On March 4, the Obama Administration released its fiscal year 2015 budget (FY 2015 Budget). In keeping with the Administration’s past budgets, the FY 2015 Budget includes a number of tax proposals that target insurance companies or that otherwise would have a direct effect on them. Specifically, those proposals would:
- Modify the proration rules for life insurance company general and separate accounts;
- Disallow deductions for “non-taxed reinsurance premiums paid to affiliates;”
- Provide for reciprocal reporting of information in connection with the implementation of the Foreign Account Tax Compliance Act (FATCA);
- Require information reporting for “private separate accounts” established by life insurance companies;
- Repeal IRC § 847, which allows insurance companies that are required to discount unpaid losses to claim an additional deduction up to the excess of (i) undiscounted unpaid losses over (ii) related discounted unpaid losses; and
- Impose a “financial crisis responsibility fee” on “financial institutions.”
In sum, these six proposals have been scored by Treasury as raising more than $70 billion of revenue over 10 years. We discuss these proposals below and also provide a brief overview of several other relevant proposals contained in the FY 2015 Budget. (Additional analyses of the more general proposals in the FY 2015 Budget can be found on Sutherland’s tax reform blog: www.TaxReformLaw.com.)
Sutherland Observation: Although the proposals included in the FY 2015 Budget are unlikely to gain much traction in Congress, it is interesting to note that there are some common themes in the FY 2015 Budget and the “Discussion Draft” of the Tax Reform Act of 2014 released by House Ways and Means Committee Chairman Dave Camp (R-Mich.) last week. For example, both the FY 2015 Budget and the Tax Reform Act of 2014 would modify the proration rules for life insurance company general and separate accounts and disallow deductions for certain reinsurance premiums paid to “non-taxed affiliates,” while leaving tax-deferred “inside build-up” intact. For a comprehensive discussion of the potential impact of the Tax Reform Act of 2014 on insurance companies, see our Legal Alert of February 28, 2014.
Modification of the Proration Rules for Life Insurance Company General and Separate Accounts
In the case of a life insurance company, the dividends-received deduction (DRD) is permitted only with regard to the “company’s share” of dividends received, reflecting the fact that some portion of the company’s dividend income is used to fund tax-deductible reserves for its obligations to policyholders. Likewise, the net increase or net decrease in reserves is computed by reducing the ending balance of the reserve items by the “policyholders’ share” of tax-exempt interest. The regime for computing the company’s share and policyholders’ share generally is referred to as “proration.”
A life insurance company’s separate account assets, liabilities, and income are segregated from those of the company’s general account in order to support variable life insurance and variable annuity contracts. In computing the separate account DRD, the company’s share and policyholders’ share of dividends received are determined separately for each separate account. In view of the nuances associated with these computations, the separate account DRD has been the subject of ongoing controversy in IRS audits of life insurance companies.
The FY 2015 Budget proposal, which is a carryover from the fiscal year 2014 budget (FY 2014 Budget), would repeal the existing regime for prorating between the “company’s share” and the “policyholders’ share.” Instead, the general account DRD, tax-exempt interest, and increases in certain policy cash values of a life insurance company would be subject to a fixed 15% proration in a manner similar to that which applies under current law to property and casualty insurance companies. Furthermore, the limitations on the DRD that apply to other corporate taxpayers would be expanded to apply explicitly to life insurance company separate account dividends in the same proportion as the mean of reserves bears to the mean of total assets of the account.
Sutherland Observation: In view of these proposed changes, dividends received by a life insurance separate account likely would be entitled to only a very small, if any, DRD.
This proposal would be effective for taxable years beginning after December 31, 2014.
