2004 Insurance Tax Year in Review: Part IV International Tax Matters by Jim Cohen, Mary Gillmarten, and Richard Safranek

Transcription

1 2004 Insurance Tax Year in Review: Part IV International Tax Matters by Jim Cohen, Mary Gillmarten, and Richard Safranek In the fourth installment of a four-part report, Richard Safranek and Mary Gillmarten of Deloitte Tax LLP's Washington office and Jim Cohen from the firm's Hartford, Conn. office discuss international tax events that occurred in Date: Mar. 10, 2005 by Richard Safranek, Mary Gillmarten, and Jim Cohen Overview "While there are many who complain that the Internal Revenue Code is incomprehensible, there are some few who revel in the intricacies of its labyrinthine composition. But those who take delight in such pursuits and who also understand the mystic processes of establishing reserves in the life insurance industry are an even rarer species of the ornithological world. Such are the vagaries of assignments, however, that it has fallen to the lot of this panel to decide a case where the two sciences conjoin. We therefore tread into the thicket with some trepidation." Judge Weis, The Mutual Benefit Insurance Company v. Commissioner, 488 F.2d 1101 (3d Cir. 1973). This has been a favorite quote of ours. It sometimes seems that each pronouncement of regulatory guidance brings additional confusion rather than clarification. Nevertheless, we forge ahead, summarizing as best we can the guidance provided for our corner of the labyrinth in The biggest news this year was legislative: enactment of the American Jobs Creation Act of Section I -- Legislation The American Jobs Creation Act of 2004 The American Jobs Creation Act of 2004 (AJCA) is the most comprehensive corporate tax reform legislation since the Tax Reform Act of Although many of the most significant international tax provisions of the new law affect manufacturers, the AJCA also includes an array of international tax provisions of interest to insurance companies. Section 965: Repatriation of Foreign Earnings Domestic insurance companies with non-u.s. operations are eligible for a one-year tax benefit in the form of an 85 percent dividends received deduction (DRD) for some extraordinary cash dividends received from a controlled foreign corporation. Ordinarily, that dividend would be taxable in full, with the U.S. tax burden reduced under the foreign tax credit rules, but no credit is allowed regarding the 85 percent deductible portion of the dividend. To qualify, the dividend must exceed a base period average so that only extraordinary dividends are eligible for the DRD. Also, the amount eligible for the DRD is limited to the greater of $500 million or the amount shown in the corporation's financial statements as permanently reinvested outside the United States. The corporation also must adopt a domestic reinvestment plan to further the provision's objective of creating a temporary economic stimulus (for example, to fund U.S. infrastructure, research and development, capital investments, debt repayment, and so forth). Treasury has promised prompt guidance on section 965. [ Editor's note: The government provided interim guidance on section 965 in Notice , which was issued after this article was submitted for publication.] The ideal candidate for this provision is a CFC with large amounts of low-taxed earnings and profits that have not previously been taxed under subpart F. Low-taxed earnings and profits are better than high-taxed because electing the DRD requires forfeiting 85 percent of the related foreign tax credits. Also, the DRD is available only after the CFC has distributed any earnings and profits that have been taxed previously as subpart F income.

2 It is not too difficult to find CFC insurance companies that pay low local taxes, and thanks to the active financing income rules in sections 953(e) and 954(i), it is not too difficult to find CFC insurance companies that do not generate significant amounts of subpart F income. It is difficult, however, to find CFC insurance companies that meet both criteria. There just are too few low-tax jurisdictions where a CFC insurance company can write sufficient same-country business to qualify for the active financing exception. Of course, many insurance groups have CFC service companies, and some of those may be in low-tax jurisdictions, where the trade-off between foreign tax credits and the DRD is more attractive. Even if the provision is determined to be beneficial, the CFC must have sufficient free cash to fund the dividend without borrowing from its U.S. shareholder. This is not to say that the provision is unhelpful to the industry, but there are likely to be few fact patterns in which electing the 85 percent DRD is a no-brainer. Change to Section 845 Section 845(a) was clarified so that it now explicitly grants the IRS authority to allocate income, deductions, and other items among related parties to a reinsurance agreement when the allocation is necessary to reflect the proper "amount" of taxable income. Previously, that authority arguably could be used only when necessary to reflect the proper "source or character" of taxable income. (Arguably, section 482 could have been used to close any such gap that may have existed in section 845(a).) If the change reinvigorates the IRS's efforts to write regulations under section 845 (which it should, because Congress indicated in the legislative history that it expected Treasury to get cracking), then the amendment may prove to be more far-reaching than the language might indicate. Foreign Tax Credit Carryovers Extended to 10 Years Excess foreign tax credits may now be carried forward for 10 years, rather than 5, and carried back 1 year rather than 2. Excess foreign tax credits that can be carried to 2004 under the existing rules are eligible for the new 10-year carryforward period. Also, the 90 percent limitation on the use of foreign tax credits to offset the alternative minimum tax was repealed, effective calendar year Domestic Loss Recapture Rule Restoring some balance to the code, Congress adopted the taxpayer-friendly corollary to the foreign loss recapture rule, which currently requires that foreign-source income be treated as U.S.-source income when past foreign losses reduced U.S.-source income. Beginning in 2007, when the rule becomes effective, if U.S. losses reduce foreign-source income, future U.S.-source income will be treated as foreign-source income, making it easier to use foreign tax credits. Subpart F Changes Congress approved several mostly taxpayer-friendly changes to the subpart F rules, but none particularly relevant to the insurance industry. One of the unfriendly changes is relevant, however: The statute of limitations for subpart F inclusions was extended to six years (up from the normal three). One-Time Elections The AJCA includes several opportunities for taxpayers to make one-time elections: 1. Exchange Rate for Foreign Tax Paid Other Than in Functional Currency -- Beginning in 2005, taxpayers may elect to translate foreign taxes into U.S. dollars at the spot exchange rate on the date of payment rather than the average exchange rate for the tax year. 2. Foreign Tax Credit Treatment of Base Difference Items -- Income that is taxed in a foreign country but not considered income under U.S. rules is included in the general foreign tax credit basket, which might be a problem for insurance groups that assign most of their income and taxes to the financial services basket. Under an election applicable to taxes accrued in 2005 and 2006, a taxpayer may elect to assign such income and taxes to the financial services basket. This will become the general rule in 2007, when the foreign tax credit baskets will be collapsed into two: the passive income basket and the general income basket. Under that regime, financial services income (including passive income) of a financial services group will be assigned to the general income basket. 3. Interest Expense Allocation -- Beginning in 2009, a U.S. group will be permitted to apply a worldwide fungibility rule in allocating interest expense. Under current law, which will continue to apply for any taxpayer that does not elect to use the new rules, interest expense paid by the U.S. group is allocated in part against foreign-source income, but none of the interest expense incurred by a foreign subsidiary in the group is allocated against U.S.-source income.

