January 5, 2018
President signs tax reform bill with numerous changes affecting the insurance industry
On December 22, 2017, the President signed the "Tax Cuts and Jobs Act" (H.R. 1) (referred to herein as the final bill, the bill or the new law) into law, the first major overhaul of the federal income tax in more than 30 years. The enactment of the bill came a week after the House and Senate conferees to the Tax Cuts and Jobs Act released a Conference Agreement (December 15, 2017), which was ultimately approved by the Senate (December 19, 2017) and the House (December 20, 2017). Previously, the House of Representatives passed its version of the Tax Cuts and Jobs Act on November 16th (House Bill) and, two weeks later, the Senate passed its tax reform bill on December 2nd (Senate Bill).
The bill dramatically lowers the corporate tax rate from 35% to 21% beginning in 2018. This rate reduction, as well as other changes, did come at a significant revenue cost and, as a result, the bill needed to raise revenue through other changes in the tax law. Among these changes were provisions that directly impact insurance companies. All of the insurance-specific provisions in the final bill were scored as revenue raisers by the Joint Committee on Taxation (JCT), with the largest revenue being generated from the changes in the tax reserve calculations for life and property/casualty companies. In all, the bill's insurance tax provisions are expected to raise approximately $40 billion over the next 10 years, excluding the other revenue raisers on corporations that are also applicable to insurers. This Alert identifies key changes in the new law relevant to the insurance industry. Companies must study the bill closely, assess its impact and immediately begin the process of recording and disclosing the financial reporting effects of the new law.
Key changes to the taxation of life insurance companies
Computation of life insurance tax reserves
In general, the method of computing reserves under Section 807(d) is significantly simplified to provide that the life insurance reserve for any contract is the greater of the net surrender value of the contract or 92.81% of the tax reserve method applicable to the contract. For variable insurance contracts, the tax reserve is the greater of: (i) the net surrender value, or (ii) the portion of the reserve that is separately accounted for under Section 817, plus 92.81% of the excess (if any) of the tax reserve method, over the net surrender value.
Section 807(d)(3) states that the term "tax reserve method" means: (i) the Commissioners Reserve Valuation Method (CRVM) for life insurance contracts; (ii) the Commissioners Annuity Reserve Valuation Method (CARVM) for annuity contracts; (iii) the method prescribed by the National Association of Insurance Commissioners (NAIC) as of the date the reserve is determined for any non-cancellable accident and health contracts; and (iv) the reserve method prescribed by the NAIC that covers such contract or, if no reserve method has been prescribed by the NAIC, a reserve method that is consistent with the reserve method under (i), (ii) or (iii). Notably, the law retains the rules disallowing deductions for deficiency and asset adequacy reserves.
A transition rule requires companies to recalculate reserves held on contracts issued before the effective date using the new reserve computation method. The difference between the reserves computed using the old method and the new method is taken into account over the subsequent eight years beginning in 2018.
As life insurance products have evolved, insurance regulators have been addressing how life insurance companies must calculate and maintain reserves — specifically, moving toward a principles-based approach to the calculation of reserves. There was a lack of clarity around how the prior law would accommodate these new reserving methodologies. The modifications to Section 807(d) appear to accommodate these new reserving methods, most notably for principles-based reserves (PBR), by clearly relying on the statutory reserving method used by the insurance company. This change will end the debate about whether the net premium reserve is the only tax deductible reserve under a PBR calculation or whether the stochastic and deterministic reserve are also deductible. Under the new law, all three components of the reserve are part of the tax reserve method for the contract. Thus, the new rules will, in many cases, simplify the calculation of deductible tax reserves and help to reduce uncertainty about the treatment of new reserving methodologies.
Of particular note, the new law eliminates the requirement that the reserve method be the method in effect at the time the contract was issued. Specifically, Section 807(d)(3)(B) now defines CRVM, CARVM and other reserve methods prescribed by the NAIC to apply "as of the date the reserve is determined." This revision appears to be building elasticity into the computation of tax-deductible reserves to accommodate new reserving methodologies.
The changes to Section 807 seem to accommodate the unlocking of assumptions used to calculate the reserves that are contemplated under PBR for life insurance contracts. Since the unlocking of assumptions is part of the reserve method, and the law no longer requires that the assumptions in effect when the contract is issued continue to be used through the life of the contract to compute the reserve, a significant administrative complication associated with implementing PBR has been eliminated.
