Continuing developments in the taxation of insurance companies

Transcription

1 Continuing developments in the taxation of insurance companies 2012: The year in review FPO

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3 Table of contents The year in review 1 Legislation 6 Federal 7 International 14 Multi-state 16 Tax accounting 34 Appendix A 39 Appendix B 43

4 The heart of the matter The American Taxpayer Relief Act of 2012 addressed certain fiscal cliff issues, but continued debate over federal deficits and spending will be a key factor in consideration for 2013 tax legislation and efforts to reform US tax laws. Continuing developments in the taxation of insurance companies

5 The year in review After a year-long, heated political campaign, on November 6, 2012, President Barack Obama was re-elected for a second term. For the insurance industry, the re-election of President Obama reaffirmed the future of the Affordable Care Act (ACA), the 2010 law that makes significant changes to the US healthcare system and creates regulated insurance exchanges where individuals and small businesses may purchase health insurance coverage. However, as the President entered his second term, harsh financial pressures a looming $600 billion fiscal cliff and a growing longterm debt continued to add to an already challenging implementation plan. According to the Congressional Budget Office, the ACA reduces the deficit over the next decade, a finding that helps President Obama protect core elements of the law. At the same time, the President himself has indicated a willingness to reduce federal health spending, raising the prospect of tighter margins for the industry. While the American Taxpayer Relief Act of 2012 addressed certain fiscal cliff issues, continued debate over federal deficits, revenues, and spending will continue to be a key factor in consideration of 2013 tax legislation and efforts to reform US tax laws to promote economic growth and competitiveness. As expected, fiscal policy dominated legislative discussions in early 2013 as President Obama began his second term and the 113th Congress was underway. The Obama Administration and Congress continue to address automatic spending reductions ( sequestration ), the expiration of a temporary funding measure for federal departments and agencies, and a federal debt limit that was suspended through May 18. President Obama and Congressional leaders continue to call for tax reform. While permanent extension of individual tax rates no longer is a primary driver of tax reform efforts, a more competitive and streamlined tax code is seen as a way to promote growth and, for some, as a way to reduce the deficit or provide revenue to support federal programs and services. However, until the debate over the debt limit, spending cuts, and funding for federal departments and agencies is resolved, it is difficult to foresee Congress having time to focus on business tax reform. On April 10, President Obama submitted to Congress a $3.77 trillion federal budget for Fiscal Year The budget separates the Administration s revenue proposals into three categories tax reform, deficit reduction, and offsets for certain tax relief proposals and new programs. The President s budget asks Congress to immediately begin the process of reforming the individual and business tax systems. The budget includes a number of international and insurance industry tax reform proposals estimated to raise $157 billion and $30.5 billion, respectively, over 10 years. Of specific importance to foreign-owned US insurance companies is a provision that limits deductions for reinsurance premiums paid by a US insurance company to its foreign affiliates. The provision is similar to previous budget proposals, as well as to the Neal Bill originally introduced by Congressman Richard Neal (D-MA) in Under this proposal, a US insurer with an affiliate that is based abroad and not subject to US tax law, could not deduct as an expense reinsurance premiums paid to that affiliate. See WNTS Insight, Obama Administration FY 2014 budget focuses on tax reform, deficit reduction, and new initiatives, April 10, 2013, and Insurance Tax Bulletin, Budget proposal to disallow deduction for reinsurance premiums paid to affiliates; other insurance tax provisions, April 11, 2013, for more information on the President s FY 2014 budget. Meanwhile, the Senate has confirmed the President s nominees for several key positions, including Secretary of the Treasury. President Obama on January 10 nominated White House chief of staff Jacob (Jack) Lew to succeed Timothy Geithner as Treasury Secretary. With Douglas Shulman s retirement as IRS Commissioner in November 2012, President Obama this year is expected to nominate a new IRS Commissioner to a five-year term. 2012: The year in review 1

6 American Taxpayer Relief Act of 2012 President Obama on January 2 signed into law the American Taxpayer Relief Act of 2012 (the Act ). The Act includes perm anent extensions of certain 2001 and 2003 tax provisions for individuals with income below $400,000, and joint filers with income below $450,000. For individuals whose taxable income exceeds these thresholds, the top income tax bracket will be 39.6% and dividends and longterm capital gains will be taxed at 20% (an additional 0.9% health insurance wage tax and 3.8% net investment income tax also became effective in 2013 under health care legislation enacted in 2010). Other provisions of the Act include permanent indexing of individual alternative minimum tax (AMT) exemption levels for 2012 and subsequent years, and a reinstatement of a personal exemption phaseout (PEP) and phaseout of itemized deductions for single filers (Pease) with adjusted gross income above $250,000 ($300,000 for joint filers). The legislation also permanently extends the $5 million per-person estate and gift tax exemption (indexed for inflation) and provides a top estate and gift tax rate of 40%. In addition, the Act extends through 2013 a 50% bonus depreciation provision for qualified property, and also includes extensions through 2013 of certain expired business and energy tax provisions. Business tax provisions renewed retroactively include the research credit (with modifications); look-through treatment for payments between related controlled foreign corporations (CFCs); the Subpart F exception for active financing income; 15-year straight-line cost recovery for qualified leasehold, retail, and restaurant improvements; and certain other provisions that expired at the end of The Act also extends through 2013 a federal deduction for individual state sales taxes, tax-free charity IRA rollovers, and certain other temporary individual provisions. In addition, the Act provides for a temporary Roth IRA conversion period. See WNTS Insight, New tax law extends business tax incentives, January 3, 2013, for a list of the tax provisions included in the Act. Debt ceiling Former Treasury Secretary Timothy Geithner early this year informed House and Senate leaders that the federal government s $ trillion statutory debt limit was reached on December 31, 2012, and that Treasury had begun taking extraordinary measures to postpone the date on which the United States would otherwise default on its legal obligations. A temporary suspension of the statutory debt limit expired on May 18, but economists projected that the Treasury Department could rely on extraordinary measures to meet the government s obligations until October. The improved deficit forecast was detailed in a Congressional Budget Office (CBO) report released on May 14 containing updated projections of federal government revenues and outlays through In a May 20 letter, Treasury Secretary Jack Lew informed Congress that the Treasury Department has begun to utilize such extraordinary measures following the reinstatement of the debt limit. The debate over raising the debt limit will continue during 2013 and the House is expected to consider debt ceiling prioritization legislation (H.R. 807, as amended by the House Ways and Means Committee). House Republicans have called for linking a future increase in the statutory debt limit to action on tax reform legislation. Republican leaders have suggested considering debt limit legislation before the August recess that would set forth GOP budget priorities. There are 55 remaining federal tax extender provisions set to expire at the end of An additional 25 provisions are scheduled to expire at various points over the coming decade. 2 Continuing developments in the taxation of insurance companies

