15 November 2017 House and Senate tax reform proposals include numerous changes affecting the insurance industry Senate Finance Committee Chairman Orrin Hatch (R-UT) released late on November 9th his Chairman's Mark of the Tax Cuts and Jobs Act (SFC Chairman's Mark),1 which adheres to the same basic tax overhaul framework as the tax bill approved by the House Ways and Means Committee (W&M Bill)2 on the same day, but includes significant differences in the design of proposals and their timing. Notably, in the SFC Chairman's Mark, the statutory corporate tax rate would be reduced to 20%, but not until 2019, and although the SFC Chairman's Mark proposes moving to a territorial tax system for foreign earnings, the plan includes different approaches to preventing base erosion. When the Trump administration and congressional Republican leaders on September 27, 2017, released a "Unified Framework for Fixing Our Broken Tax Code," the insurance industry quickly focused on one key sentence, "[T]he framework will modernize these rules to ensure that the tax code better reflects economic reality and that such rules provide little opportunity for tax avoidance." In general, the proposals to modernize insurance tax rules have resulted in significant revenue-raisers on the insurance industry and, in some instances, unintended consequences for the industry. On November 6, 2017, during markup of the W&M Bill, Kevin Brady (R-TX) stated, "I will also note that this is not the last effort to continue to make further improvements on the base bill … to address unintended consequences of certain insurance proposals and working with the council and others in that regard." Further, on November 9, 2017, as Kevin Brady introduced another amendment to the W&M Bill, he stated that "in other areas … including insurance, we continue to examine the proposals in the original bill, make refinements and changes going forward, and I'm confident at the end of the day we will strengthen all sectors, including insurance." We recognize that the changes to Subchapter L in the W&M Bill are viewed by both key House tax policymakers and industry representatives as "placeholders" as negotiations between the industry and House and Senate tax writers continue. Many in the insurance industry are proactively working with lawmakers to improve the proposals that result in unintended consequences on the insurance industry and, as such, the Subchapter L proposals identified in this Alert are subject to change. Computation of life insurance tax reserves, capitalization of certain policy acquisition expenses (Tax DAC), and modification of rules for life insurance proration for purposes of determining the dividends received deduction At the start of the House legislative process on tax reform, House Ways and Means Committee Chairman Kevin Brady issued a tax reform bill on November 2 that included three significant changes to Subchapter L, focusing on life insurance companies. The W&M Bill, as originally issued, provided that deductible tax reserves would generally equal statutory reserves, with some notable exclusions, subject to a cap of 76.5% and an elimination of the cash value floor. The Tax DAC proposal would have changed the categories of specified contracts from three to two, group and non-group. Group contracts would have been subject to Tax DAC at 4% and non-group would have been subject to Tax DAC at 11%. Finally, the proration rules of Section 812 would have been eliminated and replaced by a flat company share of 40% and a policyholder share of 60% for both separate and general accounts. After intense lobbying by the life insurance industry, these three proposals were eliminated and a "placeholder" provision that would impose a surtax of 8% on life insurance company taxable income was added. The new provision is designed to raise the same amount of revenue as the three eliminated provisions, approximately $23 billion over 10 years. The inclusion of the placeholder provision in the W&M Bill represented an accommodation by House Republican leaders that they and the industry will work together to make changes to Subchapter L in the context of life insurance taxation that will raise about $23 billion over 10 years. Those discussions are expected to play out over the next several weeks and into December as the tax reform legislation is considered in the Senate. On the Senate side, the starting point for drafting a tax reform bill, presented by Senate Finance Committee Chairman Orrin Hatch on November 9, also includes what many view as a placeholder provision. That proposal addressed Tax DAC, keeping the categories of specified contracts as in current law, but increasing the Tax DAC percentages by 20% each. The proposal also called for an extension of the current 10-year amortization period to a 50-year (600 month) amortization period. This provision also raises approximately $23 billion over 10 years. Of note, Senator Tim Scott (R-SC) has filed an amendment to the Finance Committee proposal that embodies the industry's preferred approach. It would provide that deductible tax reserves are generally equal to statutory reserves subject to a 5% haircut and, leaving the cash value floor in place, the Tax DAC provision would be generally the same as the SFC Chairman's Mark, but with a 15-year amortization period. Proration would be a flat percentage of 70% company share and 30% policyholder share for both general and