Disallowance of Deductions for “Non-Taxed Reinsurance Premiums Paid to Affiliates”
As a general matter, insurance companies are allowed a deduction for premiums paid for reinsurance. If a reinsurance transaction results in a transfer of reserves and reserve assets to a reinsurer, the potential tax liability for the earnings associated with those assets generally is shifted to the reinsurer as well. Although the insurance income of a controlled foreign corporation (CFC) may be subject to current taxation in the U.S., insurance income of a foreign-owned foreign company that is not engaged in trade or business within the U.S. generally is not subject to U.S. tax. However, reinsurance policies issued by foreign reinsurers with respect to U.S. risks generally are subject to a U.S. federal excise tax equal to 1% of the premiums paid, unless waived by a tax treaty.
According to the General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals (FY 2015 Greenbook), “[r]einsurance transactions with affiliates that are not subject to U.S. federal income tax on insurance income can result in substantial U.S. tax advantages over similar transactions with entities that are subject to tax in the United States.” The FY 2015 Greenbook also states that “[t]he excise tax on reinsurance policies issued by foreign reinsurers is not always sufficient to offset this tax advantage.”
The FY 2015 Budget proposal, which is a carryover from the FY 2014 Budget and which is similar to proposals that have been sponsored by Rep. Richard Neal (D-Mass.) on several occasions, and submitted by House Ways and Means Committee Chairman Dave Camp (R‑Mich.) and former Senate Finance Committee Chairman Max Baucus (D-Mont.) for public discussion and comment, (i) would deny an insurance company a deduction for premiums and other amounts paid to affiliated foreign companies with respect to reinsurance of property and casualty risks to the extent that the foreign reinsurer (or its parent company) is not subject to U.S. federal income tax with respect to the premiums received; and (ii) would exclude from the insurance company’s income (in the same proportion in which the premium deduction was denied) any return premiums, ceding commissions, reinsurance recovered, or other amounts received with respect to reinsurance policies for which a premium deduction is wholly or partially denied.
Sutherland Observation: The reinsurance premiums paid to the foreign reinsurer to which this proposal applies would remain subject to the federal excise tax, and it appears that the ceding company still would be required to reduce its tax reserves by the amount ceded to the reinsurer. The latter result effectively would put the ceding company on a cash basis for deducting losses on the business reinsured, unless the affiliated foreign reinsurer elects to treat such reinsurance premiums as effectively connected income (as discussed below).
A foreign corporation that is paid premiums from an affiliate that otherwise would be denied a deduction under this proposal would be permitted to elect to treat those premiums and the associated investment income as income effectively connected with the conduct of a trade or business within the U.S. and attributable to a permanent establishment for tax treaty purposes. Furthermore, for purposes of the foreign tax credit, reinsurance income treated as effectively connected under this proposal would be treated as foreign source income and would be placed into a separate category within IRC § 904.
The proposal would be effective for policies issued in taxable years beginning after December 31, 2014.
Reciprocal Reporting of Information in Connection With the Implementation of FATCA
In many cases, foreign law may prevent foreign financial institutions from complying with FATCA by reporting information about U.S. accounts to the IRS. To date, such legal impediments have been addressed through intergovernmental agreements (IGAs) under which the relevant foreign government has agreed to provide the information required by FATCA to the IRS. According to the FY 2015 Greenbook, requiring U.S. financial institutions to report similar information to the IRS with respect to nonresident accounts “would facilitate the intergovernmental cooperation contemplated by the intergovernmental agreements.”
The FY 2015 Budget proposal, which is a carryover from the FY 2014 Budget, would require certain financial institutions to report the account balance (including, in the case of a cash value insurance contract or annuity contract, the cash value or surrender value) for all financial accounts maintained at a “U.S. office” and held by foreign persons. The proposal also would expand the current reporting required with respect to U.S. source income paid to accounts held by foreign persons to include “similar non-U.S. source payments.” Finally, Treasury would be granted authority to issue regulations to require financial institutions to report:
- The gross proceeds from the sale or redemption of property held in, or with respect to, a financial account;
- Information with respect to financial accounts held by certain passive entities with substantial foreign owners; and
- Such other information that “is necessary to carry out the purposes of the proposal.”
