Emerging Issues in

Insurance Dedicated Funds

Friday September 30, 2016

ABA Tax Section Joint Fall Meeting
Insurance Companies

Moderator:
Ann Cammack, EY, Washington, DC

Panelists:
Mark Rush, MassMutual, Springfield, MA
Susan Seabrook, Buchanan Ingersoll, Washington, DC 1
 Introduction
Use of variable products, both life and annuity, in private
placement products continues to grow.
Private Equity firms are looking for products that defer tax in
current earnings.
Investors are looking for income deferral options as well as
FIRPTA and UBIT blocker options.
Investment options for purchasers of variable products are
also expanding.
Hedge funds and other asset management and investment firms
are looking to expand their unique investment strategies into
the insurance dedicated fund market place.
Insurance companies are looking to expand investment options
beyond traditional mutual fund and real estate partnership
investment options.
 Introduction
Successfully navigating the Section 817(h)
diversification and investor control rules is key
to the successful expansion of this industry.
This panel will:
Review the diversification and investor control
rules.
Discuss the application of these rules in the
context to todays transactions.
 Section 817(h) Diversification
Requirements
Enacted in 1984, section 817(h) requires the
investments supporting a variable contract to
be adequately diversified.
5 investment test must be met.
Tested quarterly with 30 days to self-correct if a
failure is found.
IRS procedures exist to correct inadvertent
diversification failures discovered after the self-
correction period. Rev. Proc 2008-41.
 Section 817(h) Diversification
Requirements
Consequences: A variable contract is not treated
as an annuity, endowment, or life insurance
contract for purposes of 72 and 7702, unless
the investments made by the segregated asset
account underlying the contract are adequately
diversified in accordance with regulations
prescribed by the Secretary.

Safe harbor rules under 817(h)(2), (h)(3), and

(h)(5).
 Section 817(h) Diversification
Requirements
Diversification tested at the asset, or investment, level unless look-through
rules are satisfied.
Taxpayers may look through investments in partnerships, RIC and trusts, to
the underlying assets of that investment if the interests in the asset are
held by certain investors only and not available for purchase by the public.
The regulations, section 1.817-5(f) set for the these rules.
The so-called permitted holders include purchasers of variable contracts,
general accounts of life insurance companies, certain qualified plans, and fund
managers.
The regulations require a pro rata allocation of earnings based on interests
held in the investment to limit carried interest allocations by fund managers.
According to the Conference Report, the fact that a similar fund is
available to the general public does not in itself cause a fund underlying a
segregated asset account to be treated as publicly available.
Private letter rulings issued by the Service indicate that clone funds can be
treated as not publicly available because the cash flows are different from the
public fund and, thus, alter the performance of the fund.
 Investor Control Doctrine
Over the past 40 years, the IRS and Treasury Department
have developed the Investor Control Doctrine to
determine when a purchaser of a life insurance or annuity
contract should be treated as the owner of the assets
supporting that contract, resulting in current tax to the
policyholder.

Unlike the diversification regulations, which set out a relatively

mechanical test, the investor control doctrine is an analysis of all
fact and circumstances surrounding a transaction.

