On November 19, retiring Senate Finance Committee Chairman Max Baucus (D-Mont.) released a “Discussion Draft” setting forth his international tax reform proposals. Of note, the Discussion Draft includes several proposals that target the international operations of U.S. insurance companies and international insurance groups with U.S. owners. Specifically, those proposals would:
- Make permanent the exceptions from insurance income and foreign personal holding company income for exempt insurance income and active insurance income;
- Modify the definitions of “qualifying insurance company” and “exempt contract” for purposes of determining exempt insurance income and active insurance income;
- Cause a significant portion (if not all) of a company’s exempt insurance income to become subject to tax on a current basis;
- Create a new Subpart F income category – “United States related income” – that would include income derived in connection with insurance or reinsurance services with respect to U.S. risks (and, as a result, likely would impact insurance and reinsurance management companies that constitute controlled foreign corporations to the extent that the companies are providing management services with respect to U.S. risks);
- Expand the controlled foreign corporation (CFC) definition by (i) eliminating the 30-day requirement and (ii) testing U.S. shareholder status based on a vote or value test, rather than just a vote test; and
- Disallow a deduction for “non-taxed reinsurance premiums” paid to affiliates.
These proposals are discussed below, along with a brief overview of several other relevant proposals contained in the Discussion Draft. (An analysis of the more general proposals in the Discussion Draft can be found on the Sutherland tax reform blog – www.TaxReformLaw.com.)
The Discussion Draft consists of (i) two separate options – Option Y and Option Z – that describe potential modifications to the Subpart F rules and other U.S. international tax provisions and (ii) a number of provisions that are common to both options. As a general matter, both options of the Discussion Draft would diminish a U.S. insurance company’s ability to defer certain insurance income earned by its CFC subsidiaries under the revised Subpart F regime. Option Y of the Discussion Draft generally would impose an immediate minimum tax at 80% of the U.S. corporate tax rate on U.S. shareholders of CFCs according to their pro rata share of the CFC’s foreign business income. Thus, if the U.S. corporate tax rate is 35%, the minimum tax under Option Y of the Discussion Draft would be 28%. Option Z of the Discussion Draft generally would impose an immediate minimum tax at 60% of the U.S. corporate tax rate on a CFC’s income derived from active business operations and subject the CFC’s other income to immediate taxation at the full U.S. corporate tax rate. Notably, each option leaves open the possibility of changing the percentages described above.
Concurrent with the release of the Discussion Draft, the Staff of the Joint Committee on Taxation issued its technical explanation of the proposals included in those materials (the JCT Technical Explanation).
Modified Definitions of “Qualifying Insurance Company” and “Exempt Contract”
Under current law, exempt insurance income is excluded from Subpart F insurance income. Exempt insurance income is defined as income derived by a “qualifying insurance company” that (i) is attributable to the issuing (or reinsuring) of an “exempt contract” by such company (or a qualifying insurance company branch of such company) and (ii) is treated as earned by such company (or branch) in its home country for purposes of that country’s tax laws. In addition, the active insurance income provisions of IRC § 954(i) incorporate the definition of qualifying insurance company by cross-reference.
Both options of the Discussion Draft would modify the definitions of the terms “qualifying insurance company” and “exempt contract” for purposes of determining exempt insurance income and active insurance income. Specifically, with respect to the qualifying insurance company definition, both options (i) would eliminate the requirement that the company derive more than 50% of its aggregate net written premiums from contracts covering home-country risks and (ii) would add two new requirements for purposes of that definition:
- First, more than 50% of the company’s gross receipts for a taxable year would be required to consist of premiums for insurance or reinsurance in connection with property, liability, or the lives or health of individuals that are treated as earned by such company in its home country for purposes of that country’s tax laws; and
- Second, the company’s applicable insurance liabilities would be required to equal more than 35% of the company’s total assets (as reported on the company’s applicable financial statement for the year within which the taxable year ends). For purposes of this requirement, “insurance liabilities” are defined as loss and loss adjustment expenses, unearned premiums, and reserves (other than catastrophe, deficiency, equalization, or similar reserves) for life and health insurance risks and life and health insurance claims with respect to contracts providing coverage for mortality or morbidity risks (but not to exceed the amount of such reserve that is required to be reported to the home country insurance regulatory body).
