Tax reform is a clear priority for both Congress and President Donald Trump, and Republican control of both chambers of Congress and the White House makes the prospect of achieving significant tax reform much more likely within the next year. To the extent comprehensive tax reform legislation is enacted, insurance companies may experience significant changes in their current tax liabilities, admitted deferred tax assets (DTAs) and, ultimately, surplus. This Alert contemplates a few of the tax accounting issues and considerations with respect to Statement of Statutory Accounting Principles No. 101, Income Taxes (SSAP No. 101), and the House Republication Blueprint (the Blueprint).¹

While the Blueprint likely will be the starting point for Congressional consideration of tax reform legislation, a House-passed bill could change dramatically as it makes its way through the legislative process. For a comprehensive explanation of the political landscape, the legislative process and leading tax reform proposals, please read EY's forthcoming publication, US tax reform for financial services: Potential tax implications for the insurance industry.

Overview of the House Republican Blueprint

While not a legislative draft, the Blueprint outlines a revenue-neutral approach to tax reform that is intended to spur economic growth. Not surprisingly, the most significant aspect of the Blueprint is a broad-based reduction in tax rates. The Blueprint would pay for this rate reduction by eliminating "targeted" tax deductions, credits and exclusions, but provides very little details on what those might be. In addition, the Blueprint would raise significant revenue by moving the US business tax regime towards a cash-flow destination-based type of tax by implementing a border tax adjustment mechanism. How the Blueprint's "move toward taxation based on business cash flow"² would affect the unique insurance tax provisions within Subchapter L of the Internal Revenue Code (IRC) is currently very unclear.

Broadly speaking, the Blueprint calls for a reduction in the top corporate tax rate from 35% to 20%. The changes proposed by the Blueprint, however, go beyond just tax rates. The Blueprint calls for potentially significant tax benefits in the form of full and immediate business expensing of investments in all tangible, intangible and real property (other than land). At the same time, the Blueprint proposes to eliminate deductibility of net interest expense, net operating loss (NOL) carrybacks, the Alternative Minimum Tax (AMT) for corporations (as well as for individuals), and other targeted deductions and credits.

Statutory current tax provision considerations

While the most significant aspect of the Blueprint is a substantial reduction in tax rates, lowering the corporate tax rate is expensive. A one percentage point reduction in the corporate tax rate costs approximately $110 billion over 10 years.³ Insurance tax base-broadeners, such as those outlined in the 2014 tax reform plan released by former Ways and Means Committee Chairman Dave Camp (the Camp Plan⁴), may be a ready source of revenue to pay for tax rate reduction as part of a comprehensive tax reform package.

The Camp Plan proposed changes that would significantly affect the federal income taxes of life, property/casualty and health insurance companies. While there were many insurance tax proposals in the Camp Plan, the most significant items included: (i) changing the calculation of tax reserves for both life and property/casualty companies; (ii) modifying the deferred acquisition costs (DAC) rules for life insurance companies; and (iii) eliminating most of the benefit of the dividends received deduction for life insurance company separate accounts. In all, the Camp Plan insurance tax proposals would have increased taxes on insurers by more than $76 billion over a 10-year period.

Whether some version of the Camp Plan insurance tax revenue raisers will be included in a new comprehensive tax reform bill may depend, in part, on the outcome of the Blueprint's border adjustment proposal. Unofficial estimates project the Blueprint's border adjustment mechanism to raise up to $1.2 trillion in revenues over a 10-year period.⁵ If the border adjustment proposal is successfully included in the final tax reform bill, the need for additional industry-specific base-broadening proposals may be reduced. If the Camp Plan insurance tax base-broadeners are used to help pay for tax rate reduction, however, insurance companies should consider, among others, the following questions:

— Which base-broadeners are likely to be included in a final tax reform bill?

— Will transitional rules allow the base-broadeners to be phased in over time, as in the Camp Plan?

— Will the phase-in period for the base-broadeners be consistent with the tax rate reduction phase-in period, if any, to minimize an immediate significant increase in taxable income?

— Will certain Camp Plan base-broadeners continue to be a viable option in conjunction with specific Blueprint proposals? For example, the Blueprint's proposal for immediate expensing of intangible assets may not comport with the Section 848 Tax DAC changes enumerated in the Camp Plan.

Generally, a significant reduction in the corporate tax rate should favorably affect statutory surplus relative to the current tax system. Insurance tax practitioners need to be diligent, however, as back-of-the-envelope calculations may not be sufficient to adequately determine the various outcomes. We strongly urge insurance companies to build a tax reform model, using various assumptions (e.g., tax rates, border adjustments, Camp Plan base-broadeners, etc.), so that management can be better informed on the potential effects and share those findings with relevant stakeholders. The results from modeling can demonstrate how a company's tax liability under the Blueprint could bear no resemblance to its current tax liability, particularly if border adjustments apply to cross-border insurance transactions.