separate accounts. Whether this amendment is included in the bill voted out of the Senate Finance Committee remains to be seen. At this time, it is clear that the life insurance industry continues to work with House and Senate tax writers to develop proposals that may be included in any final legislation. The situation remains fluid such that it is important to monitor developments and be prepared for further changes. The proposal would repeal the operations loss deduction for life insurance companies and allow the net operating loss (NOL) deduction under Section 172 (as adjusted under both proposals). This would provide the same treatment for losses of life insurance companies as for other corporations. Both proposals would have changed Section 172 such that the NOL deduction would be limited to 90% of taxable income (determined without regard to the deduction). Both proposals would provide that carryovers to future years are adjusted to take this limitation into account and may be carried forward indefinitely with an inflation adjustment. The proposal would repeal NOL carrybacks. The NOL deduction of a life insurance company is determined by treating the NOL for any tax year generally as the excess of the life insurance deductions for the tax year over the life insurance gross income for the tax year. This change would be effective for losses arising in tax years that begin after 2017. Late in the evening on November 14th, Senator Orrin Hatch released a modified Chairman's Mark for the Tax Cuts and Jobs Act that preserves present law treatment for NOLs of property and casualty ("P&C") insurance companies. Under the modification, NOLs of P&C insurance companies would be allowed to be carried back two years and carried over 20 years to offset 100% of taxable income in such years. To the extent Section 172 is changed such that NOL carrybacks are precluded, the first component of the admissibility test, SSAP No. 101 paragraph 11.a., will be largely irrelevant (capital loss carrybacks continue to be permitted under both proposals). Because SSAP No. 101 paragraph 11.a. links the hypothetical loss carryback to the IRC carryback proposals, a tax law change to those proposals 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 deferred tax assets. The proposal would amend Section 807(f) such that a change in the basis for life reserves would be taken into account under Section 481 and subject to the accounting method change rules. The proposal would be effective for tax years beginning after 2017. If the final proposal regarding tax basis of life insurance reserves results in tax reserves equaling a specified percentage of annual statement reserves, several questions will need to be answered. First, current law Section 807(f) is self-executing, while Section 481 is not. Query whether this current law treatment would continue to apply to 807(f) changes in basis. If the tax reserve computation changes to a determination based on statutory reserves, will any change in the statutory reserve computations be an 807(f) change in basis? If not, would the current law rules, such as those set forth in Revenue Procedure 94-74, still apply to determining when a change in statutory reserve computations constitutes a change in basis? The proposal would repeal the special deduction that allows insurance companies with assets below $500 million to deduct 60% of their first $3 million in income related to life insurance. The repeal would be effective for tax years beginning after 2017. Repeal of special rule for distributions to shareholders from pre-1984 policyholders surplus account (PSA) The proposal would repeal the rules for policyholders' surplus accounts under Section 815, imposing a tax on the balance of the PSA as of December 31, 2017. Life insurance company losses would not be allowed to offset the amount of the PSA subject to tax. The proposal would be effective for tax years beginning after 2017. The balance of the PSA as of December 31, 2017, would be subject to tax, payable in eight annual installments. Key proposals in the W&M Bill and SFC Chairman's Mark of interest to property and casualty (P&C) companies In general, the W&M Bill would change the loss reserve discounting rules applicable to P&C insurers by modifying the prescribed interest rate, extending the periods applicable under the loss payment pattern, and repealing the election to use a taxpayer's historical loss payment pattern. Specifically, the W&M Bill would require P&C insurance companies to use the corporate bond yield curve, as defined in Section 430(h)(2)(D)(i) and determined by the Secretary, to discount the amount of unpaid losses and loss adjustment expenses. Also, the special rule extending the loss payment patterns period for long-tail business would be applied to all types of business (short-tail and long-tail), but a 15-year limitation would replace the five-year limitation. The W&M Bill would be effective for tax years beginning after 2017 and would include a transition rule that would spread the adjustment for pre-effective date unpaid losses and loss adjustment over the 2018 tax year and succeeding seven tax years. P&C insurers would experience a deeper discount on their tax loss reserves as a result of this W&M Bill's subjecting all lines of business to a higher interest rate and extended payment patterns. The W&M Bill, however, would impact insurance companies with longer tail business (i.e., workers' compensation, medical professional liability, etc.) more significantly than those with short-tail product lines (i.e. auto physical damage, health insurance, etc.). Also, insurance companies that have historically paid claims faster than the industry average and elected the use of company-specific payment patterns would be affected. The proposal would replace the 15% reduction under Section 832(b)(5)(B) with a 26.25% reduction. The proposal would be effective for tax years beginning after 2017 under the W&M Bill and effective for tax years beginning after 2018 under the SFC Chairman's Mark. The proposal in the SFC Chairman's Mark calls for the rate to be adjusted in future years so that the product of proration and the top corporate rate is always 5.25%. The tax policy rationale for the proration rule reflects the notion that deductible reserves are generally funded in part from tax-exempt interest, deductible dividends and other untaxed amounts. The explanations to both proposals state that the proposal would keep the reduction in the reserve deduction consistent with current law by adjusting the rate proportionately to the decrease in the corporate tax rate; they do not consider that deductible reserves are being more deeply discounted under both proposals than under current law. When coupled with the loss reserve discounting proposals, P&C insurance companies, particularly those with a significant tax-exempt bond portfolio, will experience a noticeable decrease in deductible loss reserves. It is worth noting this proposal would eliminate the significant complexity contained in a similar proposal in the tax reform discussion draft released by Chairman Camp in February 2014. The proposal would repeal the Section 847 elective deduction and related special estimated tax payment rules. The proposal would be effective for tax years beginning after 2017. The proposal would reduce the corporate income tax to a flat 20% rate. The proposal would be effective for tax years beginning after 2017 under the W&M Bill and effective for tax years beginning after 2018 under the SFC Chairman's Mark. The lower corporate tax rate generally may result in a lower effective tax rate for the insurance industry. The Subchapter L base-broadeners, however, will often reduce or negate the benefits received by insurers of a lower corporate tax rate from a current tax expense perspective. In many cases, depending on an insurance company's facts, current tax expense under these proposals may be higher than under current law. Also, under the SFC Chairman's Mark, the lower corporate tax rate would not be effective until 2019; however, several base-broadeners would be effective in 2018, notwithstanding the transition rules, which could result in a significant increase in current tax expense in 2018. Insurance companies would also be required to adjust the value of deferred taxes upon enactment, both under ASC 740 and SSAP No. 101. The delayed effective date of the corporate rate reduction under the SFC Chairman's Mark would create additional complexity in determining the value of deferred taxes upon enactment due to the need to schedule the future reversals of deferred tax items to determine whether the existing rate of 35% would still be the appropriate rate, or whether the new proposed rate is appropriate. The proposal would repeal current law Section 163(j) and would limit the deduction for business interest to the sum of business interest income plus 30% of the adjusted taxable income of the taxpayer for the taxable year. By including business interest income in the limitation, the rule would operate to limit the deduction for net interest expense to 30% of adjusted taxable income. That is, a deduction for business interest would be permitted to the full extent of business interest income. To the extent that business interest exceeds business interest income, the deduction for the net interest expense would be limited to 30% of adjusted taxable income. Under the W&M Bill, adjusted taxable income would be defined as a business's taxable income calculated without taking into account business interest expense, business interest income and NOLs, as well as depreciation, amortization and depletion. Adjusted taxable income, as defined in the SFC Chairman's Mark, would not allow for the exclusion of depreciation, amortization and depletion, resulting in a lower amount by which to measure the 30% threshold. Business interest would mean any interest paid or accrued on indebtedness properly allocable to a trade or business. Any amount treated as interest for purposes of the IRC is interest for purposes of the proposal. Business interest income would mean the amount of interest includible in the gross income of the taxpayer for the tax year which is properly allocable to a trade or business. Business interest would not include investment interest, and business interest income would not include investment income, within the meaning of Section 163(d). The limitation would apply at the taxpayer level and in the case of a group of affiliated corporations that file a consolidated return, it applies at the consolidated tax return filing level. Under the W&M Bill, the proposal would allow businesses to carry forward interest amounts disallowed under the proposal to the succeeding five tax years and those interest amounts would be attributable to the business. Under the SFC Chairman's Mark, the amount