Use of Insurance Companies / Hedge Funds

Notice 2003-34 (167 KB) Issued June 9, 2003:

This notice involves the use of offshore insurance companies organized for the purpose of sheltering passive investment income over the life of the company. The shareholder of the offshore insurance company then disposes of the stock in a transaction that qualifies for capital gains treatment. The insurance written by these companies frequently contains unrealistic policy limitations and the investment income generally far exceeds the amount of premiums received from insurance contracts. In this notice the IRS has indicated that it intends to attack these types of transactions in one of three ways. 

Option 1 Definition of Insurance: The Service will argue that the insurance written by the insurance company does not meet the definition of insurance as established by the courts. This is the traditional attack based on the premise that bona-fide insurance contracts must shift and distribute risk from the insured to the insurer and that the insurer must distribute the risk amongst potential claimants. 

Option 2 Status as Insurance Company: Based on the premise that a taxpayer taxed as an insurance company must use its capital and efforts primarily in earning income from the issuance of insurance contracts.The income tax regulations provide that a company will qualify as an insurance company only if more than half of its business is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. 

When asserting this challenge, the IRS will look to all of the relevant facts and circumstances for making the determination of whether an entity qualifies as an insurance company. Items taken into consideration in this assessment may include the size and activities of the insurance company’s staff, whether it engages in other trades or businesses, and its sources of income. 

Option 3 Possible Tax Treatment of Stakeholder’s Interest in Foreign Corporation: The IRS will look for ways to categorize the income earned by the foreign corporation as passive investment income subject to U.S. income tax. This method depends upon the Service’s ability to show that the foreign corporation is not involved in the active conduct of an insurance business.