7 Sequestration The Budget Control Act of 2011 reduces federal discretionary spending by $1 trillion over 10 years, and provides for an additional $1.2 trillion in automatic defense and non-defense spending cuts that had been set to begin on January 2, 2013, if Congress could not agree on alternative proposals providing an equal amount of deficit reduction. While unable to agree on alternative proposals for deficit reduction, Congress did pass the American Taxpayer Relief Act of 2012 which delayed the automatic across-the-board sequestration spending cuts until March 1st. Despite multiple meetings between the President and Congressional leaders, no agreement was reached to avert the March 1st implementation of the scheduled spending cuts. In the Senate, neither the Democratic nor Republican proposals to address sequestration received the 60 votes needed to move forward. On March 26, to avoid the imminent partial shutdown of the federal government, President Obama signed into law a bill (H.R. 933) to fund the federal government through the end of FY 2013 (September 30). However, the bill included an amendment, approved previously by the House, to maintain the sequestration automatic spending cuts. H.R. 933 also provided increased discretion and greater flexibility to certain government agencies in implementing the sequestration spending cuts. For example, the IRS on April 19 informed employees that they would be furloughed for up to seven days, and that the first enacted furlough days would be May 24, June 14, July 5, July 22, and August 30, with another two days possible in August or September. The White House Office of Management and Budget issued a memorandum on April 4 noting that the Administration will continue to urge Congress to take action to eliminate the sequestration cuts as part of a balanced agreement on deficit reduction. Congressional budgets The Republican-controlled House on March 21, by a largely party-line vote of 221 to 207, approved an FY 2014 budget resolution that would balance the budget over 10 years through spending cuts only and no additional revenue. The House budget resolution calls for revenue-neutral tax reform in 2013 that reduces the top tax rates on individuals and corporations to 25% and transitions the tax code to a more competitive system of international taxation. The Senate on March 23 voted 50 to 49 to approve an FY 2014 budget resolution. The Senate-passed budget would reduce federal budget deficits by $1.85 trillion over 10 years, through $975 billion in new revenue and $975 billion in spending reductions. Administration, Congressional positions on deficit reduction On December 31, 2012, President Obama stated that we re going to have to do more to reduce our debt and our deficit. While commenting that he was prepared to accept some reductions in the cost of Medicare and other federal programs, President Obama stated it s going to have to be balanced, and that kind of [entitlement] reform has to go hand-in-hand with doing some more work to reform our tax code so that wealthy individuals, the biggest corporations can t take advantage of loopholes and deductions that aren t available...to most Americans. At the start of the 113th Congress, House Speaker John Boehner (R-OH), in his opening remarks to the new House, focused on the need to address the federal debt. Our government has built up too much debt, Speaker Boehner said. Our economy is not producing enough jobs. These are not separate problems. At $16 trillion and rising, our national debt is draining free enterprise and weakening the ship of state. Speaker Boehner, Senate Minority Leader Mitch McConnell (R-KY), and other Republican Congressional leaders have stated that they will not support additional revenue increases as part of any new deficit reduction legislation. 2012: The year in review 3

8 By contrast, Congressional Democratic leaders are expressing support for the Administration s position that revenue increases must accompany reductions in federal spending, especially cuts in Medicare and other mandatory spending programs. Addressing the new Senate on January 3, Majority Leader Harry Reid (D-NV) stated, Any future budget agreements must balance the need for thoughtful spending reductions with revenue from the wealthiest among us and closing wasteful tax loopholes. The need for tax reform The need to strengthen the competitiveness of US firms in the global marketplace together with slow economic growth, high unemployment rates, and projections of significant future budget deficits under current policies has increased interest in tax reform as a way of promoting US economic growth, controlling federal deficits, and spurring job creation. Since Japan reduced its corporate tax rate in April 2012, the United States has had the highest corporate tax rate among advanced economies. The United Kingdom last year announced an additional corporate rate reduction, lowering its rate to 23% effective April 2013, and to 21% effective April Including average state and local levies on top of the 35% federal rate, the combined US rate is 39.1%; the average comparable rate among the other OECD countries was 25% in The United States also is one of the few developed countries to tax foreign earnings under a worldwide tax system. All other G-7 countries and 28 of the 34 OECD countries use territorial tax systems under which all or most foreign dividends are exempt from domestic taxation. Many analysts believe the present US worldwide system reduces the ability of American companies to compete effectively in foreign markets. Others highlight that the present system imposes a substantial tax barrier to repatriation of earnings for use in the US economy, noting that nearly $2 trillion in foreign earnings is held by foreign subsidiaries that cannot be invested in US parents without being subject to US tax. The Senate Permanent Subcommittee on Investigations (PSI) on May 21 held a hearing on offshore profit shifting and the US tax code with testimony by representatives of Apple Corporation, Treasury and IRS officials, and academics. An earlier PSI hearing on offshore profit shifting was held in September 2012 with testimony from representatives of Microsoft and Hewlett-Packard (HP). During the May 21 hearing, Apple CEO Tim Cook and several Senators called for tax reform to make the US tax code more competitive. Following the hearing, PSI Chairman Carl Levin (D-MI) reportedly said that he plans to introduce new legislation to address profit shifting. The PSI hearing memorandum called for strengthening Section 482, reforming check-the-box and look-through rules, taxing CFCs under US management and control, and increased IRS enforcement of certain Subpart F rules. The need to strengthen the competitiveness of US firms in the global marketplace together with slow economic growth, high unemployment rates, and projections of significant future budget deficits under current policies has increased interest in tax reform as a way of promoting US economic growth, controlling federal deficits, and spurring job creation. 4 Continuing developments in the taxation of insurance companies

