Permanent Subpart F Exemption Proposed, Certain Unresolved Issues Remain

By Christopher Ocasal, Esq., Michael Miles, Esq., and Carol P. Tello, Esq. Sutherland Asbill & Brennan LLP, Washington, DC

Introduction of H.R. 1944

On April 2, 2009, Congressmen Richard Neal (D-Mass) and Pat Tiberi (R-Ohio) introduced H.R. 1944, which would permanently extend the Subpart F exemption for “active financing income.” (The active financing provisions allow certain active income from overseas business operations of financial services companies to be exempt from current U.S. taxation.) Insofar as insurance income is concerned, §1(b) of the bill would repeal §953(e)(10) of the U.S. Internal Revenue Code.

Section 953(e)(10) currently provides for the temporary application of §§953(e) and 954(i) (and indirectly the flush language in §954(e)) (“the Insurance Active Financing Provisions”) to certain controlled foreign corporations (CFCs) engaged in the business of insurance. The Insurance Active Financing Provisions were first enacted by the Tax and Trade Relief Extension Act of 1998 (TTREA) for taxable years beginning only during the calendar year 1999. These temporary provisions have been extended repeatedly over the last ten years: by the Tax Relief Extension Act of 1999, for two additional taxable years; by the Job Creation and Worker Assistance Act of 2002, for five additional taxable years; by the Tax Increase Prevention and Reconciliation Act of 2005, for two additional taxable years; and, finally, by the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, for one additional taxable year. The provisions currently are set to expire with respect to taxable years of foreign corporations beginning after December 31, 2009.

The repeal of §953(e)(10) would make §§953(e) and 954(i) permanent fixtures of the Code. (Note that President Obama's proposed 2010 budget plans to extend these provisions for only one additional taxable year.)

When §§953 and 954(i) were enacted by TTREA, several other Subpart F provisions, and one U.S. foreign tax credit provision, were not updated to take into account the new statutory framework, creating uncertainty about the proper application of those provisions. These provisions also should be addressed by any legislation attempting to make §§953(e) and 954(i) permanent.

Current §953(e)

For taxable years beginning after December 31, 1998 and before January 1, 2010, §953(a)(2) excludes from the definition of Subpart F insurance income any “exempt insurance income” (“EII”) as defined under §953(e). EII is defined as income derived by a “qualifying insurance company” (“QIC”) that: (1) is attributable to the issuing (or reinsuring) of an “exempt contract” (“Exempt Contract”) by such a company or by a “qualifying insurance company branch” (“QIC Branch”) of such a company; and (2) is treated as earned by such company or branch in its home country for purposes of such country's tax laws.

For an insurance or reinsurance contract of a QIC or a QIC Branch to qualify as an Exempt Contract, the contract must insure only non-U.S. risks and more than 30% of the QIC's or the QIC Branch's net written premiums must be attributable to unrelated “same-country” risks. If the contract insures risks other than “same-country” risks, the QIC or QIC Branch must conduct substantial activities in its place of organization/operation.

For a CFC to qualify as a QIC, the corporation must: (1) be subject to insurance regulations in its country of organization; (2) have more than 50% of its net written premiums (including premiums received by all branches of the QIC) attributable to unrelated “same-country” risks; (3) be engaged in the insurance business; and (4) be a corporation that would be subject to tax under Subchapter L of the Code if it were a U.S. corporation. For a branch to qualify as a QIC Branch, the branch must be: (1) a “qualified business unit” within the meaning of §989(a); (2) subject to insurance regulations in its country of operation; and (3) a branch of a QIC.

Current §954(i)

Section 954(i) provides that the “foreign personal holding company income” (“FPHCI”) of a CFC does not include “qualified insurance income” (“QII”) of a QIC. QII means income of a QIC equal to the sum of two amounts: (1) the unrelated investment income attributable to Exempt Contracts; and (2) the unrelated investment income attributable to a portion of its required surplus. (These two amounts parallel two former exceptions to §954(c): former §954(c)(3)(B) and (C).)