Once an investor control violation occurs there is no way to

correct the transaction to bring it back into compliance.
 Investor Control Doctrine
The Investor Control Doctrine seeks to determine
which party to the transaction is the substantive
owner of the assets supporting the contract.
If deferral is premised on risk of forfeiture and
ownership of the assets by the insurance company,
and not the policyholder, then substantive ownership
by the policyholder should negate deferral.
The IRS and Treasury guidance, along with judicial
precedent, look to the long line of cases that consider
when an owner is exercising control and holds the
benefits of burdens of asset ownership.
 Investor Control Doctrine
The most recent published guidance to address
investor control is Rev. Rul. 2003-91 and Rev. Rul.
2003-92.
Rev. Rul. 2003-91 states that all the facts and
circumstance must be taken into account in making
the analysis.
Facts such as the ability to select investment managers,
discuss investment performance, select assets for
investment, among others, are to be considered.
Rev. Rul. 2003-92 reiterates that the assets supporting
a variable control may not be available to the public.
 Investor Control Doctrine
The US Tax Court, in Jeffrey T. Webber v.
Commissioner, 144 T.C. 324 (2015), concluded
that the Investor Control Doctrine, as set forth in
guidance, in particular 2003-91, is valid and
applies to deny deferral if the policyholder
exercises too much control over the investments
supporting the contract.
The court gave Skidmore deference to 2003-91 as an
articulation of 40 years of development of the
doctrine.
The court also concluded that section 817(h) did not
overrule or supplant the Investor Control Doctrine.
 Emerging Issues
Which party for the transaction is responsible for
ensuring compliance?
Insurance companies often require 3-party fund
managers to monitor diversification compliance.
Some companies are requiring fund managers to also
monitor investor control compliance, especially if the
investment offering is novel.
Intermediaries that manage and broker insurance
dedicated funds to insurance companies offer some
compliance assistance but fund managers and
insurance companies need to be mindful of what
services are provided.
 Emerging Issues
Can insurance companies offer investments other than
the RICs and partnerships traditionally offered and
meet the tax rules?
Definitely yes. The IRS and Treasury are not concerned
with qualitative judgments about investment options.
One significant question is whether new investment
options need to meet look-through to satisfy
diversification.
For example, what if fees paid to a fund manager are not based
solely on a pro-rata allocation of investment returns?
Similarly, any new investment option would need to meet
investor control.
 Emerging Issues
What considerations arise for hedge funds and other
alternative investment vehicles that seek to create
Insurance Dedicated Funds (IDF)?
While the diversification rules are fairly mechanical, the
method of compensation, in particular, a fund managers
carry, may raise significant compliance issues.
Often asset management firms seek to clone existing funds
and consideration must be given to whether the fund can
be sufficiently differentiated from the original fund.
Often, the biggest hurdle is satisfying the investor control
doctrine as many asset managers are hoping to have
existing clients invest in the new IDF.
 Emerging Issues
Does the size of the investment firm offering
an IDF option matter?
Many firms with a boutique client base are
considering establishing IDFs that would be
available to existing clients as well as new clients.
Applying a 2003-91 factual analysis there would
be significant questions about whether a smaller
firm could demonstrate that no investor control
violation occurred if a current client invests in the
insurance dedicated clone fund.
 Emerging Issues
Do life insurance or annuity contracts effective block FIRPTA
or UBIT?
Many so-called blocker transactions raise both investor control
and diversification concerns that must be addressed.
In addition, questions may arise about whether other provisions
governing the taxation of life insurance products are satisfied.
For example, deferred variable annuities need to meet section 72(s)
and 72(u), and a deferred variable annuity issued to a non-profit or a
sovereign wealth fund may not satisfy section 72(u).
The section 72(s) distribution rules need to be met and the
unexpected death of the holder, or the designated holder, may
unfavorably impact the economics of the transaction, particularly real
estate investments, which are generally long-term.
Split-dollar and COLI rules may be implicated in transactions involving
an employer seeking a way to defer earnings and must be considered
before entering into a transaction.
 REG-123600-16
Defining Securities
Proposed regulations published 09/28/2016
relating to the RIC income test and asset
diversification requirements.
Treasury and the IRS have addressed whether certain
instruments or positions are securities for purposes of