9 Approaches to tax reform President Obama and Congressional leaders have put forth general tax reform principles in an effort to set the stage for an overhaul of US tax law. Both the President and House Republican leaders are proposing a corporate rate reduction that would be offset by base-broadening measures that is, by limiting or repealing tax deductions, exclusions, credits, or preferences. Because businesses could be affected significantly by emerging tax reform efforts, many companies and trade associations are actively engaged in assessing the potential benefits and risks of tax reform, and have been participating in ongoing Congressional hearings and meetings with Members of Congress and their staff. Senate Finance Chairman Max Baucus (D-MT) stated in a June 11, 2012 address on tax reform goals that any tax reform plan must be developed with a sound budget in mind that reduces deficits and debt. Senator Charles Schumer (D-NY), the third-ranking Senate Democratic leader, recently proposed that tax reform should generate increased revenues for deficit reduction through budget reconciliation legislation, which would require only a 51-vote Senate majority instead of the 60-vote majority generally needed. (See Appendix B for a discussion of the Congressional budget process.) Ultimately, whether deficit reduction should be a goal of tax reform will be a fundamental issue to be resolved by lawmakers. There is disagreement among Members of Congress over whether tax reform should be entirely revenue-neutral or should raise revenue. Allocating part of the revenue from base-broadening measures to deficit reduction would affect the extent to which corporate and individual tax rates could be reduced in revenue-neutral tax reform legislation. During House debate on the American Taxpayer Relief Act, Ways and Means Chairman Dave Camp (R-MI) stated that by making Republican tax cuts permanent, we are one step closer to comprehensive tax reform. This legislation settles the level of revenue Washington should bring in. Next, we need to make the tax code simpler and fairer for families and small businesses, Chairman Camp said. 2012: The year in review 5

10 Legislation Enacted legislation H.R Moving Ahead for Progress in the 21st Century Act (Biggert-Waters Flood Insurance Reform Act of 2012) Reauthorizes the National Flood Insurance Program (NFIP) until September 30, Key changes phase out subsidies on properties with repetitive losses, allow FEMA to purchase reinsurance, allow annual premium increases up to 20%, create a technical mapping advisory council to handle map modernization, and require the development of a plan to repay debt owed by FEMA to the United States Treasury. The act will provide stability in property loan closings and give Congress needed time to address current debt in NFIP and proposed program revisions. H.R National Flood Insurance Program Extension Act Amends the NFIA Act of 1968 to extend the NFIP, including its funding, from May 31, 2012 to July 31, The bill also excluded vacation homes and second homes from receiving subsidized premium rates ( any residential property which is not the primary residence of an individual ). The bill was passed on January 3, H.J. RES. 117 Continuing Appropriations Resolution, 2013 Continues government funding at its current level for federal agencies, programs, and services until March 27, 2013 in order to prevent a government shutdown at the end of the current fiscal year. Section 101 of the resolution also continues funding for the Federal Emergency Management Agency (FEMA) Disaster Relief Fund, which is used in recovery efforts following a natural disaster such as a flood or hurricane. Noteworthy legislation not enacted S Amends the Internal Revenue Code, with respect to the tax treatment of certain life insurance contract transactions, to require reporting to the IRS of: (1) identity of persons acquiring a life insurance contract; (2) identity of sellers of a life insurance contract and the seller s investment in the contract; and (3) reportable death benefit payments. The Bill contains three sections: one section would add new Code Section 6050X and conforming amendments; the second section would clarify rules to determine the tax basis of life insurance contracts; and the third section would provide an exception to the transfer for valuable consideration rules. H.R Flood Insurance for Farmers Act of 2012 Would amend the National Flood Insurance Act of 1968 to offset the premiums paid under the National Flood Insurance Program (NFIP) by farmers whose properties are considered at-risk due to substandard levee systems recently downgraded by the FEMA. The act would prohibit FEMA from placing prohibitions, restraints, or conditions, including requiring flood proofing or flood damage mitigation activities or related features, upon either new construction or substantial improvement of an agricultural structure in any area having special flood hazards. H.R A bill to authorize the Administrator of FEMA to waive the 30-day waiting period for flood insurance policies purchased for private properties affected by wildfire on federal lands Would amends the National Flood Insurance Act of 1968 to exempt from the statutory 30-day waiting period for a new contract for flood insurance coverage for private property if: (1) the Administrator of FEMA determines that the property is subject to elevated risk of flood due to wildfire on federal land, and (2) the coverage was purchased within 60 days after the fire containment date for the wildfire that caused the elevated flood risk. H.R Insurance Consumer Protection and Solvency Act of 2012 Would amend the Dodd-Frank Wall Street Reform and Consumer Protection Act to exclude an insurance company from the definition of a financial company. S Terminating the Expansion of Too Big to Fail Act of 2012 Would amend the Financial Stability Act of 2010, Title I of the Dodd-Frank Wall Street Reform and Consumer Protection Act, with the intention of stopping federal regulation from spreading to non-banking institutions. The bill would eliminate the duty of the Financial Stability Oversight Council to identify systemically important financial market utilities and payment, clearing, and settlement activities. 6 Continuing developments in the taxation of insurance companies