1. This proposal would expand the existing information reporting requirements imposed upon U.S. financial institutions through the collection of Forms W-8BEN from nonresident account holders and the issuance of Forms 1099 to such persons. In this regard, the proposed requirement to effectively look through certain “passive entities with substantial foreign owners” would be consistent with the reporting requirements imposed by FATCA. Moreover, as drafted, the proposal could result in Treasury imposing full “reverse FATCA” reporting obligations on U.S. financial institutions.
2. A case with potential implications on this proposal – Florida Bankers Association v. Treasury– presently is being appealed to the U.S. Court of Appeals for the District of Columbia Circuit. In that case, the district court upheld Treasury regulations promulgated in 2012 requiring U.S. banks, credit unions, and securities firms to report interest paid to some nonresident aliens to the IRS. See T.D. 9584, 2012-20 I.R.B. 900.
The proposal would be effective for returns required to be filed after December 31, 2015.
Required Information Reporting for “Private Separate Accounts” Established by Life Insurance Companies
Investments through a separate account of a life insurance company generally give rise to tax-free or tax-deferred income. This favorable tax treatment for investing through a life insurance company is not available, however, if the policyholder has so much control over the investments in the separate account that the policyholder, rather than the insurance company, is treated as the owner of those investments. According to the FY 2015 Greenbook, “better reporting of investments in private separate accounts . . . will enable the IRS to identify more easily which variable insurance contracts qualify as insurance contracts under current law and which contracts should be disregarded under the investor control doctrine.”
The FY 2015 Budget proposal, which is a carryover from the FY 2014 Budget, would require life insurance companies to report the following information to the IRS with respect to each contract whose cash value is partially or wholly invested in a “private separate account” for any portion of the taxable year and represents at least 10% of the value of the private separate account:
- The policyholder’s TIN;
- The policy number;
- The amount of accumulated untaxed income;
- The total contract account value; and
- The portion of that value that is (or was) invested in one or more private separate accounts.
For this purpose, a private separate account would be defined as any account with respect to which a related group of persons owns policies whose cash values, in the aggregate, represent at least 10% of the value of the separate account. Whether a related group of persons owns policies whose cash values represent at least 10% of the value of the account would be determined quarterly, based on information reasonably within the issuer’s possession.
This proposal would be effective for taxable years beginning after December 31, 2014.
Repeal of IRC § 847
In general, losses incurred by an insurance company that is required to discount unpaid losses include losses paid during a taxable year (net of salvage and reinsurance recovered), plus or minus the increase or decrease in discounted unpaid losses during the taxable year. Unpaid losses are determined on a discounted basis to account for the time that may elapse between an insured loss event and the payment or other resolution of the claim. Pursuant to IRC § 847, taxpayers may elect to take an additional deduction equal to the difference between the amount of their reserves computed on a discounted basis and the amount computed on an undiscounted basis.
The FY 2015 Budget proposal, which is a carryover from the FY 2014 Budget, would repeal IRC § 847 effective for taxable years beginning after December 31, 2014.
Imposition of a “Financial Crisis Responsibility Fee”
According to the FY 2015 Greenbook, this proposed fee is intended to recoup the costs of the TARP program, “as well as discourage excessive risk-taking, as the combination of high levels of risky assets and less stable sources of funding were key contributors to the financial crisis.”
The proposed fee, which is a carryover from the FY 2014 Budget, generally would apply to U.S.‑based bank holding companies, thrift holding companies, certain broker-dealers, companies that control certain broker-dealers, and insured depository institutions that have worldwide consolidated assets of at least $50 billion. U.S. companies owning and controlling these types of entities as of January 14, 2010, also would be subject to the fee. However, U.S. companies with worldwide consolidated assets of less than $50 billion would not be subject to the fee for the period when their assets are below this threshold. U.S. subsidiaries of foreign firms that fall into one of these categories and that meet the asset threshold also generally would be covered by this proposed fee.