One potential issue arises under the calculation of deterministic and stochastic reserves that include a deficiency assumption. With the law continuing to disallow the deduction of deficiency reserves, there is a question about whether companies will have to identify the deficiency element of the reserve and not deduct it or whether the provision applies only to disallow a separately identified deficiency reserve. Also, companies will need to carefully review the "tax reserve method" definition to ensure it provides the same reserve computed for NAIC annual statement purposes. To the extent there are differences, perhaps due to permitted practices, etc., the tax reserve may need to be separately calculated.
Section 807(e)(2), which specifies the issuance date of group contracts as the date the master plan is issued, is eliminated by the new law. This change arguably may cause a reliance on NAIC annual statement accounting for reserves for group contracts.
The final bill includes statutory language under Section 807(d)(1)(D) that provides a "no double counting" rule, similar to existing statutory language found in Section 811(c). The Joint Explanatory Statement to the Committee of Conference (Conference Committee Report) provides that "no amount or item is taken into account more than once in determining any reserve under subchapter L of the Code. For example, an amount taken into account in determining a loss reserve under [S]ection 807 may not be taken into account again in determining a loss reserve under [S]ection 832. Similarly, a loss reserve determined under the tax reserve method (whether the Commissioners Reserve Valuation Method, the Commissioners Annuity Reserve Valuation Method, a principles-based reserve method, or another method developed in the future, that is prescribed for a type of contract by the National Association of Insurance Commissioners) may not again be taken into account in determining the portion of the reserve that is separately accounted for under [S]ection 817 or be included also in determining the net surrender value of a contract."
Also, pursuant to Section 807(e)(6), the Secretary of the Treasury is directed to develop new reporting rules "with respect to the opening balance and closing balance of reserves and with respect to the method of computing reserves for purposes of determining income."
According to the JCT staff, the changes to Section 807 will increase revenues by $15.2 billion over 2018-2027. Although this represents a significant reduction in the reserve deduction, it could have been much worse. The original proposal in the House Ways & Means version of the bill, released on November 2nd provided that deductible tax reserves would generally equal statutory reserves, with some notable exclusions, subject to a 23.5% haircut, and eliminated the cash value floor. The JCT staff scored the original proposal as only increasing revenues by $14.9 billion over 10 years. The life insurance industry demonstrated that the proposal raised multiples of this original score and the significant tax expense increase would have caused severe adverse economic consequences. The revised JCT score, based in large part on data supplied by the industry, on the updated haircut proposal in the Senate version of the bill validates industry concerns that the revenue impact of the original estimate was significantly understated. The Senate version of the provision was generally adopted in the final bill.
Capitalization of certain policy acquisition expenses (Tax DAC)
In general, the final bill follows the Senate Bill, but modifies the tax deferred acquisition cost (DAC) percentages to account for the 21% corporate tax rate effective in 2018. Section 848 is modified by increasing the period over which specified policy acquisition expenses are amortized from 120 months to 180 months, retaining the prior-law three categories of specified insurance contracts, and increasing the tax DAC percentages. The increased tax DAC percentages in the final bill are as follows: for annuity contracts, 2.09%; for group life insurance contracts, 2.45%; and for all other specified insurance contracts, 9.20%. The changes to Section 848 are effective for tax years beginning after 2017 and, according to the JCT, increase revenues by $7.2 billion over 2018-2027.
The original proposal in the Senate Finance Committee bill would have retained the three categories of specified contracts, significantly increased the tax DAC percentages and dramatically increased the amortization period to 50 years. This provision also would have raised approximately $23 billion over 10 years. Although this original proposal was a "placeholder" provision, initial JCT scoring uncertainties over an industry-preferred amendment offered by Senator Tim Scott threatened to keep the original proposal in the Senate Bill.
The final provision enacted into law is a substantial improvement over both the proposal in the tax reform discussion draft released by Chairman Camp in 2014 and the "placeholder" provision in the Senate Finance Committee bill that would have required a much longer amortization period. Camp's proposal was scored to increase revenues $11.7 billion over 10 years according to the JCT staff. Although it is another significant tax increase on the life insurance industry, many view the final provision as an acceptable compromise compared to prior proposals.
It is important to note that the only changes made to the Section 848 DAC rules are the changes to the length of the amortization period and the DAC rates. As a result, the rest of the final provision will continue to apply as it has since its enactment in 1990. Furthermore, the regulations issued under Section 848 are expected to continue to apply unchanged.