of any interest not allowed as a deduction for any tax year may be carried forward indefinitely. Under both the W&M Bill and the SFC Chairman's Mark, the proposal would be effective for tax years beginning after December 31, 2017. Whether this proposal will impact insurance companies is unclear. Under the proposal, business interest would not include investment interest, and business interest income would not include investment income, within the meaning of Section 163(d). Section 163(d) defines investment income as gross income from property held for investment. Insurance companies generate significant investment income as an integral part of their business model that supports the ability to pay claims. Despite an insurance company's investment income being directly connected to the core operations of the business, there is concern in the industry that such investment income may fall within the definition in Section 163(d) and, although insurance companies generally have net interest income, it is possible the interest expense limitation may apply. Limitation on deduction of interest by domestic corporations that are members of an international financial reporting group Both the W&M Bill and the SFC Chairman's Mark would enact a worldwide limitation on interest deductibility. The W&M Bill would add new Section 163(n) to limit the deduction for interest paid by a domestic corporation that is a member of an international financial reporting group (IFRG), which means any group of entities that: (1) includes at least one foreign corporation engaged in a US trade or business, or at least one domestic corporation and one foreign corporation; (2) prepares consolidated financial statements; and (3) has average annual global gross receipts of more than $100 million for a specified reporting period. Under the W&M Bill, the domestic corporation's deduction for interest expense paid or accrued during the tax year could not exceed the sum of the domestic corporation's "allowable percentage" of 110% of its net interest expense, plus any interest income of the domestic corporation for that tax year. A domestic corporation's allowable percentage for a tax year is the ratio of its allocable share of the IFRG's net interest expense for the reporting year over its reported net interest expense for such reporting year of the IFRG. A domestic corporation's allocable share of an IFRG's net interest expense for any reporting year is the portion of the expense that bears the same ratio as the domestic corporation's EBITDA bears to the IFRG's EBITDA. Conversely, the SFC Chairman's Mark would enact a new provision to limit the deduction for net interest expense of a domestic corporation that is a member of a "worldwide affiliated group." A worldwide affiliated group would be a group of corporations that would qualify as an affiliated group under Section 1504, except that an ownership threshold of 50% (rather than 80%) would apply, and foreign corporations would be considered as part of the affiliated group. The new limitation would reduce the domestic corporation's interest expense deduction by the product of the domestic corporation's net interest expense multiplied by the "debt-to-equity differential percentage" of the worldwide affiliated group. The debt-to-equity differential percentage of the worldwide affiliated group would be the "excess domestic indebtedness" of the group divided by the total indebtedness of the domestic corporate members of the group. All US members of the worldwide affiliated group would be treated as one member for this purpose. Excess domestic indebtedness would be the amount by which the total indebtedness of the US members exceeds 110% of the total indebtedness that the US members would hold if their "total indebtedness to total equity" ratio were the same as that of the worldwide group. When both the Section 163(j) and worldwide interest limitations apply, the one that results in the lower limitation on interest deductions — and, therefore, the greatest amount of interest to be carried forward — will take precedence. Under the W&M Bill, any disallowed interest would be carried forward to the succeeding five tax years. Under the SFC Chairman's Mark, any disallowed interest would be carried forward indefinitely. Under both the W&M Bill and the SFC Chairman's Mark, the proposal would be effective for tax years beginning after December 31, 2017. Both the W&M Bill and the SFC Chairman's Mark proposed sweeping changes that could impact both US headquartered and non-US headquartered insurance companies. The major proposals for the international system include: (1) implementing a territorial tax system; (2) imposing a transition tax on accumulated foreign earnings; and (3) imposing anti-base erosion rules. For a more detailed analysis on the international tax proposals, see Tax Alerts 2017-1845 and 2017-1917. Both the W&M Bill and the SFC Chairman's Mark would modify the current worldwide taxation system to exempt from US tax dividends from foreign subsidiaries paid from foreign earnings. In addition, both proposals would tax on a current basis potentially significant amounts of foreign income under anti-base erosion provisions and modifications to subpart F. These so-called anti-base erosion provisions are notably different in the two proposals. In addition, both proposals would include a transition rule to the new territorial system that would subject foreign