SSAP No. 101 DTA admissibility considerations

The first component of the admissibility test, SSAP No. 101 paragraph 11.a., ties the hypothetical loss carryback to correspond with the IRC loss carryback provisions, not to exceed three years. The adjusted gross DTA admitted under paragraph 11.a. equals the amount of "federal income taxes paid in prior years that can be recovered through loss carrybacks for existing temporary differences that reverse during a timeframe corresponding with IRS tax loss carryback provisions, not to exceed three years." Under current law, ordinary losses for non-life companies can be carried back two years;⁶ for life companies, ordinary losses can be carried back three years.⁷ Capital losses for both non-life and life companies can be carried back three years.⁸

Page 26 of the Blueprint states: "[N]et operating losses (NOLs) will be allowed to be carried forward indefinitely and will be increased by an interest factor that compensates for inflation and a real return on capital to maintain the value of amounts that are carried forward. Carrybacks of net operating losses will not be permitted and the deduction allowed for an NOL carryforward in any year will be limited to 90% of the net taxable amount for such year determined without regard to the carryforward." If tax reform legislation is enacted that precludes ordinary NOLs carrybacks, SSAP No. 101 paragraph 11.a. will be largely irrelevant.⁹ Because SSAP No. 101 paragraph 11.a. links the hypothetical loss carryback to the IRC carryback provisions, a tax law change to those provisions will directly affect the first component of the admissibility test. To the extent paragraph 11.a. is largely irrelevant, paragraph 11.b. in the admissibility test would take on greater importance for determining an insurance company's net admitted DTA.

For many insurance companies, an irrelevant paragraph 11.a. may simplify the SSAP No. 101 DTA admissibility calculation. To the extent an insurance company has consistently admitted DTAs under both paragraphs 11.a. and 11.b., the concern about double-counting the same adjusted gross DTAs more than once is largely removed with an irrelevant paragraph 11.a.¹⁰ Additionally, the components of paragraphs 11.a. and 11.b. will no longer have to be bifurcated in the statutory income tax footnote. Simply put, for those companies that could admit all of their DTAs under paragraph 11.b., the application of the paragraph 11.a. requirements was an unnecessary hassle.

For other insurance companies that have been able to admit all their DTAs under paragraph 11.a. without relying on the use of paragraph 11.b., the potential irrelevance of paragraph 11.a. could pose a challenge. SSAP No. 101 paragraph 11.b. is perhaps the most confusing and misunderstood paragraph in all of SSAP No. 101. Why is paragraph 11.b. challenging? For starters, there are many moving parts and significant subjectivity used in the SSAP No. 101 paragraph 11.b. calculation. There are also Realization Threshold Limitation Tables, ExDTA ACL RBC ratios, adjusted current-period statutory capital and surplus limitations, "with and without" calculations, forecasts of projected income, the ability to admit less DTAs if an entity is limited by surplus, reversing DTAs related to nonadmitted assets … just to name a few. Taken together, all of these items culminate into an admitted DTA under paragraph 11.b.

The requirements of SSAP No. 101 paragraphs 11.b.i. and 11.b.ii. are based on Realization Threshold Limitation Tables that serve as "guardrails" in determining the amount of DTAs admissible under paragraph 11.b. Paragraph 11.b.i. limits admissibility to those DTAs expected to be realized within "the applicable period" provided in the Realization Threshold Limitation Tables (no more than three years following the balance sheet date). The second guardrail limits DTAs admitted under paragraph 11.b.i. to the amount determined under paragraph 11.b.ii. (limited to no more than 15% of adjusted current-period statutory capital and surplus for certain RBC reporting entities). The phrase "expected to be realized" requires a reporting entity to perform a "with and without" calculation to project the amount of cash tax savings a company expects to realize from its reversing deductible temporary differences within the applicable period. For more information on paragraphs 11.b.i. and 11.b.ii., insurance tax practitioners should refer to the following resources: SSAP No. 101, Exhibit A — Implementation Questions and Answers (SSAP No. 101 Q&A) and EY's publication, Statutory accounting for income taxes — Navigating the changes in SSAP No. 101.

