Part III. Administrative, Procedural, and Miscellaneous

Applicable Date Under § 645 With Respect to Trusts and Estates of Decedents Dying Before December 24, 2002

Notice 2003–33

This notice provides guidance regarding the determination of the applicable date that terminates the election period under § 645 of the Internal Revenue Code for trusts and estates of decedents dying before December 24, 2002.

Section 645 provides that a qualified revocable trust may elect to be treated and taxed for purposes of subtitle A of the Code as part of an estate (and not as a separate trust) for all taxable years of the estate ending after the date of the decedent’s death and before the applicable date. Section 1.645–1(f)(1) of the Income Tax Regulations provides that the § 645 election period begins on the date of the decedent’s death and terminates on the earlier of the day on which both the electing trust and related estate, if any, have distributed all their assets, or the day before the applicable date.

Section 645(b)(2) provides that the “applicable date” is - (A) if no federal estate tax return is required to be filed, the date which is 2 years after the date of the decedent’s death, and (B) if a federal estate tax return is required to be filed, the date that is 6 months after the date of final determination of liability for the estate tax.

Under proposed regulations for § 645 published on December 18, 2000 (REG– 106542–98, 2001–5 I.R.B. 473 [79015]), the applicable date, if a federal estate tax return is required to be filed, is the day that is 6 months after the date of final determination of liability for estate tax. The date of final determination of liability is the day on which the first of a series of events occurs. One of those events is the issuance of an estate tax closing letter, unless a claim for refund with respect to the estate tax is filed within 6 months after the issuance of the letter. Thus, under the proposed regulations, if the closing letter determines the date of final determination of liability, the applicable date is the date that is 6 months after the date that the closing letter is issued.

When the regulations were issued as final regulations on December 24, 2002, (T.D.

9032, 2003–7 I.R.B. 471 [78371]), the applicable date was changed for those situations in which a federal estate tax return is required to be filed. Section 1.645– 1(f)(2)(ii) provides that the applicable date is the later of the day that is 2 years after the date of the decedent’s death or the day that is 6 months after the date of final determination of liability for estate tax.

Further, under the final regulations, if the issuance of the closing letter triggers the date of final determination of liability, the date of final determination is the date that is 6 months after the date the closing letter is issued, rather than the date the closing letter is issued as provided in the proposed regulations. Thus, under the final regulations, if the closing letter triggers the date of final determination of liability, the applicable date (that is, 6 months after the date of final determination of liability) is the date that is 12 months after the date that the closing letter is issued.

Section 1.645–1(j) of the final regulations provides that §1.645–1(f)(2)(ii) is effective for trusts and estates of decedents dying on or after December 24, 2002. The preamble to the final regulations provides that trusts and estates of decedents dying before December 24, 2002, may follow certain provisions of the final regulations, but § 1.645–1(f)(2)(ii) is not included in those provisions.

The Internal Revenue Service has received several requests that trusts and estates of decedents dying before December 24, 2002, be permitted to rely on § 1.645– 1(f)(2)(ii) of the final regulations to determine the applicable date that terminates the election period. Accordingly, provided that a Form 1041, U.S. Income Tax Return for Estates and Trusts, has not been filed treating the § 645 election period as terminated, trusts and estates of decedents dying before December 24, 2002, may rely on § 1.645–1(f)(2)(ii) of the final regulations to determine the applicable date.

The principal author of this notice is Faith Colson of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this notice, contact Faith Colson at (202) 622–3060 (not a toll-free call).

Offshore Entities Investing in Hedge Funds

Notice 2003–34

I. PURPOSE

Treasury and the Internal Revenue Service have become aware of arrangements, described below, that are being used by taxpayers to defer recognition of ordinary income or to characterize ordinary income as a capital gain. The arrangements involve an investment in a purported insurance company that is organized offshore which invests in hedge funds or investments in which hedge funds typically invest. This notice alerts taxpayers and their representatives that these arrangements often do not generate the claimed federal tax benefits.