earnings held in assets that are deemed to be cash or cash-equivalents to a higher tax rate than illiquid assets. The W&M Bill would impose a one-time 14% tax on accumulated foreign earnings, reduced to 7% for illiquid assets. The SFC Chairman's Mark would apply rates of 10% and 5% (for illiquid assets). At the election of the US shareholder, the tax liability would be payable over a period of up to eight years. For purposes of the transition tax, neither proposal appears to address the treatment of foreign reserves as illiquid assets and the application of the lower rate to E&P connected to such reserves. Accordingly, foreign insurance subsidiaries may be subject to a higher rate of tax on un-repatriated earnings to the extent the earnings are held in cash or securities used to support insurance reserves. Under the W&M Bill, a US parent of one or more foreign subsidiaries would be subject to current US tax on 50% of the US parent's foreign earnings that are treated as having "high returns." Foreign high returns would be measured as the excess of the US parent's foreign subsidiaries' aggregate net income over a routine return (7% plus the Federal short-term rate) on the foreign subsidiaries' aggregate adjusted bases in depreciable tangible property, adjusted downward for interest expense. Foreign high returns would not include (among other items) income effectively connected with a US trade or business or subpart F income (i.e., insurance and financing income that meets the requirements for the active finance exemption (AFE) from subpart F income under current law). Similarly, the SFC Chairman's Mark would tax a US shareholder's aggregate net controlled foreign corporation (CFC) income at a rate that, presumably, would be similar to the rate on the incentives for US companies (i.e., less than or equal to 12.5%). Similar to the W&M Bill, the SFC Chairman's Mark focuses on the return from tangible property. The carve-outs for net CFC income under the SFC Chairman's Mark are similar, but not identical, to the W&M Bill. Most notably the carve-outs do not include AFE-qualifying income or commodities income. Under the transition rule, many foreign insurance company CFCs would hold very small amounts of tangible assets. Accordingly, under the SFC Chairman's Mark, many insurance company CFCs that meet the AFE rules could still be subject to the SFC Chairman's Mark proposal because it does not carve out AFE-qualifying income. Both proposals contain anti-base erosion provisions. Under Section 4303 of the W&M Bill, payments (other than interest) made by a US corporation to a related foreign corporation that are deductible would be subject to a 20% excise tax, unless the related foreign corporation elected to treat the payments as income effectively connected with the conduct of a US trade or business (ECI election). The provision would apply only to international financial reporting groups with payments from US corporations to their foreign affiliates totaling at least $100 million annually based on a formula described in Section 4303 of the W&M Bill. Similarly, the SFC Chairman's Mark would create a new base erosion minimum tax. The tax would apply to corporations (other than RICs, REITs or S-corporations) subject to US net income tax with average annual gross receipts of at least $500 million and that have made related-party deductible payments totaling 4% or more of the corporation's total deductions for the year. A corporation subject to the tax would generally determine the amount of tax owed under the provision (if any) by adding back to its adjusted taxable income for the year all deductible payments made to a foreign affiliate for the year (the modified taxable income). The excess of 10% of the corporation's modified taxable income over its regular tax liability for the year (net of an adjusted amount of tax credits allowed) is the base erosion minimum tax amount that is owed. The proposal in the SFC Chairman's Mark does not include an ECI election. These anti-base erosion provisions, as currently written, could impact related-party cross-border insurance transactions. The proposal would amend the PFIC exception for insurance companies, which would apply only if the foreign corporation would be taxed as an insurance company if it were a US corporation and if the applicable insurance liabilities reserves constitute: (1) more than 25% of the foreign company's assets or (2) at least 10% of the entity's assets if the dip below 25% is due to temporary circumstances. For the purpose of the proposal's exception from passive income, applicable insurance liabilities would mean, with respect to any P&C or life insurance business: (1) loss and loss adjustment expenses and (2) reserves (other than deficiency, contingency, or unearned premium reserves) for life and health insurance risks and life and health insurance claims with respect to contracts providing coverage for mortality or morbidity risks. The JCT descriptions of both the W&M Bill and the SFC Chairman's Mark state, "[U]nearned premium reserves with respect to any type of risk are not treated as applicable insurance liabilities for purposes of the proposal." While this statement from the JCT descriptions is clear, the statutory text in the W&M Bill is ambiguous as to whether unearned premiums are excluded for P&C companies. The section-by-section summary, however, released by the Senate Finance Committee staff on November 