Today, the White House released the Obama Administration’s proposed budget for fiscal year 2011 (the “Budget”), which contains a number of tax provisions specifically targeting the insurance industry and insurance products. The Treasury Department simultaneously released its “Greenbook” with respect to the Budget, which provides an explanation of the various revenue proposals in the Budget.

Many of the tax proposals in the Budget are not new; some were proposed by the Obama Administration with respect to last year’s budget and some have been the subject of separate legislative proposals in prior years. A copy of the Budget can be viewed online at the website for the U.S. Office of Management and Budget (www.whitehouse.gov/omb). A copy of the Greenbook can be viewed online at the website for the Treasury Department (www.ustreas.gov).

The insurance specific tax proposals include the following:

Corporate Owned Life Insurance

Currently, banks and other corporations purchase life insurance on the lives of their employees, often as a way to fund employee benefits. If the corporation directly borrows with respect to its life insurance holdings, interest on the borrowing may be disallowed, but interest on unrelated borrowings is generally deductible by the corporation if one or more exceptions are met.

The Budget proposes to repeal the exceptions regarding interest on unrelated borrowing and thereby disallow a deduction for a pro rata portion of a corporation’s interest expense if it holds cash value life insurance. If enacted, this tax proposal would generally make “COLI” an unattractive investment for businesses in most instances.

This proposal would apply with respect to life insurance contracts issued after December 31, 2010, in taxable years ending after that date.

Dividends Received Deduction

Dividends received by a life insurance company on stock held in a separate account may be eligible for a dividends received deduction (“DRD”). The amount of the deduction is limited to the “company’s share;” the “policyholders’ share” of the dividends received is not eligible for the DRD. This division of dividends received between the company’s and the policyholders’ share is referred to as proration.

The proration method used by many companies has been a source of controversy with the IRS in recent years, and proposals to change or clarify proration have circulated for some time. The Budget would adopt a proration method that generally would substantially reduce a company’s share of dividends received compared with current practices, and thereby reduce the amount of the DRD that life insurance companies otherwise would be claiming.

The DRD proposal would take effect for taxable years beginning after December 31, 2010.

Tax on Related Party, Excess Reinsurance Premiums

A domestic insurance company may reinsure U.S. insurance risks with affiliated foreign reinsurance companies. Such reinsurance premiums are generally deductible by the domestic insurer and may be subject to a U.S. insurance excise tax. This situation has generated substantial controversy where the foreign reinsurance is not subject to U.S. taxation, based on concerns that the domestic insurer may have a U.S. tax advantage over domestic insurers that do not have foreign reinsurance affiliates. A number of legislative proposals have been made over the years to address this situation.

The Budget proposes to deny a deduction for “excessive” reinsurance premiums paid by a domestic insurer to a foreign reinsurance affiliate that cover U.S. risks. In very general terms, the proposal would apply if the foreign reinsurance is not subject to U.S. tax on the reinsurance premium paid. Premiums would be considered “excessive” if they exceed 50 percent of the total direct premiums received by the domestic insurer (and its U.S. affiliates) for a given line of business.

This proposal would take effect for taxable years beginning after December 31, 2010.

Life Settlement Transactions

The Budget contains the tax proposals relating to life settlement transactions that are largely identical to those proposed last year by the Administration. Specifically, new IRS tax reporting requirements would be imposed with respect to sales of life insurance policies with a death benefit equal to or exceeding $500,000. In addition, upon payment of death benefits to a person that purchased a life insurance contract, the life insurer would be subject to new IRS tax reporting. Finally, the Budget also proposes to modify certain of the exceptions to the “transfer for value” rule to make sure they do not extend to situations involving a sale of a life insurance contract.

This proposal would take effect for taxable years beginning after December 31, 2010.

Partial Annuitizations

A taxpayer holding a nonqualified deferred annuity contract generally has the option to “annuitize” the entire contract, i.e., apply the entire cash value toward the payment of a specified stream of annuity payments from the insurance company. If the Taxpayer does that, a portion of the annuity payments are taxable based on an “exclusion ratio” calculated for the contract. In contrast, if a taxpayer withdraws funds from the contract in any other manner, generally the amounts withdrawn are taxable to the extent of the “income on contract” and may be subject to a penalty tax.

The life insurance industry has long requested guidance from the IRS regarding so-called “partial annuitizations.” In a partial annuitization, the taxpayer applies a portion of the cash value (not the entire cash value) toward the payment of a stream of annuity payments from the insurance company. The remainder of the cash value then continues to accumulate tax-free within the deferred annuity contract. To date, substantial uncertainty has existed about the tax treatment of partial annuitizations. In particular, it is unclear whether the partial annuity stream is taxable based on an exclusion ratio. This tax uncertainty has substantially inhibited taxpayers from undertaking partial annuitizations.

The Budget proposes to specifically allow partial annuitizations to be taxed based on an exclusion ratio, a proposal that is likely to be generally welcomed by the life insurance industry. This favorable tax treatment would be available if (1) the taxpayer irrevocably elects to apply a portion of the contract to purchase an annuity stream; (2) the annuity stream is for at least 10 years or the life of one or more individuals; and (3) the exclusion ratio is computed based on the expected return and investment in the contract with regard to the portion of the contract that is annuitized.

This proposal would take effect for partial annuitizations that take effect after December 31, 2010.