The JCT Technical Explanation states that the proposed revisions to the qualifying insurance company definition are designed “to better address current international insurance market practices and to better address abuse.” However, the JCT Technical Explanation does not provide any further insight as to what the perceived abuses in this area might be.
The new requirement that the company’s applicable insurance liabilities be equal to more than 35% of the company’s total assets would seem to prevent an overcapitalized company from constituting a qualifying insurance company.
Both options would retain the other definitional requirements presently applicable to a qualifying insurance company, i.e., the company (i) must be subject to home-country regulation, (ii) must derive more than 50% of its aggregate net written premiums from contracts not involving related persons, (iii) must be engaged in the insurance business, and (iv) would be subject to tax under Subchapter L if it were a domestic corporation.
With respect to the exempt contract definition, current law provides that, in order for such a contract to be treated as an exempt contract, three primary requirements must be satisfied:
- The contract must insure only non-U.S. risks;
- The qualifying insurance company (or qualifying insurance company branch) must derive more than 30% of its net written premiums from what otherwise would constitute exempt contracts (i) that cover “applicable home-country risks” and (ii) with respect to which no policyholder, insured, annuitant, or beneficiary is a related person (as defined in IRC § 954(d)(3)); and
- If the contract covers risks other than applicable home-country risks, the qualifying insurance company (or qualifying insurance company branch) (i) must conduct substantial activity with respect to an insurance business in its home country and (ii) perform in its home country substantially all of the activities necessary to give rise to the income generated by such contract.
Both options of the Discussion Draft would repeal the home-country risk prong of the 30% net written premium requirement for a qualifying insurance company (or a qualifying insurance company branch) to treat any contract as an exempt contract. In addition, both options would modify the substantial activity requirement such that any insurance contract, and not just a contract covering cross-border risks, would constitute an exempt contract only if (i) the company conducts substantial activities with respect to the contract and (ii) substantially all of the activities necessary to give rise to the income generated by the contract are performed by the company in its home country.
Sutherland Observation: With respect to the exempt contract definition, both options of the Discussion Draft would retain the current requirement that the qualifying insurance company (or qualifying insurance company branch) derive more than 30% of its net written premiums from what otherwise would constitute exempt contracts with respect to which no policyholder, insured, annuitant, or beneficiary is a related person.
Current Taxation of Exempt Insurance Income
Option Y of the Discussion Draft would add a new “low-taxed income” category to Subpart F income. This new category generally would be defined to include “any item of income,” other than certain other Subpart F income categories, including insurance income, if the effective rate of foreign income tax on such item of income is less than 80% of the maximum U.S. corporate tax rate (notably, the Discussion Draft leaves this 80% figure open to change). Thus, it appears that, notwithstanding the fact that a company’s insurance income constitutes exempt insurance income, that income could be included as Subpart F income under this new low-taxed income category.
Although neither the Discussion Draft nor the JCT Technical Explanation speaks to whether this result is intended or otherwise had been contemplated in conjunction with the preparation of the Discussion Draft, this result nonetheless seems to follow from the general design of the new low-taxed income category.
An item of income excluded from foreign personal holding company income could be treated as low-taxed income under the proposal. Thus, although foreign personal holding company income does not include qualified insurance income of a qualifying insurance company, this exception would not apply for purposes of determining low-taxed income treated as Subpart F income.
Given the relatively high corporate tax rate in the U.S. in relation to other developed countries, and the fact that the Discussion Draft proposes to define low-taxed income by reference to 80% of the U.S. corporate tax rate (although, as noted above, the Discussion Draft leaves this 80% figure open to change), it seems apparent that this new category of Subpart F income could have a very broad reach.
Option Z of the Discussion Draft would provide a new definition of Subpart F income that generally would be equal to the sum of “modified active income” and “modified nonactive income.” For purposes of this new definition, modified active income is anticipated to be equal to 60% of “active foreign market income” (although the Discussion Draft leaves this 60% figure open to change). Furthermore, under this option, exempt insurance income would be treated as active foreign market income. Thus, the effect of this proposal would be to tax 60% of a company’s exempt insurance income on a current basis.
New Subpart F Income Category Includes Income Derived in Connection with Insurance or Reinsurance Services with Respect to U.S. Risks
Option Y of the Discussion Draft also would add “United States related income” as a new category of Subpart F income. Under the proposal, United States related income would be the sum of a CFC’s “imported property income” and its “United States services income.” Although United States related income would not include insurance income or foreign personal holding company income, it would include, on account of the definition of United States services income, income derived in connection with services related to insurance or annuity contracts or reinsurance provided with respect to persons or property located in the U.S. or otherwise with respect to U.S. risks.