The first permitted amount of QII is investment income received by a QIC or a QIC Branch from unrelated persons on its reserves allocable to Exempt Contracts or, in the case of a property and casualty insurance business, on 80% of its unearned premiums from Exempt Contracts.

The second permitted amount of QII is investment income received from unrelated persons by a QIC or QIC Branch and derived from investments made by the QIC or QIC Branch of an amount of its assets allocable to Exempt Contracts equal to: (1) in the case of property, casualty, or health insurance contracts, one-third of its premiums earned on such insurance contracts during the taxable year; and (2) in the case of life insurance or annuity contracts, 10% of the life insurance reserves for such contracts. The House Report under TTREA provided that in no case does this exception apply to investment income with respect to “excess surplus.”

Reversion to Pre-1999 Code

In the event that H.R. 1944 does not become law and the Code provisions are not otherwise extended, §953(e) and §954(i) would expire for taxable years of foreign corporations beginning after December 31, 2009. Upon such expiration, the pre-1999 version of §953(a) again would contain the relevant exception to the inclusion of insurance income (as broadly defined) in Subpart F income. This pre-1999 version generally provides that only underwriting income attributable to risks located in the country of incorporation of the CFC is exempt from treatment as Subpart F income. There would be no specific Subpart F exceptions excluding any investment income (other than that attributable to “same-country” underwriting income) of an offshore insurance business. While other Subpart F exceptions or limits might apply (for example, the high-tax exception or the current earnings and profits limitation), the expiration of §§953(e) and 954(i) would increase significantly the amount of offshore insurance (underwriting and investment) income reported by U.S. corporations as Subpart F income.

Unresolved Cross-References

With the enactment of §953, and the corresponding changes to §953(a), several other Subpart F provisions in the Code were not updated to take into account the new statutory framework, creating uncertainty about the proper application of those provisions. Consequently, five provisions should be amended in conjunction with any permanent change to §§953 and 954(i): (1) §952(c)(1)(B)(vii) (certain losses attributable to the former “same-country” exception that can be treated as Subpart F losses); (2) §953(c)(3)(B) (20% gross income “related person insurance income” exception that “turns off” the former “same-country” exception); (3) §956(c)(2)(E) (an exception from a §956 inclusion for an amount equal to reserves relating to the former “same-country” exception); (4) §957(b) (definition of certain foreign insurance companies treated as CFCs); and (5) §964(d) (permitting certain QIC Branches to be treated as separate CFCs for purposes of benefiting from the exempt insurance company exception). Additionally, outside of the Subpart F regime, §904(d)(2)(D)(ii)(III) should be amended to clarify the definition of “financial services income” for U.S. foreign tax credit purposes.


A prior year's deficit in earnings and profits (E&P) may limit the amount of current Subpart F income of a “United States shareholder” of a CFC (“U.S. Shareholder”) if such deficit is a “qualified deficit.” A “qualified deficit” reduces the amount of Subpart F income taken into account by the U.S. Shareholder, but only to the extent of the U.S. Shareholder's pro rata share of such deficit. A “qualified deficit” means any deficit in E&P, not previously taken into account under §952(c)(1)(B), for any prior taxable year beginning after December 31, 1986, of a corporation that was a CFC in the year the deficit arose, provided that such deficit was attributable to the same “qualified activity” as the activity giving rise to the income being offset.

A “qualified activity” means, in the case of a “qualified insurance company” (as defined under §952(c)(1)(B)(v)) (“§952 QIC”), any activity giving rise to Subpart F insurance income or §954(c) FPHCI. Thus, Subpart F inclusions of either Subpart F insurance income or FPHCI of a §952 QIC are eligible for reduction by post-1986 deficits.