Modification of rules for life insurance proration
Identical to the Senate Bill, the final bill amends and significantly simplifies Section 812 so that, for purposes of the life insurance company proration rules, for both the separate and general accounts, the company's share is 70% and the policyholder's share is 30%. The provision is effective for tax years beginning after 2017.
Given the complexity of prior law, a change to flat company and policyholder percentage introduces substantial simplification to the Code. This enacted provision is an improvement over the proposal in the tax reform discussion draft released by Chairman Camp in February 2014 and the original proposal that was included in the House Ways & Means Committee bill issued on November 2, 2017. A one-size-fits-all approach, however, may disadvantage certain insurance companies based on their mix of business and investment approach. According to JCT staff, the enacted provision increases revenues by $0.6 billion over 2018-2027.
Net operating losses (NOL) of life and property and casualty (P&C) insurance companies
The operations loss deduction for life insurance companies is repealed. Instead, life insurance companies will be subject to the rules of Section 172, generally applicable to all other corporations. Section 172 is revised such that losses arising in tax years beginning after 2017 are:
— Limited to 80% of taxable income (determined without regard to the NOL deduction)
— Allowed to be carried forward indefinitely with an inflation adjustment but NOL carrybacks are repealed
In contrast, the NOL rules under prior law applicable to P&C insurance companies are retained. Thus, NOLs of P&C insurance companies could be carried back two years and carried over 20 years to offset 100% of taxable income in such years.
The conformity of the NOL rules for life insurance companies, along with the loss of the NOL carry-back raises significant statutory accounting issues for life insurers. For example, the first component of the admissibility test (NAIC Statement of Statutory Accounting Principles (SSAP) No. 101 paragraph 11.a.) is now largely irrelevant (note that capital loss carrybacks continue to be permitted). Because SSAP No. 101 paragraph 11.a. links the hypothetical loss carryback to the IRC carryback proposals, the change in tax law will directly affect the first component of the admissibility test. Now that paragraph 11.a. is largely irrelevant for life insurers, paragraph 11.b. in the admissibility test takes on greater importance for determining an insurance company's net admitted deferred tax assets.
Life insurers may also need to grapple with pricing pressures relating to existing policies that assume certain tax treatment of losses. Since premiums on existing contracts generally are not reset, any contracts that are priced assuming the NOL carryback will be available may become less profitable. Moreover, companies will need to assess how to price contracts going forward with regard to the taxation of losses and whether to include any assumptions in pricing.
P&C insurance companies will continue to be allowed to admit deferred tax assets under paragraph 11.a., as the NOL carryback provisions for P&C insurers are unchanged. The P&C industry was, at the end of the day, able to demonstrate to Congress the importance of retaining the two-year carryback to manage cash flow and financial statement impacts of losses, especially for catastrophe coverage writers, as part of their effort to manage risk and capital. Given the recent devastation caused by numerous natural disasters in 2017, Congress recognized the need for a well-capitalized P&C industry.
Adjustment for change in computing reserves
Like the House and Senate Bills, the final bill amends Section 807(f) so that a change in the basis for life insurance tax reserves is taken into account under Section 481 and subject to the accounting method change rules. The changes to Section 807(f) are effective for tax years beginning after 2017.
The computation of life insurance tax reserves raises several questions regarding the application of Section 807(f). For example, will any change in the statutory reserve computations be a Section 807(f) change in basis? If not, would the prior-law rules, such as those set forth in Revenue Procedure 94-74, still apply in determining when a change in statutory reserve computations constitutes a change in basis?
As noted above, the changes to Section 807(d) accommodate unlocking of assumptions used to calculate the reserve over time. As a result, a change in the calculation due to unlocking will likely not trigger a Section 807(f) adjustment event requiring a recalculation of the existing reserve and a four-year spread of the difference. Companies need to give careful consideration, however, to the specific change to determine whether it rises to the level of a change in basis under the new law.
Considering this change with the changes to Section 807(d), it would appear that the range of possible changes in basis have been significantly narrowed. As a result, an approach that requires consent of the IRS Commissioner may not be as onerous as one might think. Moreover, given the potential breadth of the definition of tax reserves under Section 807(d), and that unlocking of assumptions may no longer constitute a change in basis, one has to ask what constitutes a change in basis today. Under Revenue Procedure 94-74, the narrow view that only a mistake or change in facts is not a change in basis may actually further narrow the situations that are truly a change in basis. For example, if the wrong mortality table is used to calculate a reserve — is that a mistake, or change in basis? The analysis would be very fact specific and may depend on the actual procedures in place at the company. Some assistance with this analysis may be found in the Section 7702 waiver rulings that consider mistaken application of company interpretations of the law as waivable errors.