11 Federal Life-nonlife consolidations Tacking rule In PLR , Parent is the common parent of an affiliated group of corporations that includes life companies and non-life companies. Parent was organized in Year 1, and since Year 4, the Parent Group has filed a consolidated life/non-life federal income tax return. Sub is a subsidiary of Lifeco, which is a life insurance company and a whollyowned subsidiary of Parent. Through Year 4, Sub did not conduct an insurance business but held investment assets all of which were contributed by Lifeco as capital. In Year 5, Sub will begin writing insurance contracts that will require life insurance reserves under Section 816(b), such as reserves required by law and policies covering life, accident, and health insurance premiums combined in one policy issued on the weekly payment plan, continuing for life, and not subject to cancellation. Given the nature of Sub s activities, the IRS ruled that in Year 5, Sub qualifies as an eligible corporation to be included as a life member of the life subgroup of the parent s consolidated group. Alternative minimum tax In State Farm Mutual Automobile Insurance Company v. Commissioner, 698 F.3d 357 (7th Cir. 2012), the Seventh Circuit Court of Appeals affirmed the Tax Court s decision that the revised alternative minimum tax (AMT) computation that the Taxpayer proposed during prior litigation for the calculation of its AMT liability was improper (See 130 T.C. 263 (2008)). The Taxpayer argued that Congress intended the AMT calculation to better approximate book income and that the applicable regulations were ambiguous with respect to the calculation of the AMT liability for consolidated life and non-life groups. The Court rejected that argument stating that the issue revolved around the proper determination of AMT income before the adjusted current earnings (ACE) adjustment as used in the ACE adjustment, and in conjunction with the application of the life/non-life consolidated return rules, noting that there were two basic approaches: subgroup, which results in a direct calculation of the ACE adjustment per subgroup, or consolidated, which requires an allocation of the consolidated ACE adjustment to the subgroups. Moreover, the Court noted that the Taxpayer would assign different meanings to the same term pre-ace alternative minimum taxable income, or pamti and the Taxpayer failed to apply the normal practice of statutory construction by giving the same meaning to a term or phrase throughout a statute. Consequently, the Court affirmed the ruling of the Tax Court that held in favor of the consolidated approach. Definition of an insurance company Section 831 In PLR , the IRS ruled that a company in the business of providing roadside assistance coverage to policyholders of unrelated property and casualty insurers qualifies to be taxed as an insurance company under Section 831. Taxpayer provides motorists with roadside assistance under risk- and non-risk-based contracts. These services are provided through a network of independent contractor towing operators and locksmiths paid on a fee-for-service basis, with risk-based contracts solicited directly and through credit card issuers and other channels. In this ruling, the IRS concluded that because Taxpayer accepted a very large number of unrelated, independent, homogeneous risk-based roadside assistance contracts, the taxpayer achieved the requisite risk distribution, and that the contracts constitute insurance for federal income tax purposes. Residual value insurance A case recently docketed at the Tax Court, R.V.I. Guaranty Co., Ltd. v. Commissioner, T.C. Docket No , will decide whether residual value insurance (RVI) contracts are insurance for federal tax purposes. The case follows a technical advice memorandum issued in 2011 (TAM ) in which the IRS concluded that RVI policies that insure assets against market decreases are not insurance contracts. The IRS said that the RVI contracts were similar to insurance contracts but they did not represent insurance in its commonly accepted form. If the Tax Court holds that RVI contracts are not insurance, it could change the way compensatory damages and punitive damages are viewed under the NAIC rules for insurers unpaid loss reserves. The Court s ruling could affect all types of insurance contracts, not only RVI contracts. The R.V.I. trial is scheduled to begin in April : The year in review 7

12 Exempt status Section 501(c)(9) In PLR , the IRS ruled that an insurance trust failed to meet the burden of proof required for exemption from federal income taxes as required by Section 501(c)(9). The IRS concluded that the Trust did not function primarily as a Voluntary Employees Beneficiary Association because it was not an association of employees whose eligibility is determined by objective standards constituting an employment-related common bond among such individuals. Membership was not defined by reference to a common employer, affiliated employers, and coverage under a collective bargaining agreement, or a labor union. In addition, the IRS determined that the Trust failed to satisfy the requirement that it does not discriminate in favor of highly compensated individuals because it did not maintain adequate compensation records. Section 501(c)(29) The IRS issued temporary regulations (T.D. 9574) that provide the IRS with the authority to determine the procedures for the application for recognition as a Section 501(c)(29) qualified nonprofit health insurance issuer (QNHII) to benefit from federal income tax exemption status for organizations that participate in the Consumer Operated and Oriented Plan (COOP) programs established by the Centers for Medicare and Medicaid Services. The Temporary Regulations serve to address the requirements of Section 501(c)(29), which was added by Section 1322(h) of the Patient Protection Affordable Care Act of March 23, The Temporary Regulations provide that unless an organization notifies the Commissioner that it is applying for QNHII treatment under Section 501(c)(29) and in the manner prescribed by the Commissioner in published guidance which has not yet been published the organization will not be treated as a QNHII. Moreover, for an organization to qualify as a QNHII for purposes of federal income tax exempt status at a date earlier than the date of issuance of the required notice to the Commissioner, the organization s purposes and activities prior to the notice must accord with the requirements set forth under Section 501(c)(29). However, an organization may not receive such status before the later of its formation or March 23, The Temporary Regulations are effective from February 7, 2012, and expire on February 6, Policyholder dividends Dividend deduction In Massachusetts Mutual Life Insurance Company v. United States, Fed. Cl., No T (1/30/12), the Court ruled that a deduction for the declared guaranteed minimum amount of policyholder dividends is allowed in the year of declaration. The IRS argued that the Taxpayer lacked evidence to show that it was obliged to pay the entire guaranteed amount and that there was not an identifiable group of policyholders eligible to receive the dividend guarantee in the year the resolutions were adopted. Furthermore, the Taxpayer had no liability to pay the entire guarantee amount until a later event occurred and that event was not simply the passage of time and the preservation of the status quo, observing that the Board could reverse itself and the Insurance Commissioner could prevent the payment. The Taxpayer countered the arguments citing court rulings, such as Washington Post Co. v. United States in which the Court declared that although a liability does not accrue, as long as it remains contingent, uncertainties unrelated to the fixing of the amount of the liability do not prevent the Taxpayer from meeting the all-events test. The Taxpayer argued that the liability was, in fact, fixed with the Board s resolution. Ultimately, the Court ruled in favor of the Taxpayer, stating that the matching requirement under Section 461(h) was met and that the criteria for economic performance were satisfied. The Court concluded that dividend guarantees created an unconditional obligation to pay dividends the following year and were not subject to a condition precedent. Moreover, neither the IRS s concerns about enforceability or revocability prevented the liability from being fixed in the year in which the dividend guarantees were declared. With that, the Court ruled that the deductions the Taxpayer claimed with regard to policyholder dividends were allowable. 8 Continuing developments in the taxation of insurance companies

