April 12, 2016
Implications for Insurance Taxation?
by Larry Campbell, Surjya Mitra and Mark Smith
Although there is agreement that the U.S. corporate tax rate should be lowered, there is disagreement on key issues.
Election-year politics are dominating legislative action this year as both parties lay down policy agendas for 2017 and beyond. President Obama and the Republican leaders of Congress are offering competing plans on how to reform the U.S. tax system and how to promote other policies intended to increase economic growth and make American companies more competitive. At the same time, both Democratic and Republican candidates seeking their party’s presidential nomination are advancing tax reform plans.
During his final year in office, President Obama likely will continue to rely on his administration’s regulatory authority and the presidential veto to preserve the 2010 Affordable Care Act (ACA)—as well as other legislative and regulatory actions taken during his years in office.
Obama administration action
On Feb. 9, President Obama submitted an FY 2017 budget to Congress that reaffirmed his support for “business tax reform” that would lower the top U.S. corporate tax rate to 28%, with a 25% rate for domestic manufacturing income.
Significant international tax increase proposals that have been re-proposed include a 19% minimum tax on future foreign income and a one-time mandatory 14% tax on previously untaxed foreign income. The president’s budget, again, reserves revenue from a large number of previously proposed tax increases to support business tax reform—including specific proposals affecting insurance taxation (discussed below)—but his budget identifies only part of the revenue that would be needed to support his proposed corporate rate reductions.
House Speaker Paul Ryan (R-WI) has called for House Republicans to vote in 2016 on comprehensive tax reform legislation and on changes to federal entitlement programs as a way to define and build support for a conservative legislative agenda. Senate Majority Leader Mitch McConnell (R-KY) is also expected to advance a conservative legislative agenda with a focus on demonstrating an ability to govern and with an eye on protecting the Republican Senate majority.
House Ways and Means Committee Chairman Kevin Brady (R-TX) recently outlined his goals for producing a blueprint for comprehensive tax reform and plans to “move forward immediately to draft international tax reform legislation.” Chairman Brady has said he hopes the Obama administration and Congress can reach common ground on some policies and build on the momentum from the last year’s “tax extender” legislation, which included a provision making permanent Subpart F exceptions for active financing income.
Chairman Brady said comprehensive tax reform “will not happen until we have a new president,” but he is “hopeful that, next January, we will have a president—Republican or Democrat—who is committed to making pro-growth tax reform a reality for the American people.” The chairman outlined several principles for comprehensive tax reform, including a “competitive tax rate” and a “permanent, modern territorial-type system that helps American companies compete and win overseas.” He also said the Ways and Means Committee will look, “with fresh eyes,” at a range of tax ideas, including “consumption tax, cash flow tax, reformed income tax and any other approach that will be pro-growth.”
On international tax reform, Chairman Brady said “developments in the global environment demand our immediate attention.” He pointed to OECD “base erosion and profit shifting” (BEPS) proposals that “disproportionately burden American companies” and the European Commission anti-tax avoidance package that would provide EU member countries with an “arsenal of new revenue-grabbing tax measures.” He also discussed the growing number of corporate inversions and foreign acquisitions involving U.S. companies: “We will send a clear signal to American companies and shareholders that help is on the way—that we won’t stand idly by while our tax code drives them overseas or makes them a target for a foreign takeover.”
Senate Finance Chairman Orrin Hatch (R-UT) has said he “doubts very much” that international-only tax reform can be enacted this year. The Finance Committee Republican majority staff has been working on options for corporate integration tax reform proposals that would seek to eliminate the double taxation of corporate earnings. Corporate integration proposals generally have focused on approaches providing that any distributions made by such entities would either be deductible by the entity (dividends paid deduction) or would be excludable by the recipient (dividend exclusion). A December 2014 report prepared by the Senate Finance Committee Republican staff stated that a dividends-paid deduction “would generally be easy to implement and would largely equalize the treatment of debt and equity.” Chairman Hatch recently asked Treasury Secretary Jack Lew to “keep an open mind” to a corporate integration proposal that might help to make U.S. corporations more competitive globally and could reduce inversions.
Although there is bipartisan agreement that the U.S. corporate tax rate should be lowered significantly and that our international tax system should be updated, there is significant disagreement over key business tax issues, including how to offset the cost of a corporate rate reduction.
See Also: How a GOP Congress Could Fix Obamacare
Insurance-related revenue raisers
The Obama administration’s FY 2017 budget re-proposes several revenue-increasing measures specific to insurance companies. The proposed legislative changes generally would apply for tax years beginning after Dec. 31, 2016.
