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The Internal Revenue Service has issued final regulations that remove the look-through rule to assets of nonregistered hedge funds whose interests are available for sale to other than insurance-dedicated vehicles for purposes of satisfying the diversification requirements of Section 817 of the Internal Revenue Code. The final regulation was effective March 1, 2005, and adopts, with modification, the proposed regulations published on July 30, 2003. The use of insurance-dedicated vehicles still will be available.

Background

Diversification requirements need to be met in order to achieve favorable tax deferral on the build-up of cash-surrender value and the tax-free nature of death benefits associated with variable annuities, endowments and life insurance contracts. As an asset allocation technique, hedge funds are well-suited deferral products, because of their high portfolio turnover and short-term trading activity.

Section 817 of the Internal Revenue Code provides that a variable contract based on a segregated asset account is not treated as a variable annuity, endowment or life insurance contract unless the segregated asset account is adequately diversified. In general, diversification is achieved if no more than 55% of the value of the total assets is represented by any one investment, no more than 70% by any two investments, no more than 80% by any three investments and no more than 90% by any four investments. The rules provide for a look-through treatment of assets held through certain investment companies, partnerships or trusts for purposes of testing diversification. Under income tax regulations, look-through treatment is available for any investment company, partnership or trust only if all the beneficial interests in the investment company, partnership or trust are held by one or more segregated asset accounts of one or more insurance companies, and public access to the investment company, partnership or trust is available exclusively through the purchase of a variable contract.

Prior to these proposed and final regulations, an important exception was provided: it afforded look-through treatment to hedge fund interests that were not registered under a federal or state law regulating the offering or sale of securities. This exception allowed the use of hedge funds operated as nonregistered partnerships to be used as investment vehicles in private placement life and annuity products.

In addition to the issue of diversification, taxpayers purchasing such products also were relying on regulations promulgated under Section 817 to govern for purposes of investor control. However, in Rev. Rul. 2003-92, the IRS ruled that, in a private placement insurance product, where the subaccounts hold interests in partnerships available for purchase only by a purchaser of an annuity, a life insurance contract or other variable contracts from insurance companies, the insurance company and not the taxpayer is considered the owner of the interests in the partnerships that fund the subaccounts. Rev. Rul. 2003-92 on investor control was at odds with the regulations on diversification as to what the governing rules would be for investor control.

Final Regulations

The final regulations confirmed the removal of the exception for nonregistered hedge funds provided for in the proposed regulations.

The final regulations continue to hold that look-through treatment will be available for interests in a nonregistered hedge fund if all the beneficial interests in the hedge fund are held by one or more segregated asset accounts of one or more insurance companies, and public access to the fund is available exclusively through the purchase of a variable contract.

Additionally, the final regulations provide transition relief for arrangements that were in existence on March 1, 2005. As such, arrangements in existence on March 1, 2005, will be considered to be adequately diversified if (1) those arrangements were adequately diversified within the meaning of Section 817 before March 1, 2005, and (2) by Dec. 31, 2005, the arrangements are brought into compliance with the final regulations.

Implications

The final regulations align the diversification rules for nonregistered hedge funds with the IRS’s position on investor control as expressed in Rev. Rul. 2003-92. Therefore, the final regulations have clear implications for insurance carriers that issue variable life and annuity products in which the underlying investment is an unregistered hedge fund that is not an insurance-dedicated vehicle, meaning that it is available to the general public and not just to insurance-dedicated vehicles. Any variable contract that is based on such a segregated asset account will not be treated as an annuity, endowment or life insurance contract. As such, income on the variable contract would be treated as ordinary income received or accrued by the policyholder.

Hedge funds targeting themselves as an asset class for variable annuities, endowments or life insurance may need to consider forming insurance-dedicated vehicles in order to actively attract these types of investors.

Howard Leventhal, co-national director of Ernst & Young’s Asset Management Tax Practice, is a partner in Ernst & Young’s Global Hedge Fund Practice and is based in the firm’s Financial Services Office.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.