13 Insurance premiums Risk distribution The Fifth Circuit Court ruled in F.W. Services v. Commissioner, 5th Cir., No (1/25/12), that monetary funds paid to insurer by a business and held for reimbursement purposes were not insurance premiums because the contract lacked adequate risk distribution. Therefore, the Taxpayer did not meet the statutory requirements for deduction under Section 162(a). Taxpayer, a temporary personnel agency, purchased two insurance policies from insurer. Both policies contained a loss reimbursement endorsement requiring the Taxpayer to reimburse the insurance company for each claim. Taxpayer engaged with a third party to make payments to insurer on its behalf. Per the agreement, if the payments made exceeded the final premium at the end of the contract, then the Taxpayer would receive reimbursement for the difference; if payments were less, then the Taxpayer would make additional payments. At the end of the contract, the Taxpayer deducted the entire premium paid on the two policies under Section 162(a), for which the IRS issued a notice stating that the payments were not deductible as insurance premiums. Furthermore, the Court ruled that the payments did not constitute insurance premiums because the Taxpayer s contract with the third party lacked adequate risk distribution. Taxpayer cited Helvering v. Le Gierse, 312 US 531 (1941), highlighting that its contracts with the insurer and the third party, when read together, proves a shift in risk. However, the Court ruled that reading the contracts together does not warrant an adequate shift in risk and thus is not insurance. Consequently, the Court ruled that payments made to insurer and held for reimbursement purposes were not insurance premiums because the third-party contract lacked a shift in risk. Priority guidance plan The IRS and Treasury released an update to the priority guidance plan, noting the addition of 10 projects between January 1 and March 31, The original plan, released November 19, 2012, included 317 projects identified as priorities for the July 2012 June 2013 plan year. Priority guidance plan projects related to insurance companies and products include the following (two of which have been completed): Final regulations under Section 72 on the exchange of property for an annuity contract. Proposed regulations were published on October 18, Guidance on annuity contracts with a long-term care insurance rider under Sections 72 and 7702B. Revenue Ruling under Section 801 addressing the application of Revenue Ruling or Revenue Ruling to health insurance arrangements that are sponsored by a single employer. Guidance to clarify which table to use for Section 807(d) (2) purposes when there is more than one applicable table in the 2001 CSO mortality table. Notice clarifying whether deficiency reserves should be taken into account in computing statutory reserves under Section 807(d)(6). This was published on April 1, 2013, as Notice Revenue Ruling on the determination of the company s share and policyholder s share of the net investment income of a life insurance company under Section 812. Guidance clarifying whether the Conditional Tail Expectation Amount computed under AG 43 should be taken into account for purposes of the Reserve Ratio Test under Section 816(a) and the Statutory Reserve Cap under Section 807(d)(6). Regulations under Section 833 to establish the method to be used by Blue Cross Blue Shield entities in determining the medical loss ratio required by that section. This was published on May 13 as REG under Treas. Reg. sec : The year in review 9

14 Guidance on exchanges under Section 1035 of annuities for long-term care insurance contracts. Regulations under Section 7702 defining cash surrender value. Regulations under Section 882 regarding inbound transactions involving insurance companies. Despite industry requests, the Priority Guidance Plan does not include any mention of guidance concerning Life Principles-Based Reserves. The IRS and Treasury s priority guidance plan contains 10 projects related to insurance companies and products that are identified as priorities for the July 2012 June 2013 plan year. Bad-debt deductions The Large Business and International (LB&I) Division of the IRS released an Industry Director Directive (IDD) allowing insurance companies to elect what is effectively a safe harbor for partial worthlessness deductions with respect to loan-backed and structured securities as defined in Statement of Statutory Accounting Principle (SSAP) 43R. The new safe harbor is patterned after the safe harbor under Treas. Reg. Section (d). Taxpayers are permitted to make this one-time election going back to the 2009 taxable year, through the 2012 taxable year, with a true-up adjustment and full audit protection for years prior to, and including, the year of election. The safe harbor method prescribed by the IDD requires conformity with the statutory accounting treatment for impairment of loanbacked securities for which a deduction would be allowed under Section 166. The safe harbor method requires that, except to the extent of any market-related impairment, postimpairment tax basis will equal post-impairment statutory carrying value. Life insurance products Life insurance contracts In PLR , the IRS concluded that a reduction in the face amount of a life insurance contract was not an alteration under the terms of the contract. Instead, the reduction in face amount was treated as the issuance of a new contract as of the date of alteration. As a result, the contract was required to be retested under Section 7702 using the 2001 CSO mortality tables to determine whether the contract qualified as a life insurance contract for Federal income tax purposes. Corporate-owned life insurance Notice and consent requirements In PLR , the IRS ruled that corporate-owned life insurance policies purchased by a closely held corporation on the lives of its shareholders sufficiently satisfied the notice and consent requirements of Section 101(j)(4). Taxpayer is a closely held corporation whose shareholders are also its employees. Taxpayer executed an agreement with each shareholder providing that Taxpayer will obtain life insurance on the life of each shareholder, and that Taxpayer will be the owner and beneficiary of the life insurance. Prior to purchasing these life insurance contracts, Taxpayer did not obtain separate documentation from each affected shareholder. However, Taxpayer obtained separate documentation after purchasing these life insurance contracts. The IRS found that through the agreement and the application, each shareholder was informed in writing that Taxpayer will be a beneficiary of any proceeds payable upon the death of the shareholder. The IRS considered all of the documentation as a whole, and ruled that the requirements of Section 101(j)(4) were met. 10 Continuing developments in the taxation of insurance companies