Sutherland Observation: The apparent effect of this proposal would be to cause income earned by insurance and reinsurance management companies that constitute CFCs to be treated as Subpart F income to the extent that the companies are providing management services with respect to U.S. risks.
Expanded CFC Definition
With respect to foreign corporations, the current rules of Subpart F apply to those foreign corporations that are CFCs for an uninterrupted period of at least 30 days during any taxable year. The Discussion Draft would eliminate the 30-day requirement, thereby broadening the scope of Subpart F so that its rules apply to foreign corporations that are CFCs at any point during the taxable year.
The Discussion Draft also would expand the definition of U.S. shareholder under Subpart F to include any U.S. person that owns 10% or more of the total value of shares of all classes of stock of a foreign corporation. Under current law, a CFC generally is defined as any foreign corporation if U.S. persons own (directly, indirectly, or constructively) more than 50% of the corporation’s stock (measured by vote or value), taking into account only those U.S. persons that own at least 10% of the stock measured by vote only.
Sutherland Observation: The Discussion Draft’s proposal to expand the CFC definition by testing U.S. shareholder status based on a vote or value test, rather than just a vote test, likely will cause many non-publicly traded insurance companies to revisit their ownership structures, because many have relied on the current definition of U.S. shareholder for that purpose.
Deduction for “Non-Taxed Reinsurance Premiums” Paid to Affiliates Disallowed
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 CFC may be subject to current taxation in the U.S., insurance income of a foreign-owned foreign company that is not engaged in a U.S. trade or business generally is not subject to U.S. federal income 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.
The Discussion Draft proposal, which is similar to proposals that have been included in recent budget proposals from the Obama Administration, as well as those that have been sponsored by Rep. Richard Neal (D-Mass.) on several previous occasions, (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 a U.S. shareholder of that company) is not subject to U.S. federal income tax with respect to the premiums received; and (ii) would exclude from the ceding company’s income (in the same proportion in which the premium deduction was denied to it) any return premiums, ceding commissions, reinsurance recovered, or other amounts received with respect to a reinsurance transaction for which a premium deduction is wholly or partially denied.
Sutherland Observation: The reinsurance premiums paid to the foreign reinsurer would remain subject to the U.S. federal excise tax, and it appears that the ceding company still must reduce its tax reserves by the amount ceded to the reinsurer. The latter result would effectively 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 U.S. trade or business and attributable to a permanent establishment for tax treaty purposes. For purposes of the foreign tax credit, reinsurance income treated as effectively connected under this rule would be treated as foreign source income and would be placed into a separate category within IRC § 904.
Additional Proposals of Note
In addition to the proposals discussed above, the Discussion Draft contains a number of proposals that have a broader application to corporate taxpayers (both U.S. and non-U.S.). In particular, the Discussion Draft would:
- Repeal the provisions of IRC § 956 concerning CFC investments in U.S. property;
- Repeal the IRC § 902 deemed-paid credit;
- Treat as a corporation any business entity that otherwise would be eligible under the entity classification rules of IRC § 7701 to elect its status for U.S. federal tax purposes if it is wholly owned either by a single CFC or by two or more members of an “expanded affiliated group,” one of which is a CFC;
- Repeal the rules that impose an interest charge when a U.S. person that owns stock of a passive foreign investment company (PFIC) receives an excess distribution with respect to that stock and, more generally, simplify the rules related to PFICs;
- Prohibit members of a U.S. affiliated group from allocating interest expense on the basis of the fair market value of assets for purposes of IRC § 864(e);
- Repeal the portfolio interest exception for corporate debt obligations currently provided under IRC § 871(h) and IRC § 881(c);
- Repeal the dual consolidated loss rules;
- Increase a foreign shareholder’s ownership threshold for stock of certain publicly traded qualified investment entities (i.e., generally any real estate investment trust (REIT) and any regulated investment company (RIC) that is a U.S. real property holding corporation) from 5% to 10% for purposes of the exemption from the FIRPTA tax of IRC § 897 on certain distributions from the qualified investment entity; and
- Exempt from the FIRPTA rules of IRC § 897 any U.S. real property interest held by certain foreign pension funds or by a foreign entity wholly owned by such a qualified foreign pension fund.