As mentioned, the Camp Plan revenue raisers may be used to help pay for tax rate reduction in final tax reform legislation. The Camp Plan revenue raisers would significantly increase taxes on the insurance industry, even with a reduced corporate tax rate. Federal income taxes affect statutory surplus through current and deferred income taxes. Many of the Camp Plan revenue raisers on the insurance industry are temporary differences that increase current income taxes, but may not ultimately affect an insurance company's net admitted DTA by an offsetting amount. This result occurs for two reasons. First, the adjusted gross DTAs (i.e., insurance tax reserves, Tax DAC, etc.) may not fully reverse within the three-year applicable period under paragraph 11.b.i. Second, reporting entities must value their temporary differences at the enacted tax rate in which they are expected to reverse. Future tax deductions that result from the reversal of existing temporary differences would yield reduced tax benefits due to a lower corporate rate.

The Blueprint's 20% corporate tax rate could, similar to the Camp Plan, be phased down from 35% to 20% over several years.¹¹ If tax reform results in the enactment of a phased-down tax rate from 35% to 20%, it will be critical for insurance companies to accurately project the reversal of both deductible and taxable temporary differences to ensure the appropriate enacted tax rate is applied in calculating adjusted gross DTAs and DTLs, as well as calculating DTAs expected to be realized within the applicable period under paragraph 11.b.i.

SSAP No. 101 paragraph 11.c. allows for adjusted gross DTAs not meeting earlier admission components to be admitted to the extent they offset gross DTLs. Paragraph 11.c. requires reporting entities to consider the reversal patterns of temporary differences. If the corporate tax rate is phased down over an extended period, reporting entities will need to continue to be mindful of reversal patterns. One of the objectives for considering the reversal patterns of temporary differences under paragraph 11.c. is to prevent a reporting entity from offsetting long-term DTAs with short-term DTLs. This will continue to be important regardless of whether NOLs expire. The concern of offsetting long-term DTLs with short-term DTAs, however, is mitigated by an indefinite NOL carryforward period.

Again, modeling the effects of tax reform on an insurance company's surplus may provide illuminating results. Whether tax reform significantly affects statutory surplus will ultimately depend on an insurance company's specific fact pattern and how final tax reform disrupts that fact pattern. Although House Republican leaders aim to enact tax reform that is revenue-neutral, the specific circumstances of each company may not reflect that goal. It is far too early for companies to begin changing their SSAP No. 101 tax provision templates, as the tax reform process may take the better part of 2017, if not longer. Now is the time, however, to start thinking through some of the relevant issues and understanding where there may be SSAP No. 101 admissibility challenges (e.g., shortages in data, lack of knowledge around paragraph 11.b., etc.).

Conclusion

At this point, perhaps the only thing about tax reform that is truly certain is that the bill that ultimately reaches the President's desk will be far different than any bill initially passed by the House. Insurance companies that closely monitor the tax reform debate and model the potential effects of the leading tax reform proposals under various scenarios will be better positioned to inform management and policymakers, and also better able to execute business planning strategies as the final legislation takes shape.

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RELATED RESOURCES

— For more information about EY's Tax Accounting services, visit us at www.ey.com/US/TaxAccounting
— For more information about EY's Tax Accounting University education program for clients, visit us at www.ey.com/TAU

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ENDNOTES

¹ This document was published by the House of Representatives Republican Tax Reform Task Force on June 24, 2016, under the title A Better Way — Our Vision for a Confident America.

² Blueprint, supra note 1, at 23.

³ Joint Committee on Taxation memorandum, Revenue Estimates, October 27, 2011.

⁴ David Camp, then in his role as House Ways and Means Committee Chairman, released this document on February 26, 2014, as a discussion draft for comprehensive tax reform. Camp subsequently introduced the document as a legislative bill, H.R.1, the Tax Reform Act of 2014, on December 11, 2014.

⁵ This is a very high-level estimate considering US imports are approximately 15% of GDP and exports are approximately 12% of GDP. The net 3% trade imbalance at the Blueprint's 20% corporate tax rate equals 0.6% GDP (3% times 20%). 0.6% of GDP is roughly $120 billion a year (over 10 years is $1.2 trillion).

⁶ IRC Section 172.

⁷ IRC Section 810.

⁸ IRC Section 1212.

⁹ The Blueprint is silent on capital loss carrybacks. To the extent capital loss carrybacks continue to be permitted, paragraph 11.a. would not be entirely irrelevant.

¹⁰ See SSAP No. 101 Q&A 4.9, which addresses the issue of double-counting DTAs, includings both capital and ordinary temporary differences.

¹¹ The Camp Plan proposed phasing down the corporate tax rate from 35% to 25% over five years, a two percentage point reduction in the rate each year. The Blueprint is silent on whether tax rates would be phased down over time.