by Norse N. Blazzard and Judith A. Hasenauer
The financial and insurance trade press has been publishing articles in the past few weeks regarding final regulations from the Internal Revenue Service regarding whether “publicly available” investments such as hedge funds can be used as underlying investments in variable life insurance and variable annuity contracts.
Unfortunately, many of the articles seem to have created the wrong impressionthat hedge funds can no longer be used as underlying investments in variable products.
For those not necessarily versed in some of the technical aspects of variable product taxation, the term “publicly available,” as used by the IRS in connection with variable annuities and variable life insurance, means an investment vehicle such as a mutual fund or a hedge fund that can be purchased by investors directly, other than through a variable product.
Also, the tax law applicable to variable products [Section 817(h) of the Internal Revenue Code] requires that investments underlying these products must be “adequately diversified.” Failure to be “adequately diversified,” as defined in the Code, means the variable products will have investment gains currently taxed directly to the contract owner; the products, in effect, forfeit tax-deferral on such gains.
In July 2003, the IRS proposed amendments to the diversification regulations under Section 817(h) of the IRC. The proposed regulations (an amendment to Treasury Regulations Section 1.817-5) were intended to clarify some issues regarding use of “non-registered” partnerships and similar entities as investments underlying variable products. Virtually all hedge funds are “non-registered” partnerships in that they are partnerships not registered either with the SEC or with any state regulatory agency.
The regulations in effect at the time the proposed regulations were released seemed to state that, for the purpose of meeting the diversification requirements of Section 817(h), a “publicly available” non-registered partnership, such as most hedge funds, could be used to underlie variable insurance products, and that the required diversification testing would be passed through to the investment portfolio of the underlying hedge fund(s).