12, states, "[U]nder the provision, the PFIC exception for insurance companies would be amended to apply only if the foreign corporation would be taxed as an insurance company were it a US corporation and if loss and loss adjustment expenses, unearned premiums, and certain reserves constitute more than 25% of the foreign corporation's total assets." This sentence from the Senate Finance Committee staff section-by-section summary seems clear that unearned premiums are included in the ratio. To the extent unearned premiums are excluded from the ratio, many P&C insurers will be adversely affected. Increase in credit against estate, gift, and generation-skipping transfer tax; repeal of estate and generation-skipping transfer taxes With regard to the estate tax, the W&M Bill would: (1) double the basic exclusion amount to $10 million, indexed for inflation; (2) repeal, beginning after 2023, the estate and generation skipping taxes; and (3) retain the stepped-up basis for estate property. With regard to gift tax, the proposal would: (1) lower the gift tax to a top rate of 35%; (2) retain the $10-million basic exclusion; and (3) retain the $14,000 annual exclusion. Both exclusion amounts will be indexed for inflation. The proposal would be effective for tax years beginning after 2017 and would repeal the estate tax after 2023. The proposal would double the estate and gift tax exemption amount. This is accomplished by increasing the basic exclusion amount provided in Section 2010(c)(3) from $5 million to $10 million. The $10-million amount would be indexed for inflation occurring after 2011. The proposal would be effective for estates of decedents dying, generation-skipping transfers, and gifts made after December 31, 2017. Tax reporting for life settlement transactions, clarification of tax basis of life insurance contracts, and exception to transfer for valuable consideration rules The SFC Chairman's Mark would include certain rules related specifically to life insurance contracts. First, this proposal would impose a reporting requirement on both the acquirer of an interest in an existing life insurance contract and the payor of death benefits. This proposal would be effective for tax years after 2017. Second, the proposal would reverse the position the IRS took in Revenue Ruling 2009-13 such that no adjustment would be made for the "cost of insurance" (i.e., mortality, expense, or other reasonable charges incurred under the contract) in determining the basis of a life insurance or annuity contract. This proposal would be effective for transactions entered into after August 25, 2009. Finally, the proposal would provide that the exceptions to the transfer for value rules under Section 101(a) would not apply to a reportable policy sale, which means that some or all of the death benefits could be includible in taxable income. This proposal would be effective for tax years after 2017. House Republican leaders would like to bring their bill to the House floor this week. While the bill will likely be considered under a "closed rule" that will not permit floor amendments, it is possible that further changes to the bill could be made prior to final House passage as part of the adoption of that rule, meaning that adoption of the rule for House consideration of the bill would automatically incorporate changes developed by the leadership over the next few days. The Senate Finance Committee began mark up of its proposal on November 13 and may finish their work by the end of the week. Once the bill is approved by the Senate Finance Committee, the full Senate will likely consider the final product after Thanksgiving. The FY 2018 budget included reconciliation instructions for a tax bill that can add to the deficit by no more than $1.5 trillion over the first 10 years, which the plans adopted by Ways and Means and proposed by Senate Finance Committee Chairman Hatch adhere to. However, the Byrd Rule under the reconciliation process precludes any title of the tax bill from adding to the deficit beyond the 10-year budget window. Prior to completion of markup in the Finance Committee, it is expected that Chairman Hatch will propose changes to the bill to accommodate this rule. Senate floor action on the Finance Committee-passed bill in early December could bring further changes before a final Senate bill is passed. Just getting to final passage in the Senate will require delicate negotiations because Republicans hold such a thin, 52-48 majority. What is clear is that the Senate is developing a bill that will differ in significant ways from the bill produced by the House Ways and Means Committee. There are several options for the White House and congressional Republicans to reconcile those differences and produce a final bill by the end of the year. The most conventional option is a House-Senate conference that would follow Senate approval. A conference would require the House and Senate to engage in negotiations to reconcile the differences between both plans and produce a compromised version of the bill that would then be approved by both chambers and sent to the President for his signature. Another option is for the House to adopt whatever bill the Senate passes and send that bill to the President for his signature. 1 For an overview of the entire SFC Chairman's Mark, see Tax Alert 2017-1907. 2 For an overview of the entire W&M Bill, see Tax Alert 2017-1831. Document ID: 2017-1937 |