15 Transfer of BOLI policies In PLR , the IRS ruled that the transfer of life insurance policies by two banks to a limited liability company (LLC) in exchange for membership interests in the LLC will not be treated as a transfer to an investment company, within the meaning of Section 351, if the company was already incorporated. The IRS also addressed the tax implications of the deductibility of unrelated interest expenses under Section 264(f)(1) and the status of each bank under Section 264(f)(8). The LLC in this case has three member-partners, two of which are banks. The banks own life insurance policies on the lives of current and former employees. Some of the banks policies are general account life insurance policies (general account BOLI) and some are separate account life insurance policies (separate account BOLI). The banks will transfer some of their respective general account and separate account BOLI to the LLC solely in exchange for membership interests. The LLC s third member-partner will manage the BOLI. The LLC has represented that it satisfies the requirements of Section 52 to be treated as a single employer as one of the banks that has less than 50% interest. The IRS concluded that the transfer of the policies to the LLC will not be treated as a transfer to an investment company within the meaning of Section 351, assuming the LLC was incorporated. The IRS also concluded, among other things, that the LLC and one of the banks will be treated as one taxpayer under Section 264(f)(8), while the second bank will be treated separately. Therefore, only the BOLI policies held by the LLC where the LLC is the beneficiary will constitute an employer-owned life insurance contract if the policy covers the life of an insured who is an employee of the LLC or of the first bank. Long-term care benefits rider In PLR , the IRS ruled that a long-term care benefits rider (Rider) added to a single premium deferred annuity contract offered by a stock life insurance company was considered an insurance contract under Section 7702B(b)(1). Taxpayer is a stock life insurance company taxable under Section 801, and is the issuer of certain annuity contracts, which include a single-premium deferred annuity contract. The annuity contract is not a variable contract within the meaning of Section 817(d). Taxpayer proposed to offer a non-cancellable rider option to provide certain long-term care benefits (LTC Benefits) during the time the person covered by the Rider is a chronically ill individual within the meaning of Section 7702B(c)(2) and receives qualified long-term care services within the meaning of Section 7702B(c)(1) through the agency or facility identified in the plan of care. Through the Rider, Taxpayer assumes the risk that the insured will be ineligible for long-term care benefits. The risk assumed by Taxpayer will be distributed across the large number of insureds who purchase the Rider. Accordingly, the IRS concluded that LTC benefits paid under the Rider are excludable from gross income under Section 104(a)(3). After-death distribution option In a pair of letter rulings, PLR and PLR , the IRS ruled that a distribution option under an annuity contract qualifies under Section 72(s) where the option provides for after-death distributions and is available to a non-spouse beneficiary if the owner dies before the annuity has begun. The taxpayers are stock life insurance companies that offer non-qualified deferred variable annuity contracts. The owner of an annuity contract may designate the beneficiaries, who are entitled to the contract s death benefits. The taxpayers developed a new after-death distribution option that would be made available to a non-spouse beneficiary when an annuity contract owner with a guaranteed lifetime withdrawal benefits option with two covered persons, one of whom is the non-spouse beneficiary, dies prior to the contract s annuity starting date. Under Section 72(s), a non-qualified annuity contract will not be treated as an annuity contract for federal income tax purposes unless it provides for certain distributions in the event that the contract holder dies. The IRS found that the intent of Section 72(s) does not prevent the non-spouse beneficiary of a non-qualified annuity contract from electing to be treated for tax purposes as if he or she had received the entire interest. 2012: The year in review 11

16 Captives Definition of insurance The IRS ruled in PLR that a general insurance captive, licensed and organized under the laws of a foreign country, qualified as a domestic insurance company for income tax purposes because the captive was able to demonstrate risk shifting and risk distribution, and that the reinsurance premiums paid to a reinsurance pool are ordinary and necessary business expenses for federal income tax purposes. The taxpayer, a corporation, offers four types of contracts, including a policy covering buildings, business personal property, etc., to various insured corporations that are owned by the taxpayer s sole shareholder. To assist in achieving its overall risk distribution, the taxpayer takes part in a reinsurance pool with 14 unrelated insurers. According to case law, a contract must include both risk shifting and risk distribution in order to constitute insurance. The IRS found that through the taxpayer s arrangement in the reinsurance pool, there were a significant number of unrelated covered entities such that none is paying for a significant portion of their own risk. Thus, the IRS concluded because insurance risks were covered, risk shifting and distributed were achieved and the contracts issued by the taxpayer to its insureds were insurance contracts for tax purposes. Reserves Extracontractual obligations In State Farm Mutual Automobile Insurance Company v. Commissioner, 698 F.3d 357 (7th Cir. 2012), the Seventh Circuit Court of Appeals affirmed and reversed in part a Tax Court decision regarding the tax treatment of bad-faith damage awards that have not been paid and used in determining insurance loss. Previously, the Tax Court ruled that the adverse award for bad-faith damages should not have been included in computing the Taxpayer s insurance loss reserve. The Taxpayer appealed, and the Court ruled that bad-faith awards for compensatory damages should be included in the computation of loss reserves. However, upon reliance on the authoritative guidance issued by the National Association of Insurance Commissioners (NAIC), the Court reasoned that the punitive damages portion of the bad-faith award is a regular business loss deductible only when paid. According to NAIC, only compensatory damages for bad-faith judgments are taken into consideration for calculating unpaid loss reserve, not punitive damages. Loss discount factors Rev. Proc set forth, for purposes of Section 846, the loss payment patterns and discount factors for each property and casualty line of business for the 2012 accident year. These factors are to be used by property and casualty insurance companies in discounting unpaid losses. Rev. Proc set forth, for purposes of Section 832, the salvage discount factors for the 2012 accident year that must be used for each line of business to compute discounted estimated salvage recoverable. All the factors were determined using the applicable interest rate under Section 846(c), which was 2.89%. 12 Continuing developments in the taxation of insurance companies

