Investment vehicles set up by Paulson & Co. and Highbridge Capital Management in tax-friendly Bermuda may be under threat from the U.S. Internal Revenue Service.

The IRS, in proposed rules published Thursday, said that the favorable treatment enjoyed by insurers under the tax code shouldn’t extend to companies that borrow their insurance executives from another firm. Paulson, the New York hedge fund manager run by billionaire John Paulson, and JPMorgan Chase & Co.’s Highbridge unit both have Bermuda insurance affiliates that share most staff with other companies.

The IRS is reacting to calls from Senator Ron Wyden, an Oregon Democrat, to halt a technique that U.S. hedge fund managers have used for more than a decade to lower personal income tax bills. By routing hedge-fund investments through an insurance company in a low-tax offshore jurisdiction, investors can lower the rate they pay on profits and postpone the bills indefinitely.

Wyden’s concern is that some companies treated like insurers may be hedge funds in disguise.

“This glaring tax loophole has been a thorn in the side of taxpayers over 10 years,” Wyden said in a statement Thursday, calling the IRS action “an important first step.”

John Rathgeber, the chief executive officer of Watford Re, the Bermuda company affiliated with Highbridge, said the IRS is wrong to focus on staffing arrangements.

“It’s true that we have a small number of employees, currently four, and that many functions are outsourced, but we don’t see how that’s germane to the issue,” he said in an email. Representatives for Paulson, JPMorgan and Highbridge had no immediate comment.

Pacre, Watford

The proposed rule is subject to change and wouldn’t take effect until months from now when final regulations are issued.

The IRS also plans to create other rules to determine if some companies are holding more assets than they need to back their insurance operations — another sign that they might be getting the tax break inappropriately. It plans to field comments on the rules over the next three months.

Paulson set up Pacre Ltd. in Bermuda in 2012 with no offices or employees of its own. It relied on another insurer, Validus Holdings Ltd., for underwriting staff. Top Paulson executives put $450 million of their own money into Pacre, which promptly invested the money in Paulson hedge funds. Pacre sells far less insurance than industry norms.

Last year, Highbridge helped set up Watford in Bermuda with $1.13 billion in capital. Watford relies on Highbridge to manage virtually all of its investments. It says on its website that its reinsurance operations are managed by “dual employees” shared with insurer Arch Capital Group Ltd.

Significant Risk

“Whether you pay someone as an employee or pay them as a consultant, the question is: ‘Are the individuals executing a valid business plan?'” Rathgeber said. “It’s self-evident to anyone knowledgeable about reinsurance, which would include our regulator and the rating agencies, that Watford Re is assuming significant insurance risk.”

Other hedge fund-backed insurers have in-house underwriting teams, including Third Point Reinsurance Ltd. in Bermuda, founded by hedge fund manager Dan Loeb; and David Einhorn’s Greenlight Capital Re Ltd. in the Cayman Islands. Representatives from Third Point Re, Greenlight, Arch and Validus declined to comment.

Short-Term Gains

Ordinarily, hedge fund managers’ profits from trading are taxed as short-term capital gains at rates of up to 43.4 percent, plus state taxes. Insurance companies have to pay taxes on their reserves only when sold, giving the hedge fund investors the ability to defer taxes and pay at the lower rates — 23.8 percent — that apply to long-term capital gains.

The notice from the IRS doesn’t use the word “loophole” and doesn’t invoke the agency’s authority to immediately stop what it sees as abusive transactions. Instead, the notice said the government is trying to “clarify” when “purported” reinsurance companies are really in the insurance business.

Distinguishing genuine insurers from asset managers can be complicated. Metrics that classify companies based on claims costs, reserves or investment income can be misleading because the figures fluctuate year-to-year based on financial markets and the frequency of hurricanes that can cost the industry billions of dollars.

“Anyone that spent a day in our office would clearly see that we’re a real insurance company,” Chris Coleman, chief financial officer of Third Point Re, said at a conference in March.

–With assistance from Doni Bloomfield in New York.