Deficits in “same-country” underwriting income that arose in a taxable year beginning before December 31, 1998, or after December 31, 2010 (assuming H.R. 1944 or a similar bill is not enacted), are not eligible to reduce Subpart F inclusions in later years for Subpart F purposes. Nevertheless, §952(c)(1)(B)(vii)(I) allowed a U.S. Shareholder of an insurance company CFC to elect for all U.S. tax purposes to have former §953(a)(1)(A) apply without regard to the “same-country” exception. Thus, in part, this election permitted deficits attributable to “same-country” activities of a §952 QIC to offset its future Subpart F insurance income and FPHCI. (Further, it also permitted a U.S. Shareholder to generally elect not to defer Subpart F insurance income for all U.S. tax purposes.) Once made, this election could only be revoked with the consent of the Secretary. In the case of an affiliated group of corporations, no election could be made under §953(c)(1)(B)(vii)(I) unless all CFCs who were members of such group and were organized under the laws of the same country made such election. Thus, for affiliated groups, this election was an all-or-nothing proposition (on a country-by-country basis).

After the enactment of §953(e) under TTREA, the availability of the election under §952(c)(1)(B)(vii) for taxable years beginning after December 31, 1998, was unclear since the election continued to reference the “same-country” exception provided under former §953(a)(1)(A). As there is no recognizable tax policy reason to limit the application of this election to the “same-country” exception, §952(c)(1)(B)(vii) should be amended to permit a taxpayer to waive the application of the exemptions provided under §§953(e) and 954(i) for taxable years in which these exemptions are in effect.


Section 953(c) broadens the definitions of CFCs and U.S. Shareholders under Subpart F so as to virtually assure that U.S. persons who participate in group and association captive insurance companies will be currently taxed on the related person insurance income (“RPII”) of the captives, even if such persons own fairly nominal interests in the captives.

RPII means any Subpart F insurance income attributable to an insurance, reinsurance, or annuity contract, with respect to which, directly or indirectly, the person insured (in the case of an insurance or reinsurance contract) or the purchaser or beneficiary (in the case of an annuity contract) is a U.S. Shareholder of a CFC insurance company or is a person related to a U.S. Shareholder.

For these purposes, the term U.S. Shareholder means a U.S. person that owns (but only under §958(a)) any of the stock of a CFC insurance company at any time during the foreign insurer's taxable year. A CFC for this purpose is a foreign corporation that has 25% or more of its stock (measured by either voting power or value) owned (as defined under §958(a)) or deemed owned (as defined under §958(b)) by U.S. Shareholders (as defined under §953(c)(1)(A)) on any day during the taxable year of the foreign corporation.

The RPII provisions do not apply, in part, if the foreign corporation's RPII, determined on a gross basis, for the taxable year is less than 20% of the foreign corporation's Subpart F insurance income (also determined on a gross basis). For this purpose, insurance income from “same-country” risks as provided under former §953(a)(1)(A) is taken into account. The Joint Committee report to the Tax Reform Act of 1986 indicates that the purpose of this exception was to exclude from the RPII provisions “foreign insurance companies with 25% or more U.S. ownership that do not earn a significant proportion of related person insurance income.”

The RPII de minimis income test under §953(c)(3)(B) currently refers to the pre-1999 “same-country” exception under former §953(a)(1)(A). The failure to update this cross-reference may be read to exclude insurance income exempt under §953(e) from the 20% gross income test, and thus decrease the availability of the RPII de minimis income test. While this reading may be supported by the wording of the current statute, this position would not appear to be consistent with the pre-1999 version of §953. The more natural reading of this provision would appear to be that the 20% gross income test should be applied without regard to the §953(e) exclusion.


In addition to the amount of Subpart F insurance income and FPHCI required to be included under Subpart F, a U.S. Shareholder is also required to include in income its pro rata share of any increase in a CFC's E&P invested in United States property (“U.S. Property”). For these purposes, §956(c)(1) defines U.S. Property. Under §956(c)(2)(E), however, the term U.S. Property does not include an amount of assets of an insurance company equivalent to the unearned premiums or reserves ordinary and necessary for the proper conduct of its insurance business attributable to contracts that are not contracts described under §953(a)(1).

Because §956(c)(2)(E) currently refers to the pre-1999 “same-country” exception under former §953(a)(1)(A), it is unclear how this exception should be applied, if at all. There is no indication in the legislative history to §953(e) that Congress intended to repeal §956(c)(2)(E) for taxable years in which §953(e) was applicable. Thus, it would appear that §956(c)(2)(E) should continue to be available for such years. Further, §956(c)(2)(E) should be amended to make it clear that the reserve amounts to be taken into account are the same amounts that are described under §954(i)(4) (method for determining unearned premiums and reserves) and §954(i)(5) (amount of reserves).