II. BACKGROUND

The typical arrangement involves a Stakeholder, subject to U.S. income taxation, investing (directly or indirectly) in the equity of an enterprise (“FC”), usually a corporation organized outside the United States. FC is organized as an insurance company and complies with the applicable local laws regulating insurance companies.

FC issues “insurance or annuity contracts” or contracts to “reinsure” risks underwritten by insurance companies. Some of the contracts do not cover insurance risks. Other contracts significantly limit the risks assumed by FC through the use of retrospective rating arrangements, unrealistically low policy limits, finite risk transactions, or other similar devices.

FC’s actual insurance activities, if any, are relatively small compared to its investment activities. FC invests its capital and the amounts it receives as consideration for its “insurance” contracts in, among other things, hedge funds or investments in which hedge funds typically invest. As a result, FC’s portfolio generates investment returns that substantially exceed the needs of FC’s “insurance” business. FC generally does not currently distribute these earnings to Stakeholder.

Stakeholder takes the position that FC is an insurance company engaged in the active conduct of an insurance business and

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1970); Serv. Life Ins. Co. v. United States, 189 F. Supp. 282, 285–86 (D. Neb. 1960), aff’d on other grounds, 293 F.2d 72 (8th Cir. 1961); Inter-Am. Life Ins. Co. v. Commis- sioner, 56 T.C. 497, 506–08 (1971), aff’d per curiam, 469 F.2d 697 (9th Cir. 1971); Nat’l. Capital Ins. Co. of the Dist. of Co- lumbia v. Commissioner, 28 B.T.A. 1079, 1085–86 (1933). In Inter-Am. Life Ins. Co., 56 T.C. at 506–08, the Tax Court applied the standard of § 1.801–3(a), and held that the taxpayer was not an insurance company because it was not using its capital and efforts primarily in earning income from the issuance of insurance. The court in particular noted the disproportion between investment income and earned premiums. The court also noted the absence of an active sales staff soliciting or selling insurance policies.

Even if the contracts qualify as insurance contracts as explained above, the character of all of the business actually done by FC may indicate that FC uses its capital and efforts primarily in investing rather than primarily in the insurance business.

C. Possible Tax Treatment of Stakeholder’s Interest in FC

Sections 1291–1298 provide special rules for taxing an investment in a foreign corporation that is a passive foreign investment company (as defined in § 1297). These rules impose current U.S. taxation (or similar treatment) on U.S. persons that earn passive income through a foreign corporation. A foreign corporation is a passive foreign investment company if (1) 75 percent or more of the gross income of such corporation for the taxable year is passive income, or (2) the average percentage of assets (as determined in accordance with § 1297(e)) held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent. Section 1297(a). For these purposes, passive income generally means any income which is of a kind which would be foreign personal holding company income as defined in § 954(c). Foreign personal holding company income includes dividends, interest, royalties, rents, annuities, and gains from the sale or exchange of property giving rise to such types of income. Section 954(c)(1).

is not a passive foreign investment company. Therefore, when Stakeholder disposes of its interest in FC, it will recognize gain as a capital gain, rather than as ordinary income.

III. DISCUSSION

The business of an insurance company necessarily includes substantial investment activities. Both life and nonlife insurance companies routinely invest their capital and the amounts they receive as premiums. The investment earnings are then used to pay claims, support writing more business or to fund distributions to the company’s owners. The presence of investment earnings does not, in itself, suggest that an entity does not qualify as an insurance company.

Treasury and the Internal Revenue Service are concerned that in some cases FC and its Stakeholders are inappropriately claiming that FC is an insurance company for federal income tax purposes to avoid tax that otherwise would be due. The Service will challenge the claimed tax treatment in appropriate cases, as outlined below.

