New IRS Guidance for Insurance Companies

Transcription

1 New IRS Guidance for Insurance Companies March 2015 kpmg.com

2 The IRS in March 2015 publicly released two private letter rulings and a Chief Counsel advice memorandum concerning insurance-related tax issues and concluding: Changes in related life insurance companies reserves were changes in basis subject to Code section 807(f) the first significant, albeit private, guidance on reserve changes since the issuance of Rev. Rul Indemnity reinsurance of a closed block of life insurance policies ceded from one life insurance company to its subsidiary constitutes both regular indemnity reinsurance and a potential section 351 transaction Contracts issued by a captive insurance company that offered protection from the loss of earnings arising from foreign exchange fluctuations are not insurance contracts. The following discussions provide an initial analysis of this IRS guidance. Insurance - PLR on changes in reserves treated as changes in basis The IRS released a private letter ruling* concluding that changes in related life insurance companies reserves were changes in basis subject to Code section 807(f). PLR (release date March 13, 2015, and dated November 13, 2014) PLR [PDF 60 KB] represents the first significant, albeit private, guidance on reserve changes since the issuance of Rev. Rul , C.B. 157 *Private letter rulings are taxpayer-specific rulings furnished by the IRS National Office in response to requests made by taxpayers and can only be relied upon by the taxpayer to whom issued. It is important to note that, pursuant to section 6110(k)(3), such items cannot be used or cited as precedent. Nonetheless, such rulings can provide useful information about how the IRS may view certain issues. Background The letter ruling addresses reserve changes by two related insurance companies. Insurance Company N (IC N) is a U.S. branch of a foreign domiciled life insurance company. Insurance Company O (IC O) is a U.S. domiciled life insurance company and is a member of a consolidated group filing a life/nonlife return. IC N entered into reinsurance agreements with unrelated third parties in which it assumed risks under whole life insurance contracts and term life insurance contracts. IC N then entered into a reinsurance agreement with IC O under which IC N retroceded the risks on the term life insurance contracts to IC O under a 100% coinsurance arrangement. IC N retained the risks on the whole life insurance contracts. IC N received policy level data from the cedants with respect to the insurance contracts underlying the reinsurance agreements. 1

3 IC N and IC O maintained two information technology systems to account for the data relating to the reinsurance agreement with the unrelated third parties and the intercompany reinsurance of the term life business. A policy administration system tracked data relating to premium, benefit payments, and all relevant items other than life insurance reserves. Life insurance reserves were administered through a valuation system. The two systems maintained the accounting records for the contracts then transferred the data into the general ledger systems that were used to prepare financial statements, including the statutory financial statements that were used to prepare the companies federal income tax returns. In tax year U, it was determined that certain of the whole life insurance contracts were improperly coded in the valuation system as term life insurance contracts. Because of this coding, the valuation system improperly treated the reserves on the contracts as ceded by IC N to IC O even though the contracts were retained by IC N under the terms of the reinsurance contract between IC N and IC O. As a consequence, the life insurance reserves were improperly reported on the statutory annual statement and federal income tax returns of IC O rather than IC N. All other relevant items of income and deduction, including premiums, claim payments and expenses were reported by the proper legal entity. The reserve deductions associated with the improperly coded contracts were reported by the wrong legal entity for more than one tax years. Because the deduction for claims paid under life insurance contracts was tracked in the administration system, the claims were reported on the appropriate legal entity when paid. When a claim is paid, the life insurance reserve associated with that insurance contract is released. Thus, the inappropriate reporting of the life insurance reserve is inherently selfcorrecting over time. IC N and IC O discovered the incorrect treatment of the reserves and recorded the reserves in the appropriate legal entity for statutory accounting purposes in tax year U. Ruling The letter ruling concludes that the changes in the life insurance reserves of IC N and IC O are changes in basis of computing reserves subject to the 10-year spread rules of section 807(f). Tax year U is treated as the year of change. The taxpayers opening balances of the reserves for tax year V will be adjusted to properly state the reserves and the change for each entity (i.e., a deduction for the increase in reserves for IC N and income for the decrease in reserves for IC O) is spread over 10 years. KPMG observation There has been scant guidance on section 807(f) since Rev. Rul was issued 20 years ago, so this ruling provides needed insight into the IRS s position on changes to life insurance reserve computations. The calculation of life insurance reserves under section 807(d) is highly complex; it is based in complicated actuarial guidance and principles, as well as information technology systems that are constantly evolving. Consequently, life insurance companies frequently make changes to their statutory and tax reserve calculations. Section 807(f) is a provision that allows taxpayers to 2