Tax reporting for life settlement transactions, clarification of tax basis of life insurance contracts, and exception to transfer for valuable consideration rules
Both purchasers of life insurance policies in a reportable transaction and issuing life insurance companies will be subject to new information reporting requirements. New rules relating to the transfer for value rules of Section 101(a)(2) clarify the prior-law exceptions to these rules, tightening them up by essentially requiring that the parties to a transaction have an independent relationship other than the settlement transaction to be eligible for the exceptions. Finally, the cost basis of life insurance contracts is clarified such that no adjustment is required for cost of insurance.
The change generally is effective for settlement transactions, death benefits paid, and transfers for value after December 31, 2017. The cost basis change, however, is effective for transactions entered into after August 25, 2009, revoking Revenue Rulings 2009-13 and 2009-14, which required cost basis to be reduced by cost of insurance.
The retroactive application of the cost basis rule, which effectively sets the Section 72(e)(6) investment in the contract calculation as the way to compute "cost basis" and gain or loss on contracts as the method to follow, not only repeals the two revenue rulings but arguably puts to bed a long-standing question about the continued viability of a line of cases relied on in those rulings that concluded basis could be calculated different ways for different purposes and different transactions. Under the new law, effectively only the Section 72(e)(6) calculation will be used to determine cost basis or investment in the contracts.
The retroactive effective date of the cost basis change may provide refund or recalculation opportunities for holders of contracts that were subject to a cost basis adjustment. Clearly, such opportunities will depend on the facts and circumstances of the transaction and consideration must be given to whether the applicable tax years are already closed.
Some concern has been raised about the impact of the narrowing of the exceptions to the transfer for value rules and the definition of a reportable life settlement transaction on corporate acquisitions of entities with existing corporate or bank-owned life insurance policies. Because these policies often cover former employees, there is concern that purchase of the entity holding the contract may trigger reporting obligations and impose the transfer for value limitations on tax-free death benefits. The application of these rules to such transactions will be driven by the facts of each case, but depending on the structure of the transaction, there may be compelling arguments that these new rules do not apply. As a result, consideration should be given to how best to structure such a transaction and the need for a private letter ruling.
Repealing small life insurance company deduction
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 is repealed for tax years beginning after 2017.
Repeal of special rule for distributions to shareholders from pre-1984 policyholders surplus account (PSA)
Section 815, relating to the PSA, is repealed and any remaining balance in such accounts as of December 31, 2017 is subject to tax in eight annual installments. Life insurance company losses are not allowed to offset the amount of the PSA subject to tax. The repeal of Section 815 is effective for tax years beginning after 2017.
Key changes to the taxation of P&C insurance companies
Modification of discounting rules for P&C insurance companies
P&C loss reserve discounting rules are modified by changing 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, P&C insurance companies will 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. The corporate bond yield curve reflects the average for the proceeding 60-month period (rather than the 24-month period in the House Bill) of monthly yields on investment-grade corporate bonds with varying maturities and that are in the top three quality levels available. The prior law three-year period for discounting certain lines of business, other than long-tail lines, was not modified under the final bill. The prior law 10-year period for certain long-tail lines is extended for a maximum of 25 years. Finally, the election to use company-specific, rather than industry-wide, historical loss payment patterns was repealed.
The changes to Section 846 are effective for tax years beginning after 2017 and include a transition rule that spreads the adjustment for pre-effective date unpaid losses and loss adjustment expenses over the subsequent eight years beginning in 2018.
P&C insurers with long-tail business will experience a deeper discount on their tax loss reserves as a result of the higher interest rate and extended payment patterns. Also, insurance companies that have historically paid claims faster than the industry average and elected the use of company-specific payment patterns will be affected. The change to the 60-month average from the proposed 24-month average, however, was a significant improvement sought by the industry, as the 60-month average more closely approximates the investment portfolios of insurance companies that support their reserves. The change is a favorable one and mitigates some of the adverse impact of the longer payment patterns.