17 Small insurance company election Effect of a mistaken election In PLR , the IRS denied a taxpayer s request to revoke a mistaken election for treatment as a small insurance company, finding the election invalid since the taxpayer was not an insurance company in the year the election was made. The taxpayer provided home insurance to homeowners, but incurred start-up business expenses and earned interest income only during its first year of operations. The taxpayer inadvertently made the small insurance company election when filing its first-year income tax return, but realized the mistake the next year and requested a ruling for the election to be revoked. The IRS concluded that the election was invalid so it did not need to be revoked. Demutualization In a demutualization transaction, the US District Court of Arizona held in Bennett Dorrance et ux. v. United States, No. 2:09-cv-01284, that the basis of shares received upon the demutualization could be reasonably determined. The Court further ruled that the open transaction doctrine did not apply; noted that it should be used only in rare circumstances; and held that the basis of the shares should be apportioned according to Treas. Reg. Section (a). The court s approach differed from the approach of the Court of Federal Claims in Fisher v. US, 82 Fed. Cl. 780 (Fed. Cl. 2008), and the US District Court for the Central District of California in Reuben v. US, No. CV SJO PJWX. Top Issues: The Insurance Industry in 2013 Top Insurance Industry Issues in 2013 describes in detail the challenges insurers are facing and the strategies they can use to cope with change, manage risk, enhance their operations, and grow. assets/pwc-top-insurance-industry-issues-2013.pdf Strategic Risk Management: Facilitating Risk- Based Insurance Decisions As described in the thought leadership piece, PwC believes that insurers require a strategic risk management (SRM) solution that identifies, assesses, and economically manages potentially enterprise-threatening losses over time. In other words, SRM is a way to mitigate evolving risks before they spiral out of control. assets/pwc-insurance-strategic-risk-management.pdf 2012: The year in review 13

18 International FATCA Final regulations Final regulations for the Foreign Account Tax Compliance Act (FATCA) were released on January 17, The final regulations contain over 500 pages of guidance that will undoubtedly take a significant amount of time to digest and implement for stakeholders including banks, investment funds, insurance companies, and their clients. The final regulations follow the February 2012 release of the proposed regulations, and provide significant clarity on a number of open items the insurance industry had identified in the proposed regulations. While some of the provisions in the final regulations attempt to simplify the impact on the insurance industry, other provisions have ultimately complicated FATCA s impact. FATCA was enacted as part of the Hiring Incentives to Restore Employment Act (HIRE Act) in March 2010 to serve as an administrative tool to prevent and detect US tax evasion and improve taxpayer compliance. As a result, Chapter 4 (Sections ) was added to Subtitle A of the Internal Revenue Code. Chapter 4 expands the US information reporting regime by imposing documentation, withholding, and reporting requirements on payments to Foreign Financial Institutions (FFIs) and Non-Financial Foreign Entities (NFFEs). Taxpayers should begin taking action now by analyzing current policies, procedures, and processes to determine enterprise risk, assess current preparedness, and develop a long-term sustainable implementation roadmap for compliance with FATCA by its effective date of January 1, Captive insurance companies Foreign captive insurance companies may be subject to FATCA as either FFIs or NFFEs. When FATCA was enacted, it was made to be broadly applicable and intentionally capture a variety of entities in order to mitigate increasing offshore tax evasion. While a captive insurance company would not be considered a financial institution in the traditional sense, it may be subject to the reporting and withholding obligations under FATCA. Even if the foreign captive insurance company has made a Section 953(d) election to be treated as a US entity for tax purposes, the company may not qualify as a US person under the final FATCA regulations, leaving it to fall under the FFI or NFFE provisions. Under the FATCA rules for NFFEs, any US source insurance premiums will be considered withholdable payments subject to 30% withholding without valid documentation. Therefore, foreign captive insurance companies should be ready to provide appropriate tax documentation to US withholding agents. FATCA registration The IRS released draft Form 8957, Foreign Account Tax Compliance Act (FATCA) Registration, for public review and comment on April 5, No accompanying instructions were included. Form 8957, when issued in final form, may be used by FFIs to register for FATCA purposes. In the IRS release of the draft Form 8957, the IRS reiterated its intention to utilize an online registration portal for FATCA registration. The portal is expected to be available in July The IRS also released more information about the schema of its so-called December List, a published list of FFIs that have registered with the IRS by October 25 and their corresponding global intermediary identification number (GIIN). The online Portal and Form 8957 (when finalized) will enable FFIs to obtain a GIIN and be included in the list. The final FATCA regulations: 500 pages of guidance downloadable in an easy-to-read format The final FATCA regulations formatted with references is an easy-to-read format from PwC s Global Information Reporting (GIR) practice. The PDF includes bookmarks for major sections, a clickable table of contents, and reference hyperlinks. Read more on FATCA for the insurance industry: How do the final FATCA regulations impact insurers? The insurance industry and FATCA Moving from assessment to implementation: Top 13 in Continuing developments in the taxation of insurance companies