4 correct or adjust the basis of their reserve calculations without requiring consent of the IRS to change these calculations. There has long been uncertainty as to whether certain types of changes are changes in basis subject to section 807(f), accounting method changes subject to section 446, or errors. Under section 807(f), changes in basis are subject to a 10-year spread of the amount of the change. Accounting method changes require the consent of the IRS and are subject to different, shorter spread periods as set forth in recently released Rev. Proc Errors must be corrected in the earliest open tax year, and may result in a permanent overstatement or understatement of taxable income. Rev. Rul provided some guidance on identifying changes in basis under section 807(f) and concluded that even changes in computations in a taxpayer s reserves for items which are mandated by statute, such as interest rates or mortality tables, are changes in basis rather than corrections of errors. Example 4 of the revenue ruling, however, provides that at least some computer coding errors are not changes in basis under section 807(f) and are errors. Reserve calculations are complex and generally made using computer systems. It is often difficult to discern whether a particular issue is caused by a programming error, an input error, or a mistake in categorizing a contract that leads to an incorrect calculation. While Rev. Rul was sufficient to deal with most changes in reserves, it did not adequately address the intersection of section 807(f) with the rules in section 446 and the regulations thereunder, which distinguish between changes in accounting methods and corrections of errors. PLR helpfully clarifies that section 807(f) is a subset of accounting method changes governed by section 446. Analytically, one first addresses whether the change in the reserve calculation is a method change or an error under section 446. Under Reg. section (e), items that one might typically think of as errors are treated as changes in method under section 446 if they are recurring and temporary (i.e., they do not result in a permanent reduction or increase in the taxpayer s taxable income). Therefore, the population of items categorized as errors under section 446 is fairly narrow and generally limited to nonrecurring items. If the change in reserves meets the definition of an accounting method (nonpermanent and recurring), then it is subject to section 807(f). The private letter ruling appears to take a very broad view of what types of changes in the calculation of a reserve constitute a change in basis. In this situation, the reserve was properly computed. There was no change proposed in the calculation of the life insurance reserve for any of the contracts underlying the reinsurance agreements. The only issue was that the reserve was reported in the wrong legal entity. The IRS could have concluded that the change at issue in the ruling was a change in accounting method governed by section 446 because there was no change in the calculation of the amount of the reserve, which one might think necessary for section 807(f) to apply. The letter ruling seems to support the proposition that the concept of a change in basis is broad enough to encompass reserve changes that do not involve the calculation of the reserve itself. The facts at issue in the private letter ruling appear viscerally similar to the facts in Rev. Rul Situation 4, which was the only example of an error in the ruling. In Situation 4, the insurance company discovered that due to a computer programming error, certain policies had been omitted from the computation of the company s closing reserves. Had the omitted policy 3

5 been included, the company s closing life insurance reserves under section 807(d) would have been greater than the amounts originally claimed. Rev. Rul concludes that the correction for omission of reserves for certain contracts is not a change in basis under section 807(f) or a change in method of accounting under sections 446 and 481. The key distinction between the recent letter ruling and Situation 4 is that the error in Situation 4 was nonrecurring the accounting method change rules in Reg. section (e) require that the mistake occur for more than one tax year. This distinction was made by the IRS in Examination and Appeals Coordinated Issue Papers released subsequent to Rev. Rul The calculation of the actuarial reserve is only one item that is used to compute the deduction allowed for a reserve under section 807. The other relevant items are the net surrender value of the contract, which serves as a floor on the reserve, and the statutory reserve which serves as a cap on the reserve deduction. Most practitioners have not viewed changes in the net surrender value or the statutory reserve held with respect to a contract that changes the amount deductible under section 807 as a change in basis. Typically, these items have been viewed as changes in limits around the deduction and as representing neither changes in basis under section 807(f) nor accounting method changes governed by section 446. The recent letter ruling gives rise to an interesting, unanswered question as to whether, for instance, changes in the calculation of the statutory reserve which indirectly affect the amount of the reserve deduction allowed for a contract is a change in method of accounting even if it does not constitute a change in basis. Insurance - Asset transfer bifurcated into reinsurance, potential section 351 transaction The IRS publicly released a private letter ruling* concluding that indemnity reinsurance of a closed block of life insurance policies ceded from one life insurance company to a subsidiary life insurer constitutes both regular indemnity reinsurance up to the fair market value of assets that would have been transferred in an arm s length reinsurance transaction and a potential section 351 transaction (with the potential section 351 contribution being the amount of the excess assets transferred to the reinsuring subsidiary). PLR (release date March 13, 2015 and dated November 14, 2014) Read PLR [PDF 46 KB] *Private letter rulings are taxpayer-specific rulings furnished by the IRS National Office in response to requests made by taxpayers and can only be relied upon by the taxpayer to whom issued. It is important to note that, pursuant to section 6110(k)(3), such items cannot be used or cited as precedent. Nonetheless, such rulings can provide useful information about how the IRS may view certain issues. Background P is the parent company of a life-nonlife consolidated group. P s indirect subsidiary (LifeCo) plans to cede a regulatory closed block (RCB) of participating life insurance policies to either an existing or newly created life insurance company subsidiary (Sub) using indemnity reinsurance specifically, less-than-100% coinsurance. 4