The transition rule presents significant complications for insurance companies, as the method for doing the computation is dependent upon a calculation of discount factors and an interest rate for 2018 for which additional guidance is needed from Treasury. The calculation is required to be made using an interest rate that is not yet available, nor fully defined. Moreover, the calculation contemplates a recalculation of existing loss reserves for all accident years. It appears the provision requires using 2018 discount rates to perform this recalculation, rather than taking a vintage approach that would require a recalculation of discount factors for a number of prior years. Confirmation on this point will be critical guidance needed from the Secretary. There are ways to estimate the interest rate for 2018 and discount factors, but companies will need to understand that in the absence of clear guidance, these are only estimates and changes will likely occur as official guidance is published.
According to the JCT, the changes to Section 846 will increase revenues by $13.2 billion over 2018-2027.
Modification of proration rules for P&C insurance companies
The P&C proration rate of 15% in Section 832(b)(5)(B) is replaced with a 25% reduction so that the product of the proration percentage and the 21% corporate tax rate is 5.25%. The change is effective for tax years beginning after 2017. Notably, the change is linked to the corporate tax rate, so that if the corporate tax rate were again to be changed, the proration percentage would also change accordingly.
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. While the Conference Committee Report explains that the proposal keeps the reduction in the reserve deduction consistent with prior law by adjusting the rate proportionately to the decrease in the corporate tax rate; it does not indicate that the loss reserve discounting changes were taken into account in developing the new proration approach. When coupled with the loss reserve discounting provision, P&C insurance companies, particularly those with significant tax-exempt bond portfolios, may experience a noticeable decrease in their loss reserve deduction as a result of the increased proration percentage. However, this will in part be mitigated by the reduction in the overall tax rate.
According to the JCT, the changes to the P&C proration rules will increase revenues by $2.1 billion over 2018-2027.
Repeal of special estimated tax payments
The Section 847 elective deduction and related special estimated tax payment rules are repealed for tax years beginning after 2017.
General changes to the taxation of corporations
Reduction in corporate tax rate
The corporate income tax rate is reduced to a flat 21% rate, effective for tax years beginning after 2017.
The lower 21% corporate tax rate generally may result in a lower effective tax rate for the insurance industry. The Subchapter L base-broadeners, however, will 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 the new law may be higher than under prior law.
Insurance companies are also required to adjust the value of deferred taxes upon enactment, both under ASC 740 and SSAP No. 101. Because the President signed the tax bill before December 31, the value of deferred taxes must be adjusted in the December 31, 2017 year-end financial statements.
The Securities and Exchange Commission staff issued Staff Accounting Bulletin (SAB) 118 and Compliance and Disclosure Interpretation 110.02 addressing the enacted US tax reform legislation. This guidance provides an alternative model for companies to consider in accounting for the change in tax law. See SAB 118 — Income Tax Accounting Implications of the Tax Cuts and Jobs Act for further details.
Corporate alternative minimum tax (AMT)
The corporate alternative minimum tax (AMT) is repealed, as provided in the House Bill. Taxpayers with an AMT credit can use the credit to offset their regular tax liability. Taxpayers are able to claim a refund of 50% (100% for years beginning in 2021) of the remaining credits (to the extent the credits exceed regular tax for the year) in tax years beginning before 2022. The provision applies to tax years beginning after 2017.
Dividends received deduction (DRD)
The amount of deduction allowable against the dividends received from a domestic corporation is reduced. Specifically, the deduction for dividends received from other than certain small businesses or those treated as "qualifying dividends" is reduced from 70% to 50%. Dividends received from 20%-owned corporations is reduced from 80% to 65%. Importantly, the final bill does not include a mechanism for so-called corporate integration.
Limitation on deduction for interest
The final bill adopts a compromise approach between the House and Senate Bills with respect to business net interest expense limitations under a revised Section 163(j). The revised Section 163(j) limitation applies to net interest expense that exceeds 30% of adjusted taxable income (ATI). Beginning in 2018, ATI is computed without regard to depreciation, amortization, or depletion. Beginning in 2022, ATI will be decreased by those items, thus making the computation 30% of net interest expense exceeding earnings before interest and taxes (EBIT). ATI would otherwise be defined similar to current Section 163(j). Interest expense needs to be related to a "business," which means the interest is properly allocable to a trade or business.
Business interest means 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 means the amount of interest includible in the taxpayer's gross income for the tax year that is properly allocable to a trade or business. Business interest does not include investment interest, and business interest income would not include investment income, within the meaning of Section 163(d).