The fee would be based on the company’s “covered liabilities.” For this purpose, covered liabilities generally constitute the consolidated risk-weighted assets of the company, less its capital, insured deposits, and certain loans to small business. These amounts would be computed using information filed with the appropriate federal or state regulatory agency. For insurance companies, certain policy reserves and other policyholder obligations also would be deducted in computing covered liabilities.
The rate of the fee applied to covered liabilities would be 17 basis points, and a 50% discount would apply to more stable sources of funding, including long-term liabilities. The fee would be deductible in computing corporate income tax.
The proposed fee would be effective as of January 1, 2016.
Additional Proposals of Note
In addition to the proposals discussed above, the FY 2015 Budget contains a number of other proposals that are relevant to insurance companies, or that otherwise have a broader application to corporate taxpayers. In particular, those proposals, most of which have carried over from the FY 2014 Budget, would:
- Modify the treatment of derivative contracts and the rules related to the identification of hedges. Under this proposal, derivative contracts, which would be defined broadly to include any contract the value of which is determined, directly or indirectly, in whole or in part, by the value of “actively traded property,” generally would be required to be marked to market at the end of each taxable year, and any gains or losses from marking the derivative contract to market would be treated as ordinary income or loss. Mark-to-market accounting would not be required, however, for a transaction that qualifies as a “business hedging transaction.”
- Require accrued market discount on bonds to be taken into income currently in the same manner as original issue discount (OID).
- Require information reporting for certain life settlement transactions.
- Restrict the exception to pro rata interest expense disallowance for corporate-owned life insurance to “20-percent owners.”
- Exempt certain foreign pension funds from the application of the Foreign Investment in Real Property Tax Act (FIRPTA).
- Reform the international tax rules. Specifically, the package of international tax proposals included in the FY 2015 Budget would:
- Defer deduction of interest expense related to deferred income of foreign subsidiaries;
- Require the determination of the foreign tax credit on a pooling basis;
- Tax currently “excess returns” associated with transfers of intangibles offshore;
- Limit shifting of income through intangible property transfers;
- Restrict deductions for “excessive interest” of certain members of “financial reporting groups;”
- Modify the tax rules for “dual capacity taxpayers;”
- Tax gain from the sale of a partnership interest on a “look-through” basis;
- Prevent the use of leveraged distributions from related foreign corporations to avoid dividend treatment;
- Extend IRC § 338(h)(16) to certain asset acquisitions;
- Remove foreign taxes from an IRC § 902 corporation’s foreign tax pool when earnings are eliminated;
- Create a new category of Subpart F income for transactions involving digital goods or services;
- Prevent avoidance of foreign base company sales income;
- Restrict the use of “hybrid arrangements” that create “stateless” income;
- Limit the application of exceptions under Subpart F for certain transactions that use “reverse hybrids” to create “stateless” income; and
- Limit the ability of domestic entities to expatriate.
- Defer deduction of interest expense related to deferred income of foreign subsidiaries;
- Repeal the “boot-within-gain” limitation of current law in the case of any reorganization transaction if the exchange has the effect of a distribution of a dividend, as determined under IRC § 356(a)(2).
- Conform the “control” test of IRC § 368 with the “affiliation” test of IRC § 1504.
- Amend the application of the general earnings and profits adjustment rules with respect to distributions of stock of another corporation.
- Repeal the “non-qualified preferred stock” provision of IRC § 351(g) and the cross-referencing provisions of the Internal Revenue Code that treat non-qualified preferred stock as boot.
- Repeal the rules under IRC § 708 concerning technical terminations of partnerships.
- Repeal the anti-churning rules under IRC § 197.
Sutherland Observation: The FY 2015 Budget does not contain proposals to extend the exceptions under Subpart F for certain active financing income and active insurance income. The absence of such proposals is noticeable in view of the fact that these exceptions expired at the end of 2013. However, discussions have continued in Congress regarding possible “extenders” legislation, so the absence of such proposals in the FY 2015 Budget may not signal anything more than a recognition of those ongoing discussions.