Among the insurance-related measures are provisions that would:
- Disallow the deduction for non-taxed reinsurance premiums paid to affiliates — This proposal would disallow any deduction to covered insurance companies for the full amount of reinsurance premiums paid to foreign affiliated insurance companies with respect to reinsurance of property and casualty risks if the premium is not subject to U.S. income taxation. The proposal would provide a corresponding exclusion from income for reinsurance recovered, with respect to a reinsurance arrangement for which the premium deduction has been disallowed. The proposal would also provide an exclusion from income for ceding commissions received with respect to a reinsurance arrangement for which the premium deduction has been disallowed. The exclusions are intended to apply only to the extent the corresponding premium deduction is disallowed. The proposal would provide that a foreign corporation that is paid a premium from an affiliate that would otherwise be denied a deduction under this provision may elect to treat those premiums and the associated investment income as income effectively connected with the conduct of a trade or business in the U.S. If that election is made, the disallowance provisions would not apply.
- Conform net operating loss rules of life insurance companies to those of other corporations — This proposal would modify the carry-back and carry-forward periods for losses from operations of life insurance companies to conform the treatment to that of other taxpayers. Under the proposal, losses from operations of life insurance companies could be carried back up to two taxable years prior to the loss year and carried forward 20 taxable years following the loss year.
- Modify rules that apply to sales of life insurance contracts, including transfer for value rules — This proposal would create a reporting requirement for the purchase of any interest in an existing life insurance contract with a death benefit equal to, or exceeding, $500,000. The proposal would also modify the transfer for value rule to ensure that exceptions to that rule would not apply to buyers of policies.
- Modify dividends received deduction for life insurance company separate accounts — This proposal would repeal the present-law proration rules for life insurance companies and apply the same proration regime separately to both the general account and separate accounts of a company. Under the proposal, the policyholders’ share would be calculated based on a ratio of the mean of the reserves to the mean of the total assets of the account. The company’s share would be equal to one less than the policyholders’ share.
- Expand pro rata interest expense disallowance for company-owned life insurance (“COLI”) — This proposal would curtail an exception to a current law interest disallowance of a pro rata portion of a company’s otherwise-deductible interest expense, based on the un-borrowed cash value of COLI policies. As modified, the exception would apply only to policies covering the lives of 20% owners of the business. The proposal would apply to contracts issued after Dec. 31, 2016, in tax years ending after that date.
- Repeal special estimated tax payment provision for insurance companies under section 847 — This proposal would repeal IRC Section 847 and would include the entire balance of an existing special loss discount account in income in the first tax year after 2016. Alternatively, the proposal would permit an election to include the balance in income ratably over four years. Existing special estimated tax payments would be applied.
Insurance Developments: Judicial and Administrative
A number of judicial and administrative developments occurred in 2015 concerning insurance companies.
These developments affected insurers in various lines of business:
- Life insurers: The most significant development for life insurers was not solely a tax development. Life principal-based reserves (PBR) will be effective when 42 states representing 75% of total direct written premiums amend their standard valuation law. At the current rate of adoption, Life PBR is expected to be effective Jan. 1, 2017, for contracts issued on or after that date. Life PBR will implicate a number of tax issues, and, for the first time, the IRS and Treasury included guidance on Life PBR in its annual Priority Guidance Plan. Also during 2015, the Tax Court decided in Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015) that a policyholder was liable for taxes on income earned on assets supporting a variable life insurance contract based on the policyholder’s control over the assets. The case accorded deference to a number of the IRS’s “investor control” revenue rulings and could result in closer attention to variable life insurance and annuity contracts that are privately placed.
- Non-life insurers: In 2015, the Tax Court addressed what qualifies as insurance risk for purposes of classifying contracts as insurance contracts. In R.V.I. Guaranty Co., Ltd v. Commissioner, 145 T.C. 9 (September 21, 2015), the court held that residual value insurance (RVI) contracts that protect against an unexpected decline in the market value of leased personal property qualify as insurance contracts for federal income tax purposes. The case’s reasoning relies heavily on the treatment of the contracts by non-tax regulators, and it provides taxpayers further guidance for distinguishing between investment risk and insurance risk.
- Health insurers: In 2015, a Treasury Inspector General for Tax Administration (TIGTA) report criticized the IRS for the “finality” requirement that prevents the service from assessing health insurers that inadvertently or otherwise were not assessed the correct amount (or any) of the health insurance provider fee, which is apportioned among all covered health insurers. Other health insurance providers still wait for the IRS to act on refund requests of the fee in 2015. The ultimate resolution remains uncertain.