The limitation applies at the taxpayer level and, for a group of affiliated corporations that file a consolidated return, would apply at the consolidated tax return filing level. Also, disallowed amounts can be carried forward indefinitely.
Importantly, unlike the House and Senate bills, the final bill drops the additional interest expense limitation that would have been imposed through a worldwide debt cap under what would have been Section 163(n).
The provision is effective for tax years after 2017.
The version of the legislation that began in the House was unclear as to how it would affect insurance companies. Under the original proposal released by House Ways and Means Committee Chairman Kevin Brady (R-TX), 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, which supports the ability to pay claims. Despite an insurance company's investment income being directly connected to the core operations of the business, there was concern in the industry that such investment income may fall within the definition in Section 163(d) and the interest expense limitation could possibly apply, even though insurance companies generally have net interest income. However, Footnote 688 in the Conference Committee Report clarified this matter by stating, "Section 163(d) applies in the case of a taxpayer other than a corporation. Thus, a corporation has neither investment interest nor investment income within the meaning of [S]ection 163(d). Thus, interest income and interest expense of a corporation is properly allocable to a trade or business, unless such trade or business is otherwise explicitly excluded from the application of the provision." As a corporation can net its investment income against its interest expense, it is unlikely insurance companies will be significantly affected by this new limitation.
Special rules for tax year of income inclusion
The final bill adopts a provision in the Senate Bill that modifies the recognition of income rules under Section 451(b) by requiring the recognition of income no later than the tax year in which an item is taken into account as income on an applicable financial statement or another financial statement under rules provided by the Secretary. The new law also requires the application of the revenue recognition rules under Section 451 before applying the special rules under part V of subchapter P, which, in addition to the original issue discount (OID) rules, also includes rules regarding the treatment of market discounts on bonds, discounts on short-term obligations, OID on tax-exempt bonds, and stripped bonds and stripped coupons.
The provision generally applies to tax years beginning after December 31, 2017. In the case of income from a debt instrument having OID, the provision applies to tax years beginning after December 31, 2018. Also, application of these rules is a change in the taxpayer's accounting method for Section 481 purposes.
While the final book/tax conformity rule has somewhat narrowed in its applicability since the provision was originally introduced in the Senate Finance Committee bill, the new provision will require insurance companies to carefully evaluate both tax rules and financial accounting rules to determine the appropriate timing of income recognition. Questions still remain, however, as to exactly which items of income will be recognized earlier for federal income tax purposes. Specifically, questions remain as to whether the new provision will eliminate the ability to defer the accrual of market discount for insurers. Life insurers, however, may be able to rely on Section 811(b)(3) to continue to defer the accrual of market discount, but questions still remain on this issue. Section 811(b)(3) states, "no accrual of discount shall be required under paragraph (1) on any bond (as defined in Section 171(d)), except in the case of discount which is — (A) interest to which Section 103 applies, or (B) original issue discount (as defined in Section 1273)." P&C insurers, excluding Section 831(b) companies, do not have a similar accounting methods provision under Subchapter L.
Insurance companies determine federal taxable income using the NAIC annual statement. It is logical to assume that the applicable financial statement for purposes of Section 451(b) must be the NAIC annual statement. However, based on the statutory text of Section 451(b), it is not yet certain that the applicable financial statement is the NAIC annual statement for all insurers. This will have to be made clear in regulations issued by the Secretary.
Also, there was concern whether the new provision could require a mark-to-market tax adjustment for certain investment assets. Footnote 872 in the Conference Committee Report makes clear the provision does not require recognition of gain or loss from securities that are marked-to-market for financial reporting purposes if the gain or loss from such investments is not realized for federal income tax purposes until the taxpayer sells or otherwise disposes of the securities.
Key international tax changes affecting insurance companies
The new law significantly modifies the US international tax system, by: (1) implementing a form of territorial tax system for business income; (2) imposing a one-time transition tax on accumulated foreign earnings; and (3) introducing new anti-base erosion rules. For a more detailed analysis on the new international tax laws, see Tax Alert 2017-2166.
Territorial taxation of foreign income and transition tax
The bill modifies the current worldwide taxation system to exempt from US tax the dividends from foreign subsidiaries paid from foreign earnings. In addition, the one-time transitional tax will be imposed on a US shareholder's pro-rata share of the undistributed, non-previously taxed post-1986 earnings of a CFC or other "specified foreign corporation," at an effective rate of either 15.5% (to the extent of cash or other liquid assets) or 8% (for illiquid assets) by applying a new participation exemption deduction provided in Section 965(c). A US shareholder can elect to pay the tax over a period of up to eight years, with larger payments due in the last three years.