A. Definition of Insurance

For FC to qualify as an insurance company, FC must issue insurance contracts. Neither the Code nor the regulations define the terms “insurance” or “insurance contract.” The United States Supreme Court, however, has explained that for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present. Helvering v. LeGierse, 312 U.S. 531 (1941). The risk shifted and distributed must be an insurance risk. See, e.g., Allied Fidelity Corp. v. Commissioner, 572 F.2d 1190 (7th Cir. 1978), cert. denied, 439 U.S. 835 (1978); Rev. Rul. 89–96, 1989–2 C.B. 114.

Risk shifting occurs if a person facing the possibility of an economic loss resulting from the occurrence of an insurance risk transfers some or all of the financial consequences of the potential loss to the insurer. The effect of such a transfer is that a loss by the insured will not affect the insured because the loss is offset by the insurance payment. Risk distribution incorporates the “law of large numbers” to allow the insurer to reduce the possibility that a single costly claim will exceed the amount available to the insurer for the pay

ment of such a claim. Clougherty Pack- ing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987). Risk distribution necessarily entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks. See Hu- mana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989). Treasury and the Service are concerned that any risks assumed under the contracts issued by FC may not be insurance risks. Treasury and the Service are also concerned that the terms of the contracts may significantly limit the risks assumed by FC.

B. Status as an Insurance Company

A corporation that is an insurance company for federal income tax purposes is subject to tax under subchapter L of the Internal Revenue Code. For this purpose, an insurance company is a company whose primary and predominant business activity during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. While a taxpayer’s name, charter powers, and state regulation help to indicate the activities in which it may properly engage, whether the taxpayer qualifies as an insurance company for tax purposes depends on its actual activities during the year. § 1.801–3(a) of the Income Tax Regulations; § 816(a) (which provides that a company will be treated as an insurance company only if “more than half of the business” of that company is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies).

To qualify as an insurance company, a taxpayer “must use its capital and efforts primarily in earning income from the issuance of contracts of insurance.” Indus. Life Ins. Co. v. United States, 344 F. Supp. 870, 877 (D. S.C. 1972), aff’d per curiam, 481 F.2d 609 (4th Cir. 1973), cert. de- nied, 414 U.S. 1143 (1974). To determine whether FC qualifies as an insurance company, all of the relevant facts will be considered, including but not limited to, the size and activities of its staff, whether it engages in other trades or businesses, and its sources of income. See generally Bowers v. Lawyers Mortgage Co., 285 U.S. 182 (1932); Indus. Life Ins. Co., at 875–77; Car- dinal Life Ins. Co. v. United States, 300 F. Supp. 387, 391–92 (N.D. Tex. 1969), rev’d on other grounds, 425 F. 2d 1328 (5th Cir.

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fied production methods. These sections provide that self-constructed assets produced by the taxpayer on a routine and repetitive basis in the ordinary course of the taxpayer’s trade or business are “eligible property.” There is uncertainty about the proper interpretation and application of the term “routine and repetitive.” Accordingly, the Treasury Department and the Service plan to publish guidance that will clarify the types of property that qualify as eligible property under §§ 1.263A–1(h)(2)(i)(D) and 1.263A–2(b)(2)(i)(D) and, in particular, that will address the interpretation and application of the term “routine and repetitive.” This notice requests comments in connection with the guidance and informs taxpayers of the procedures that the Service will follow in the interim with respect to applications for consent to change to the simplified service cost or simplified production methods for self-constructed assets under §§ 1.263A–1(h)(2)(i)(D) and 1.263A–1(b)(2)(i)(D).

BACKGROUND

Rev. Proc. 2002–9, 2002–1 C.B. 327, as modified and clarified by Announcement 2002–17, 2002–1 C.B. 561, modified and amplified by Rev. Proc. 2002–19, 2002–1 C.B. 696, and amplified, clarified, and modified by Rev. Proc. 2002–54, 2002–35 I.R.B. 432, provides procedures by which taxpayers may obtain automatic consent to change to the methods of accounting described in the Appendix of the revenue procedure. Section 4.01(1)(a)(vi) of the Appendix of Rev. Proc. 2002–9 permits certain resellers to use the automatic consent procedures to change from a non-UNICAP method to a UNICAP method specifically described in the regulations. Section 4.02 of the Appendix of Rev. Proc. 2002–9 permits producers of real or tangible personal property to use the automatic consent procedures to change to a UNICAP method specifically described in the regulations. For this purpose, the simplified production method and the simplified service cost method are UNICAP methods specifically described in the regulations. See sections 4.01(2)(g) and 4.02(3) of the Appendix of Rev. Proc. 2002–9.