- Captive insurance companies: During 2015, the IRS issued two Chief Counsel Advice (CCA) that analyze whether specific types of policies issued by captive insurance companies constitute insurance for federal income tax purposes. In CCA 201511021, the IRS determined that contracts indemnifying the policyholder for loss of earnings resulting from foreign currency fluctuations did not satisfy the three-prong test to be considered insurance because foreign currency risk is not an insurance risk. The CCA was issued before the tax court’s decision in R.V.I. Guaranty Co., Ltd., so it did not take the tax court’s approach into account. In CCA 201533011, the IRS concluded that excess loss policies issued by a captive insurance company that covered healthcare risks of members of unrelated HMOs are not insurance contracts because they lacked the requisite element of risk shifting. Based on the facts as presented, the CCA analyzed the arrangement as an interest-bearing deposit, but it then concluded that receipts were included in income and deductions were allowed for future claim payments when made. Also in 2015, the IRS issued IR 2015-19, which added section 831(b) companies to the “Dirty Dozen” list of tax scams, indicating the IRS would target these companies in examination.
- PFIC exception for income derived in the active conduct of an insurance business: Again during 2015, the IRS proposed regulations that would provide guidance on investment income that is treated as derived in the active conduct of an insurance business and, therefore, not treated as “passive income” under the passive foreign investment company (PFIC) rules. In particular, Prop. Reg. §1.1297-4 would provide that “active conduct” requires that an insurer conduct its activities through its own officers and employees and that investment income be earned on assets held to meet obligations under insurance and annuity contracts. Several comments were submitted on these issues and on the use of a bright line test for whether assets are held to meet obligations under insurance contracts.
- Cross-border reinsurance: The Court of Appeals for the District of Columbia Circuit ruled in Validus Reinsurance, Ltd v. United States of America, 786 F.3d 1039 (2015) that the Federal Excise Tax (FET) on insurance premiums does not apply to retrocessions between two foreign insurers, regardless of whether the underlying risks are U.S.-based. Accordingly, the IRS issued Rev. Rul. 2016-3, 2016-3 I.R.B. 282, which revokes the ruling setting forth the IRS’s prior position on the application of FET on a cascading basis to either reinsurance or retrocession arrangements between two foreign insurers. The Validus decision and Rev. Rul. 2016-3 mark the end of the controversy with the IRS on this issue, and most companies already have submitted claims for refund of previously-paid excise tax on a cascading basis, or they plan to do so.
- Inversions: In 2014, the Treasury Department and the IRS issued Notice 2014-52, which describes regulations the Treasury and IRS intend to issue concerning transactions sometimes referred to as “inversions.” The notice included a “cash box” rule, which targeted taxpayers who engage in certain inversion transactions with foreign corporations and their subsidiaries with substantial liquid assets. As a follow up to that notice, the Treasury and IRS issued Notice 2015- 79, providing more information about the intended regulations. In particular, Notice 2015-79 describes regulations that the IRS and the Treasury intend to issue addressing transactions that are structured to avoid the purposes of §7874 (concerning expatriated entities) and addressing “post-inversion tax avoidance transactions.” The latter notice clarifies that property held by a U.S. insurance corporation and a foreign corporation that is engaged in the active conduct of an insurance business will be exempted from the “cash box” rule. As in prior years, the IRS and Treasury jointly issued a Priority Guidance Plan outlining guidance it intends to work on during the 2015-16 year. The plan continues to focus more on life than property and casualty insurance companies. The following insurance-specific projects were listed as priority items. Many carried over from last year’s plan, including:
- Final regulations under §72 on the exchange of property for an annuity contract. Proposed regulations were published on Oct. 18, 2006;
- Regulations under §§72 and 7702 defining cash surrender value;
- Guidance on annuity contracts with a long-term care insurance feature under §§72 and 7702B;
- Guidance under §§807 and 816 regarding the determination of life insurance reserves for life insurance and annuity contracts using principles-based methodologies, including stochastic reserves based on conditional tail expectations;
- Guidance under §833 (expected to address de minimis MLR relief);
- Guidance on exchanges under §1035 of annuities for long-term care insurance contracts; and
- Guidance relating to captive insurance companies.
- Election year politics and disagreements between President Obama and Congressional Republicans (notably on how to offset any corporate tax reductions) make domestic or international tax reform unlikely in the coming year.
- President Obama’s FY2017 budget proposes several revenue-increase measures specific to insurance companies. However, it remains to be seen which, if any, of the measures will come into effect.
- Multinational insurers and reinsurers should closely monitor legislative and regulatory developments pertaining to taxation of overseas profits. Both the PFIC regulation and the promised regulations on inversions could have a significant effect on some companies and their shareholders.
- Life insurers should consider the effect of Life PBR tax issues on product development, financial modeling and compliance as they prepare for the Jan. 1, 2017, effective date.
- Non-life insurers with non-traditional lines of business should consider the effect, if any, that the R.V.I. Guaranty Co. case and the two chief counsel advice memoranda on the nature of insurance risk and the presence of risk shifting may have on insurance qualification.
- Captive insurers should be prepared for additional IRS scrutiny as a result of the Priority Guidance Plan item promising guidance, and the inclusion of §831(b) companies in the IRS “Dirty Dozen” list.