The bill does not address the treatment of foreign reserves as illiquid assets and the application of the lower rate to E&P connected to such reserves. Moreover, the new law does not adopt a House provision that would have provided special relief for so-called blocked assets of a CFC. Accordingly, foreign insurance subsidiaries will likely 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.
New current-year inclusion to US shareholders for global intangible low-taxed income and deduction allowable for foreign-derived intangible income and GILTI inclusions
The bill includes a Senate provision that imposes a tax on a US shareholder's aggregate net CFC income that is treated as global intangible low-taxed income (GILTI). GILTI is gross income in excess of returns from "qualified business asset investment" (QBAI) of its CFCs. GILTI excludes effectively connected income (ECI), subpart F income, certain high-taxed income, dividends from related parties, and foreign oil and gas extraction income. The extraordinary return base is equal to 10% of the CFCs' aggregate adjusted basis in the QBAI. Only 80% of the foreign taxes paid on the income would be allowed as a foreign tax credit (per a formula in the final bill). All CFCs are aggregated for purposes of the computation. Notwithstanding that the US corporation will be treated as having paid only 80% of the foreign taxes, the final bill amends Section 78 generally to treat the US corporation as having received dividends from the relevant CFCs equal in the aggregate to 100% of the foreign taxes (per the formula in the final bill). The final bill also creates a new foreign tax credit limitation category under Section 904(d) for GILTI that does not constitute passive category income (passive GILTI will continue to be treated as income in the passive limitation category). Excess foreign tax credits in the non-passive GILTI limitation category for a tax year cannot be carried back or forward to another tax year. For tax years beginning after December 31, 2017 and before January 1, 2026, the highest effective tax rate on GILTI is 10.5%. For tax years beginning after December 31, 2025 the effective tax rate on GILTI is 13.125%. Similar to the Senate Bill, the final bill did not carve out income that would qualify for the active financing exception (AFE).
The bill also maintains the tax incentive in the Senate Bill for US companies to earn intangible income from US intangibles abroad. Income from foreign derived intangible income (FDII) for tax years beginning after December 31, 2017 and before January 1, 2026 is provided an effective tax rate of 13.125%. For tax years beginning after December 31, 2025, the effective tax rate on FDII is 16.406%. Eligible income does not include, among other items, financial services income (i.e., insurance, banking, financing, etc.) under Section 904(d)(2)(D).
Most foreign insurance company CFCs hold very small amounts of tangible assets. Accordingly, many insurance company CFCs that meet the AFE rules could still be subject to the GILTI rule because the new law lacks a carve out for AFE qualifying income. It will be important for insurance companies to model the potential impact of GILTI inclusions taking into account the total tested income of all CFCs and the limitations on the foreign tax credits that can be used to reduce US tax on the GILTI inclusion.
The FDII deduction, in turn, incentivizes US corporations to provide services to a person outside the US. Insurance groups should consider all potential cross-border functions that could potentially be impacted by the FDII deduction and potential changes to those functions to take into account these new rules.
Base erosion provisions
The bill includes a new base erosion anti-abuse tax (BEAT) provision. The BEAT applies to corporations (other than RICs, REITs, or S-corporations) that are 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 3% (2% in the case of banks and certain security dealers) or more of the corporation's total deductions for the year. A corporation subject to the tax generally determines the amount of tax owed under the provision (if any) by adding back to its adjusted taxable income all deductible payments made to a foreign affiliate (base erosion payments) for the year to determine modified taxable income. Base erosion payments do not include cost of goods sold, certain amounts paid with respect to services, and certain qualified derivative payments. Regarding outbound services payments, such payments do not constitute base erosion payments if such services meet the requirements for eligibility for use of the services cost method under Section 482 (with certain modifications). The excess of 10% (5% in the case of one tax year for base erosion payments paid or accrued in tax years beginning after December 31, 2017) 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. For tax years beginning after December 31, 2025, the rate is increased from 10% to 12.5%. Clarifying language was added in conference providing that that a base erosion payment includes any premium or other consideration paid or accrued by the taxpayer to a foreign person that is a related party of the taxpayer for any reinsurance payments taken into account under Sections 803(a)(1)(B) or 832(b)(4)(A).
