NEW YORK (HedgeWorld.com)–New rulings and a proposal from the Internal Revenue Service in the past two weeks clarify tax exemption requirements for insurance-wrapped hedge fund investments.
On July 29, the IRS proposed to remove a look-through provision for unregistered partnerships such as hedge funds in determining whether a key diversification standard is met. Insurance-based products have to meet a diversity criterion that mandates at least five investments and certain percentage allocations to each.
Unregistered partnerships still will be able to use a look-through to underlying investments in establishing that they are sufficiently diversified, but only if the investment vehicles are exclusive to insurance purchasers and are held in separate accounts owned by insurance companies.
The IRS explained that it wants to cancel the provision because this particular rule does not limit the ownership of interests. Many of the partnerships in question are offshore hedge funds and "interests in these partnerships are available for purchase directly by the general public as well as through the purchase of a variable contract," the proposal states. The change is to make sure the investments are available exclusively via insurance contracts.
Some attorneys have argued that the diversification rule supersedes the control rule, an interpretation that appears to conflict with the proposed regulation. The control rule is a requirement that insurance companies rather than policyholders control the investment. It is meant to prevent people from investing in generally available funds through insurance so as to defer taxes on earnings that would otherwise be taxable .
"The Treasury Department and the IRS believe that these arrangements are the type of overly investment-oriented insurance and annuity arrangements that Congress sought to prevent when it enacted the diversification rules," the proposal says.