6 LifeCo plans to cede to Sub the capital and surplus and assets and liabilities attributable to the RCB. The reinsurance agreement between LifeCo and Sub includes a recapture provision which, if exercised, would require Sub to return the assets that were transferred to it by LifeCo. The fair market value (FMV) of the assets transferred from LifeCo to Sub pursuant to the reinsurance agreement were in excess of the amount LifeCo would be required to pay in an arm s length indemnity reinsurance transaction. Ruling Without significant analysis, the PLR concludes that: The reinsurance asset transfer from LifeCo to Sub is treated as indemnity reinsurance subject to subchapter L rules to the extent the FMV of the assets transferred match that required in an arm s length reinsurance transaction. Treatment of a portion of the transaction as indemnity reinsurance does not preclude the transfer of excess assets from qualifying as a section 351 nonrecognition transaction. KPMG observation This PLR was issued shortly after PLR (Oct. 21, 2014) that concludes that an indemnity reinsurance transaction qualified as a section 351 nonrecognition transaction. Like the prior ruling, this PLR seems to focus on the permanence of the transfer of the contractual rights and obligations associated with the indemnity reinsurance relationship, as opposed to the permanence of the transfer of the value of the future expected profit stream of the business. In the first ruling, the reinsurance agreement did not provide the ceding company an explicit recapture right, which the reinsurance agreement in this PLR did. In allowing bifurcation of the transaction(s), the ruling appears inconsistent with Rev. Rul , CB 140, which was interpreted to require aggregation in such cases. The PLR does not require section 351 treatment of the excess assets but merely allows for this treatment. IRS Chief Counsel - Foreign currency swap-based products not insurance The IRS released a Chief Counsel advice memorandum* concluding that contracts issued by a captive insurance company that offered protection from the loss of earnings arising from foreign exchange fluctuations are not insurance contracts. CCA (release date March 13, 2015 and dated December 1, 2014). Read CCA [PDF 87 KB] *Chief Counsel advice documents are legal advice, signed by executives in the National Office of the IRS Office of Chief Counsel and issued to IRS personnel who are national program executives and managers. The documents are issued to assist IRS personnel in administering their programs by providing authoritative legal opinions on certain matters, such as industry-wide issues. However, they are not to be used or cited as precedent. 5