Similar to the Senate Bill, the new rules provide an exception under which certain qualified derivative payments are not treated as base erosion payments. However, the Conference Committee Report (which was included in the final bill) clarified that the term "derivative" does not include any insurance, annuity, or endowment contract issued by an insurance company to which subchapter L applies (or issued by any foreign corporation to which subchapter L would apply if the foreign corporation were a domestic corporation).
Penalties that arise under the BEAT provision for taxpayers that use certain business tax credits, including the low-income housing tax credit and renewable energy tax credits, are significantly mitigated under the final bill.
The BEAT has the potential to significantly impact cross-border insurance and reinsurance transactions. As this provision is applicable beginning in 2018, companies with significant related-party cross-border insurance transactions must begin to analyze the BEAT's impact on both existing and future transactions.
Provisions potentially impacting branch operations
Section 367(a)(5) active trade or business exception repealed
The final bill includes a provision in which transfers of property used in an active trade or business will no longer qualify as a non-recognition transfer. This provision is effective for transfers after December 31, 2017.
Limitation on cross-crediting foreign taxes
The final bill establishes a separate foreign tax credit basket for branches. This will minimize a corporation's ability to cross-credit between branches and CFCs.
Insurance groups should review the US tax positions of their branch structures and consider tax-efficient options for their branch operations taking into account the foreign tax credit limitation. To the extent companies consider incorporation of branches, the repeal of the active trade or business exception under Section 367(a) is likely to have a significant impact on domestic US corporations that decide to incorporate a foreign branch or transfer assets out to a foreign corporation in a non-recognition transfer.
Restriction on insurance business exception to passive foreign investment company (PFIC) rules
The new law amends the PFIC exception for insurance companies, which would apply only to a qualifying insurance corporation, which the new law defines as a "foreign corporation — (A) which would be subject to tax under subchapter L if such corporation were a domestic corporation and (B) the applicable insurance liabilities of which constitute more than 25% of its assets, determined on the basis of such liabilities and assets as reported on the corporation's applicable financial statement for the last year ending with or within the taxable year." There is an alternative test that utilizes a different threshold (i.e., applicable insurance liabilities may make up a minimum of 10% of the entity's assets if, under regulations provided by the Secretary, the applicable facts and circumstances indicate that the entity is predominantly engaged in an insurance business and failure to meet the 25% threshold is due solely to runoff-related or rating-related circumstances involving this insurance business).
For purposes of the PFIC insurance 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 for contracts providing coverage for mortality or morbidity risks.
The provision is effective for tax years beginning after 2017.
The JCT descriptions of both the House and Senate bills state that "unearned premium reserves with respect to any type of risk are not treated as applicable insurance liabilities for purposes of the proposal." The statutory text in the new law excludes unearned premiums from the ratio, which would adversely affect many foreign P&C insurers.
Further, given the language in the final bill that applies the PFIC insurance exception solely to "foreign corporations," it is not clear how a foreign company that owns stock in a US insurance company will factor the income and assets of that US insurance company into the PFIC computations. Depending on whether there will be any clarification of the final bill via regulatory guidance, foreign companies will need to consider how income and assets of US insurance company subsidiaries can qualify for the PFIC insurance exception.
Additional tax law changes of interest to the insurance industry
Modifications to estate, gift, and generation-skipping transfer taxes
The estate and gift tax exemption amount provided in Section 2010(c)(3) is increased from $5 million to $10 million. The $10-million amount is indexed for inflation occurring after 2011.
The provision is effective for estates of decedents dying, generation-skipping transfers, and gifts made after December 31, 2017.
After months of discussion, debate, negotiation, votes and re-votes, the Tax Cuts and Jobs Act is now the current tax law. While the impetus was tax reform, the impact goes well beyond tax reform. We are only just beginning to understand the breadth of the new law's effect. The impact will range across growth and strategy, product pricing, operating model, technology, capital, liquidity and investments, and more. It is important that decisions made in all these areas are coordinated, consistent and prioritized carefully.
As we enter 2018, we know there are many questions that don't yet have answers. Our insurance tax practice will continue to analyze the new law, provide thought leadership, and monitor the issuance of guidance on the bill, including legislative measures to correct technical issues with the law, regulatory and sub-regulatory (e.g., Notices) guidance from the IRS and Treasury, and the JCT's Bluebook explanations. More to come.