section 851.
By 2010, the IRS was devoting substantial resources to
PLR requests on point.
Proposed regulations state it is not clear whether Congress
intended to allow RICs to invest in securities that provide
commodity exposure.
In July 2011, the IRS notified taxpayers that the IRS would no
longer issue PLRs on point.
 REG-123600-16
Defining Securities
The RIC income test and asset diversification
requirements both use the term securities.
For the income test, security is defined by
reference to section 2(a)(36) of the 1940 Act.
For the asset diversification requirements, no
definition is provided for security.
Section 851(b)(6) provides that the terms used in
section 851(b)(3) and (c) have the same meaning as
when used in the 1940 Act.
 REG-123600-16
Defining Securities
Thus, the determination of whether certain
investments that provide RICs with commodity
exposure are securities for purposes of the
income test and for the asset diversification
requirements requires IRS to implicitly
determine what is a security within the meaning
of the 1940 Act.
Section 38 of the 1940 Act grants exclusive rulemaking
authority under the 1940 Act to the SEC.
Any future guidance as to whether particular financial
instruments are securities for purposes of the 1940 is
therefore within the jurisdiction of the SEC.
 REG-123600-16
Defining Securities
The Treasury Department and the IRS have:
Reviewed the issues,
Considered the concerns expressed, and
Considered resource constraints.
As a result, the IRS determined it should no
longer issue PLRs on questions relating RIC
treatment that require a determination of
whether a financial instrument or position is a
security under the 1940 Act.
 REG-123600-16
Defining Securities
Contemporaneously with the publication of the
proposed regulations, the Treasury Department and
the IRS issued Rev. Proc. 2016-50.
Rev. Proc. 2016-50 provides that the IRS ordinarily will not
issue rulings or determination letters on any issue relating
to the treatment of a corporation as a RIC that requires a
determination of whether a financial instrument or
position is a security under the 1940 Act.
Comments requested as to whether previously-issued
guidance that involves determinations of whether a
financial instrument or position held by a RIC is a security
under the 1940 Act should be withdrawn effective as of
the date of publication of final regulations.
 REG-123600-16
Inclusions Under 951(a)(1)(A)(i) or 1293(a)
In certain circumstances, a U.S. person may be required under
section 951(a)(1)(A)(i) or 1293(a) to include in taxable income
certain earnings of a foreign corporation in which the U.S. person
holds an interest, without regard to whether there is actually a
corresponding distribution to the U.S. person.
Section 851(b) was amended by the Tax Reduction Act of 1975 for
inclusions under section 951(a)(1)(A)(i)
Section 851(b) was amended by the Tax Reform Act of 1986 for
inclusions under section 1293(a).
The language in both amendments provides that there shall be treated
as dividends amounts included in gross income to the extent that
there is a distribution out of E&P.
The significance of treating an inclusion as a dividend under section
851 is that a dividend is qualifying income under section 851(b)(2).
 REG-123600-16
Inclusions Under 951(a)(1)(A)(i) or 1293(a)
The amendments to section 851(b) made by the 1975 Act and the 1986
Act unambiguously condition dividend treatment of an inclusion under
section 951(a)(1)(A)(i) or 1293(a) on a distribution from the foreign
corporations E&P attributable to the amount included.
Absent a distribution, there is no support in the Code for treating an inclusion
under section 951(a)(1)(A)(i) or 1293(a) as a dividend under section 851.
Notwithstanding the distribution required by section 851(b), the IRS issued
letter rulings under section 851(b)(2) that permit an inclusion under section
951(a)(1)(A)(i) or 1293(a) to qualify as other income even in the absence of
a distribution.
The proposed regulations specify that:
An inclusion under section 951(a)(1)(A)(i) or 1293(a) is treated as a dividend
for purposes of section 851(b)(2) only to the extent that the distribution
requirement in section 851(b) is met.
For purposes of section 851(b)(2), an inclusion under section 951(a)(1) or
1293(a) does not qualify as other income derived with respect to a RICs
business of investing in stock, securities, or currencies.
 Broader Implications
Section 1.817-5(h)(10) of the regulations generally provides that all
terms used in that section have the same meaning as when used in
section 851.

Section 851(c) provides that all terms not defined in the subsection
shall have the same meaning as when used in the Investment
Company Act of 1940, as amended.

Query whether given the explicitly stated lack of authority to

promulgate guidance interpreting undefined 1940 Act terms, the
IRS lacks the authority to challenge a taxpayers own interpretation
of undefined terms, particularly where the interpretation is
consistent with SEC interpretations of the term.