7 Background A global group of corporations involved in the design, manufacture, and marketing of medical, industrial, and commercial products in the environmental and life sciences industries (Taxpayer Group) includes a U.S. captive insurance company (Captive). Captive provides coverage to the Taxpayer Group for automobile liability, products and general liability workers' compensation, product warranty, credit guarantee insurance, earthquake damage coverage, retiree medical cost coverage, and guaranteed renewable accident and health insurance. Due to the global nature of Taxpayer Group s business, fluctuations in foreign currencies relative to the U.S. dollar may adversely affect Taxpayer Group's financial results. Prior to the transactions at issue, Taxpayer Group did not use derivative instruments to hedge its risk of loss from such fluctuations. Taxpayer Group s parent company (Parent) entered into contracts with Captive on behalf of some members of the Taxpayer Group to guard against the risk arising from fluctuations in the rate of exchange between the U.S. dollar and certain foreign currencies. One type of contract protects the member against a decrease in the value of the specified foreign currencies and the other protects against an increase in value of the specified foreign currencies. Under the contracts, Captive agrees to indemnify the participating members for the "loss of earnings" connected to either a decrease or increase in the value of each specified foreign currency relative to the U.S. dollar up to a stated coverage limit for the one-year term of the contract.* The coverage limit is the lesser of: (1) an undefined "specified loss limit" (according to the CCA, this limit may be based on the prior year's export sales), or (2) the sales revenue during the contract period (for contracts covering decreases in value). Contracts covered multiple foreign currencies. *The CCA notes that a new one-year contract was entered into each month through endorsement. For each contract, "loss of earnings" is defined as the percentage increase or decrease in the rate of exchange of the U.S. dollar against the specified foreign currency between the effective and expiration dates, multiplied by the coverage limit. The CCA notes that in the tax opinion obtained by Taxpayer Group regarding the contracts, the Taxpayer Group represents that this loss of earnings does not measure the actual loss suffered by the change in foreign exchange rates, but rather "provides a reasonable approximation" of the actual loss. For each contract, the premium is determined by multiplying the "rate of premium" by the coverage limit. Initially, the rate of premium per dollar of coverage is defined as twice the amount of premium as quoted by Bloomberg on the effective date, as a percentage of notional for a 12-month call option contract for the purchase of U.S. dollars against the specified foreign currency. The premium listed in each contract was a deposit premium only, and was the maximum that each participant would be required to pay. The actual premium was determined after the expiration date of each contract, based on the actual loss experience. The final premium was the lesser of the retrospective adjusted premium and the deposit premium. The retrospective adjusted premium equals the deposit premium less the retrospective premium adjustment, which is: (1) a specified percentage of the deposit premium, minus (2) paid losses 6

8 in excess of a different specified percentage of the deposit premium. If the retrospective adjusted premium is less than the deposit premium, Captive will refund the difference to the participant. If the retrospective adjusted premium is greater than the deposit premium, the participant does not pay additional premium. The premium reconciliation is computed at the expiration of each contract. Contracts were vetted (and presumably priced) by an outside actuary. No single participant accounts for more than 15% of the premiums paid to Captive with respect to Contracts 1 and 2. The CCA also notes there is no mention of any parental guarantee, premium loan back, or other aspect of the arrangement that would be inconsistent with a bona fide insurance arrangement. Issue addressed The issue addressed in the CCA was whether the arrangement between members of Taxpayer Group and the Captive involving foreign currency fluctuations constitutes insurance for federal tax purposes. CCA conclusions The CCA memo begins by acknowledging there is no income tax definition of insurance. The CCA next avers that the predicate for insurance is insurance risk as distinguished from investment risk. The CCA states [n]ot all contracts that transfer risk are insurance policies even where the principal purpose of the contract is to transfer risk and opines that [i]nsurance risk requires a fortuitous event or hazard and not a mere timing or investment risk. After reviewing the facts and circumstances of the contracts, the CCA concludes that the risk involved is an investment-type risk as it is solely the manifestation of fiat currency valuation. The CCA notes as support for its position that although SSAP No. 60, Financial Guaranty Insurance, references protection against the fluctuation in currency exchange rates, "insurance" for this risk does not appear to be commonly available from the major carriers. The CCA points to the lack of a casualty event as further evidence the contracts do not provide insurance and contrasts this coverage with property coverage and business interruption coverage, i.e., known insurance products. The CCA also notes that the pricing of the contracts does not appear to leave sufficient risk of loss to qualify as insurance for federal tax purposes. The CCA categorizes the Captive s obligations under the contracts other payment liabilities under Reg. section (g)(7), which means loss payments made by the Captive under the contracts are not incurred (and deductible) until they are paid. The CCA asserts the recurring item exception is not available for these liabilities. KPMG observation The CCA perpetuates and expands upon the IRS s historic position that an insurance contract must involve insurance risk, as juxtaposed against investment or business risk. It also reiterates that insurance for tax purposes must involve a casualty event (or fortuity ), and that contract 7

9 termination does not define a casualty event. The fortuity issue is currently in litigation before the U.S. Tax Court in RVI v. Commissioner. 8

10 Contact a KPMG professional: Craig Pichette Washington National Tax Partner Financial Institutions and Products T E cpichette@kpmg.com Sheryl Flum Washington National Tax Managing Director Financial Institutions and Products T E sflum@kpmg.com Jean Baxley Washington National Tax Director Financial Institutions and Products T E jbaxley@kpmg.com ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. KPMG is a global network of professional firms providing Audit, Tax and Advisory services. Weoperate in 152 countries and have 145,000 people working in member firms around the world. The independent member firms of the KPMG network are affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. Each KPMG firm is a legally distinct and separate entity and describes itself as such KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Printed in the U.S.A. NDPPS The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.