Section 957(b) provides a special definition of a CFC for foreign corporations with Subpart F insurance income, but solely for purposes of taking into account §953 insurance income. This special definition reduces the “more than 50%” test generally applicable to determining CFC status for purposes of the CFC provisions. Under this special definition, a foreign corporation may be a CFC if U.S. Shareholders own (under §958) more than 25% of its stock (measured by either voting power or value). This reduction in the ownership threshold only applies, however, if the foreign corporation's gross amount of premiums or other consideration in respect of the reinsurance or the issuing of insurance or annuity contracts “described in section 953(a)(1)” exceeds 75% of the gross amount of all premiums or other consideration in respect of all risks.

Section 957(b) is unclear in its current form, since it requires, in determining whether a foreign corporation is a CFC under the reduced 25% ownership threshold, that such entity have 75% of its gross insurance underwriting income attributable to Subpart F insurance income. Under the current statute, however, all gross insurance underwriting income is Subpart F insurance income as “described in section 953(a)(1).” Thus, the 75% threshold is not necessary. If the statute is interpreted to apply the 75% ratio to income other than income exempt under §953(e), this reading presents the problem that §953(e) first requires the existence of a CFC in order to have EII. Thus, there is a circularity problem under this interpretation of the statute.

Under the current version of §957(b), there are three possible readings of the statute that would avoid this circularity: (1) read the statute to cross-reference to former §953; (2) read the statute to cross-reference to current §953(a)(2); or (3) read the statute to cross-reference to current §953(a)(1).

Under the first option, there would be an asymmetry in using the pre-1999 Subpart F exception contained in former §953(a)(1)(A) to determine the application of the post-1998 Subpart F exception contained in current §§953(a)(2)/953(e). Despite this asymmetry, one could apply former §953(a)(1)(A) to determine whether a lower threshold of ownership is required under §957(b), and then separately determine whether an inclusion is required under current §953(a), after applying §953(e). In that case, however, a foreign corporation could have 25% or more of its gross premiums sourced to its country of incorporation and avoid CFC status under §957(b), even if all of its income would have been included under former §953 as Subpart F insurance income (for example, where the foreign corporation has 25% or more “same-country” risks, but does not meet the 30% or 50% “same-country” risk thresholds of §§953(e)(2)(B)(i) and 953(e)(3)(B)). Thus, under this reading, the symmetry of applying former §953(a)(1)(A) and reconciling its implicit policy with §953(e) would create the opportunity for certain foreign insurance companies to escape the lower threshold of CFC status under §957(b), even if all of their income otherwise would give rise to Subpart F income.

Under the second option, a taxpayer would read the statute as if §957(b) should have cross-referenced to current §953(a)(2), which in turn cross-references to §953(e). Some commentators have suggested this reading. The difficulty with this reading is that §953(e) requires that, in order for insurance income to be excluded from Subpart F insurance income, a foreign corporation must be a QIC, as defined under §953(e)(3). For a foreign corporation to be a QIC, §953(e)(3) requires, in part, that such corporation be a CFC. If a cross-reference to §953(a)(2) or §953(e) is read into §957(b), it becomes impossible to apply §957(b) without also having to read into §957(b) the rule that, in determining whether §953(e) applies in the context of §957(b), the foreign corporation is assumed to be a CFC. No such assumption is provided in the statute or its legislative history.

Under the last option, §957(b) could be read to cross-reference to current §953(a)(1). In this regard, §957(b) refers to “the gross amount of premiums or other consideration in respect of the reinsurance or the issuing of insurance or annuity contracts described in section 953(a)(1) [exceeding] 75 percent of the gross amount of all premiums or other consideration in respect of all risks.” Because current §953(a)(1) encompasses all insurance income, every company with gross insurance premiums would satisfy the 75% threshold test. Thus, this reading would render the 75% threshold meaningless. Further, under this reading, all foreign corporations with any gross insurance premiums would be subject to a 25%-vote-or-value threshold. However, this reading would follow the literal language of the statute and would capture all potential foreign corporations with Subpart F insurance income, leaving §953(e) to sort out which amounts are included and which are excluded from Subpart F income. This reading, therefore, would give maximum effect to §953(e) and would sweep the largest number of foreign corporations into the CFC definition, which is a principle inherent in §958(a).


