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.

Open Doors

In addition, two recent rulings by the IRS make clear that the exclusivity requirement applies to all policy purchasers. This generalizes a private letter ruling issued last October in response to a question from Keyport Life Insurance, part of Sun Life Financial Service of Canada. According to that decision, hedge funds that are not exclusive to insurance do not have insurance status for tax deferral.

“The rulings clarify what is acceptable, unlike Keyport, which told us what was not,” commented an industry veteran who has been following this lengthy saga. “We should see a number of insurance companies structuring products that will conform to the rulings.”

Recent rulings clarify acceptable methods for insurance-based hedge fund investing, said William Dreher, managing director of Compensation Strategies Inc., New York. He, too, feels that the practical effect will be to open doors to hedge fund investments that satisfy the requirements.

Indeed, insurance companies already have been developing hedge fund menus that meet these rules for investing through life insurance, and some managers have launched insurance-only funds for such platforms and .

CKurdas@HedgeWorld.com