19 Update on IGAs In July 2012, the US Treasury as well as the Treasury Departments of France, Germany, Italy, Spain, and United Kingdom (the G5 countries) released a model intergovernmental agreement (IGA) for implementing the broad-ranging provisions of FATCA. Following the release of the Model Agreement, the US Treasury and United Kingdom s HM Treasury in September 2012 announced the signing of the first IGA. As anticipated, the US-UK IGA closely followed the Model Agreement but specifically identified the UK institutions and products that are seen as presenting a low risk of being used to evade US tax and therefore will be effectively exempt from FATCA requirements. In November 2012, the US Treasury issued a press release announcing that it is working with more than 50 countries and jurisdictions around the world to improve international tax compliance and to efficiently and effectively implement the information reporting and withholding tax provisions of FATCA. According to the Treasury, this development marks an important milestone in establishing a common intergovernmental approach to combating tax evasion. The press release lists jurisdictions in which the Treasury is in the process of finalizing an IGA, as well as those in which it is actively engaged in a dialogue and those it is working with to explore options. Shortly thereafter in November 2012, the US Treasury signed IGAs with Mexico and Denmark. Although the articles and annexes for the Mexico and Denmark IGAs follow a similar format as the Model IGA, some differences do exist. Similar to the US-UK IGA, the most significant differences are contained in Annex II, which is customized to identify the local entities, accounts, and products that present a low risk of being used by US persons to evade US tax. An onslaught of similar IGAs implementing the tax reporting and withholding procedures associated with FATCA are expected in the coming months. Domestic asset liability percentages In Rev. Proc , the IRS provided the domestic asset/liability percentages and domestic investment yields for foreign life insurance companies needed to compute minimum effectively connected net investment income under Section 842(b) for the 2011 tax year. For the 2011 tax year, the relevant domestic asset/liability percentages and domestic yields were: Type of company Domestic asset/liability percentages Domestic investment yields Foreign life insurance companies 166.1% 3.2% Foreign property and liability insurance companies 189.6% 3.2% Transfer pricing In 2011, a Dutch lower court issued a ruling relating to the transfer pricing arrangements between a Dutch vacation resort and its Irish captive insurance company. At the time of reservation, tourists can buy cancellation insurance, which the resort subcontracts to its captive insurance company in Ireland. The Dutch Tax Administration added the entire profit of the Irish captive insurance company to taxable income of the Dutch resort. The Dutch Tax Administration argued that the various agreements between the Netherlands and Ireland were all closely connected and did not change how the cancellation insurance was operated by the group. It also argued that the Irish organization lacked key elements of reinsurance, such as diversification, value creation by reducing costs, and costs of capital as well as asset/liability management. The Court followed the argument of the Dutch Tax Administration that in Ireland only administrative services have been rendered with no insurance or reinsurance activities. It ruled that those services can be rewarded at cost plus a modest mark up. The insurance risk does not require a separate remuneration. The remainder of the Irish insurance profit must be taxed at the Dutch resort. The Court also held that the investment income from the interest on the group loan can be allocated to the Irish captive insurance company. 2012: The year in review 15

20 Multi-state Alabama H.B. 257 (effective 08/01/2012) provides a tax credit for investments in businesses located within qualified low-income communities. The credit is transferable, nonrefundable, and may be used to offset state income, financial institution excise, and premium tax. Any unused portion of the credit may be carried forward to be used in subsequent taxable years. For investments in a downtown core area or central business district, the credit would be 8.33% of the investment for six years beginning the year after investment, for a total of 50%. For investments in other locations, the credit would be 7% of the investment for five years beginning the year after the investment and 4% for the sixth year after the investment, for a total of 38%. The investment is capped at $10 million per affiliated group. H.B. 323 (effective 08/01/2012) provides that each insurer authorized to write insurance in Alabama shall be assessed an annual fee of $200 by the Commissioner of Insurance to fund the operations of the insurance fraud unit. Assessments are due 30 days after the insurer receives written notice from the state. Assessments shall accrue interest at 6% per year on and after the due date. Failure to pay the assessment will result in the suspension or revocation of the insurer s certificate of authority. S.B. 230 (effective 08/01/2012) provides a nonrefundable premium tax credit to insurers for covering homeowners insurance policies with wind coverage in areas covered by the Alabama Insurance Underwriting Association (i.e., the Gulf of Mexico region). The credit is 20% of the insurance premium tax otherwise due on property in Zone 4 and 35% of the premium tax otherwise due on the property in Zones 1, 2, and 3. To qualify for the credit, the premium payment must be 12% less than the premium due by the homeowner under the Alabama Wind Pool Plan. Alaska S.B. 23 (effective 05/30/2012) amends various provisions regarding the film production tax credit available against the income and premium tax by extending the sunset date from July 1, 2013 to July 1, Further, the Department of Revenue is now responsible for the administration, review, and approval of the film production credit (previously, the Department of Commerce, Community, and Economic Development). Additionally, it reduces the minimum amount of film production expenses that eligible taxpayers must incur in Alaska from $100,000 to $75,000 and increases the measurement period from 24 months to 36 months. The maximum credits that may be awarded to all eligible film productions are increased from $100 million for productions before July 1, 2013 to $200 million for productions after June 30, 2013 and before July 1, Arizona H.B amends the quality jobs tax credit against income and insurance premium tax to eliminate the 400 employees-per-employer per-year limitation, but adds a requirement that all hiring must be made within 12 months after the start of the required capital investment. (Credit is applicable retroactively for taxable years beginning after June 30, 2011.) S.B (effective retroactively to taxable years beginning 07/01/2011) revises the new employment tax credit against the premium tax to specify that the credit is allowed against the premium tax liability for increases in full-time employees residing in the state and hired in qualified employment positions in Arizona. The amount of the tax credit is equal to $3,000 for each full-time employee in a qualified position for the first year or partial year of employment (unless hired in the last quarter). Additionally, clarifies that the 5% penalty on failure to remit tax payments via EFT is based on the amount of funds not properly remitted by EFT (versus the tax liability reflected on the return). 16 Continuing developments in the taxation of insurance companies