INTERIM PROCEDURES FOR ACCOUNTING METHOD CHANGE APPLICATIONS

Pending the issuance of further guidance, the following procedures will apply

Section 1297(b)(2)(B) provides an exception to passive income for any income derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business and which would be subject to tax under subchapter L if it were a domestic corporation (the insurance income exception). If FC would not be subject to tax under subchapter L if it were a domestic corporation (for the reasons discussed above), then the insurance income exception to passive income will not apply, and FC will be subject to the general income and assets tests described above. Additionally, even if FC would be subject to tax under subchapter L if it were a domestic corporation, the insurance income exception may not apply to FC because this exception is applicable only to income derived in the active conduct of an insurance business.

The Service will scrutinize these arrangements and will apply the PFIC rules where it determines that FC is not an insurance company for federal tax purposes.

IV. DRAFTING INFORMATION

The principal authors of this notice are John Glover of the Office of Associate Chief Counsel (Financial Institutions & Products) and Theodore Setzer of the Office of Associate Chief Counsel (International). For further information regarding this notice, contact Mr. Glover at (202) 622– 3970 or Mr. Setzer at (202) 622–3870 (not a toll-free call).

Organizations Exempt Under Section 501(c)(15)

Notice 2003–35

The purpose of this notice is to remind taxpayers that an entity must be an insurance company for federal income tax purposes in order to qualify as exempt from federal income tax as an organization described in § 501(c)(15) of the Internal Revenue Code.

Section 501(a) provides that an organization described in § 501(c) shall be exempt from federal income tax. Section 501(c)(15) provides that an insurance company (other than a life insurance company) is tax-exempt if its net written premiums (or, if greater, direct written premiums) for

the taxable year do not exceed $350,000. For purposes of this annual test, the company is treated as receiving during the taxable year premiums received during the same year by all other companies within the same controlled group, as defined in § 831(b)(2)(B)(ii).

For an entity to qualify as an insurance company, it must issue insurance contracts or reinsure risks underwritten by insurance companies as its primary and predominant business activity during the taxable year. For a discussion of the analysis applicable to evaluating whether an entity qualifies as an insurance company, see Notice 2003–34, 2003–23 I.R.B. 990 (June 9, 2003) and Notice 2002–70, 2002–44 I.R.B. 765 (November 4, 2002).

The Service is scrutinizing the taxexempt status of entities claiming to be described in § 501(c)(15) and will challenge the exemption of any entity that does not qualify as an insurance company. The Service will challenge the exemption of the entity, regardless of whether the exemption is claimed pursuant to an existing determination letter or on a return filed with the Service.

Taxpayers claiming exemption pursuant to § 501(c)(15) should also consider whether they are engaged in arrangements described in Notice 2002–70 or substantially similar thereto.

DRAFTING INFORMATION

The principal author of this notice is Lee T. Phaup. TE/GE Division, Exempt Organizations. For further information concerning this notice, contact Ms. Phaup at (202) 283–8935 (not a toll-free call).

Simplified Service Cost Method; Simplified Production Method

Notice 2003–36

PURPOSE

The Treasury Department and the Internal Revenue Service have become aware that uncertainty exists as to what types of property constitute “eligible property” under §§ 1.263A–1(h)(2)(i)(D) and 1.263A– 2(b)(2)(i)(D) of the Income Tax Regulations for purposes of qualifying taxpayers to use the simplified service cost and the simpli

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Tax Regulations for a qualified personal residence trust (QPRT) with one term holder.