurance policies that fail the actuarial tests for life insurance. See e.g. IRC §§72, 402(b), 408, 7702(g). But I do not believe any of the exceptions apply to these types of products.

The most likely result is that this policy is a simple securities account under US tax law. The policyholder is the owner of the PFICs held in the policy, and the policyholder is taxed directly.

Thank you

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