Pursuant to an election under §964(d)(2)(D), a “qualified insurance branch” (“QIB”) of a CFC that meets the definition under that provision can elect to be treated as a separate foreign corporation. Upon a §964(d) election, the QIB is treated as a foreign corporation created under the laws of the country in which it conducts its operations for purposes of §1 through §1399 (relating to most income tax provisions), §6038 and §6046 (relating to return and information filing provisions with respect to certain foreign corporations), and any other Code provision as provided under regulations to be issued. The House Report on this provision under the Technical and Miscellaneous Revenue Act of 1988 indicates that “a qualified insurance branch of a controlled foreign corporation is treated as a separate corporation for purposes of applying the same-country exception to insurance underwriting income derived by controlled foreign corporations.”

Section 964(d)’s definition of a QIB should be reconciled with §953(e)’s definition of a QIC Branch, and §964(d) generally should be expanded to permit the election to go both ways, i.e., from branch to corporation and from corporation to branch. The original purpose of §964(d) was to permit Subpart F deferral for insurance operations required to be in branch format. Because §953(e) now addresses both QICs and certain QIC Branches, and because of the very tight anti-abuse rules of §953(e)(7), there should be no policy reason why §964(d) should not permit QICs to elect to be treated as QIC Branches or QIC Branches to be treated as QICs. (In both cases, under any amendment, the eligible QIC or eligible QIC Branch should be determined without regard to the 50% test of §953(e)(3)(B).) This change would maximize the policy objectives of §964(d) for situations where a particular insurance operation must be conducted in either branch or corporate form for local regulatory reasons.


Section 901 grants U.S. taxpayers a credit to offset U.S. income taxes imposed on certain foreign-source taxable income of the taxpayers. The credit is based on the amount of certain foreign income taxes paid directly by the U.S. taxpayer or, in the case of U.S. corporate taxpayers that own foreign subsidiaries, deemed to have been paid by those U.S. corporate shareholders under §§902 and 960. Under §960, if a corporate U.S. Shareholder is required by §951 to take into income currently certain items of income of a CFC, the U.S. Shareholder may be able to obtain a credit for certain foreign taxes paid by the CFC. These credits are subject to the limitations of §904(a). Section 904(d) provides that the limitation of §904(a) applies separately with respect to certain categories of income commonly known as “baskets.” Currently, there are only two baskets: the passive basket and the general limitation basket. The passive basket includes income of a type that would be FPHCI, but excludes income that would be “financial services income” (“FSI”).

FSI is defined to include income of a kind that would be Subpart F insurance income as defined in §953(a), determined without regard to the former same-country exception of §953(a)(1)(A). Because current §953(a) excludes EII under §953(a)(2), EII arguably could be considered income other than FSI. While the §904 regulations provide a general catch-all for “similar items of income,” use of this catch-all provision requires disclosure or an IRS pronouncement. To avoid unnecessary complexity, a statutory change should be made to define Subpart F insurance income under §904(d)(2)(D)(ii)(III) by reference to §953(a)(1) (excluding §953(a)(2)).


While H.R. 1944 is a bill that should be welcomed by financial institutions for making §§953(e) and 954(i) permanent, any legislation in this area should also provide necessary conforming amendments to the provisions mentioned above in order to integrate fully §§953(e) and 954(i) into the Code. Making those additional modifications would eliminate much of the confusion that has existed for the last decade regarding the proper application of the active financing income exception to insurance companies.

This commentary also will appear in the June 2009, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Yoder, 926 T.M., Subpart F -- General, and Yoder, 927 T.M., CFCs -- Foreign Personal Holding Company Incomeand in Tax Practice Series, see ¶7130, U.S. Persons -- Foreign Activities.