3 Elimination of Overlapping Antideferral Regimes Effective in 2005, offshore insurance companies need no longer concern themselves with the personal holding company rules, the foreign personal holding company rules, or the foreign investment company rules. The controlled foreign corporation rules and the passive foreign investment company rules had largely taken over the field of antideferral regimes and still apply. The elimination of the other sets of antideferral rules does remove several potentially troublesome issues from consideration, especially when the insurance company's shareholder group consists largely of individuals. Treasury Studies Congress instructed Treasury to study (1) how well the earnings stripping rules prevent unfair competition by foreign-owned businesses, (2) the effectiveness of the transfer pricing rules, (3) whether any tax treaty provisions have been used inappropriately, and (4) how well the new inversion provisions are working to prevent corporate expatriation transactions. The Pension Funding Equity Act of 2004 As mentioned above in the discussion of federal tax matters (Part I), the Pension Funding Equity Act clarified the definition of insurance company for federal tax purposes and amended sections 501(c)(15) and 831(b) to make it more difficult to qualify for tax benefits under those provisions. Nonresident Aliens Subject to Tax on Policies Issued by Foreign Branches of U.S. Insurers Section II -- Foreign Operations of U.S. Taxpayers Citations: For Rev. Rul , IRB 109 (July 12, 2004), see The Insurance Tax Review, Sept. 2004, p. 449, Doc [PDF], or 2004 TNT For Rev. Rul , IRB 516 (Sept. 3, 2004), see The Insurance Tax Review, Oct. 2004, p. 671, Doc [PDF], or 2004 TNT Overview: The IRS ruled that income received by nonresident aliens under life insurance or annuity contracts issued by a foreign branch of a U.S. life insurance company is U.S.-source income subject to the 30 percent withholding tax under sections 871(a) and The IRS subsequently delayed the implementation date for some taxpayers. Discussion: This ruling reflects a change from prior practice by the IRS, which had tacitly accepted the industry position that benefit payments by foreign branches of U.S. life insurance companies are foreign-source income to the beneficiaries and thus not subject to U.S. withholding taxes. Obviously, imposition of a 30 percent withholding tax on those payments would make it difficult for U.S. companies to compete with local companies or with other non-u.s. companies serving that market whose governments do not tax the payments. Companies affected by the IRS position must decide whether to restructure their offshore operations (possibly by transferring their branch operations to a non-u.s. entity) or to challenge the IRS position on its merits. The IRS concluded that the income has a U.S. source because it is analogous to interest and dividends, which generally have a U.S. source if paid by a U.S. corporation. The American Council of Life Insurers (ACLI) had asked that the ruling be withdrawn pending a period of public comment. However, in Rev. Rul , the IRS merely limited the application of Rev. Rul to payments made after January 1, 2005, if the payments are made under a contract issued before June 12, A deferred effective date is little comfort to those companies affected by the ruling, because it does nothing to resolve the fundamental issue and, worse, signals the IRS's resolve to maintain the position announced in Rev. Rul One challenge might be based on the view that the IRS has made the wrong analogy. Rather than analogizing to interest paid by a U.S. company, the IRS should have analogized the payments to interest paid by a U.S. branch of a foreign insurance company. Under section 884(f), interest paid by a U.S. branch of a non-u.s. company is considered U.S.-source income. By analogy to that provision, payments made by a foreign branch of a U.S. company would be treated as foreign-source payments. It is important to note that death benefits continue to be exempt from withholding through section 101 and Treasury reg. section (b)(1), which provides that items of income excluded from gross income without regard to the U.S. or foreign status of the owner are not subject to withholding. The ruling applies only to benefit payments and other withdrawals under life insurance policies and to annuity payments. Proposed Regulations on Stock Held by Foreign Insurers Section III -- U.S. Operations of Foreign Insurance Companies Citations: For REG , 69 F.R (June 25, 2004), see The Insurance Tax Review, Aug. 2004, p. 287, Doc

4 [PDF], or 2004 TNT Overview: The IRS published proposed regulations on the determination of the effectively connected U.S. income of foreign insurance companies. Discussion: Section 864 provides rules to determine whether fixed or determinable, annual, or periodic income from U.S. sources is effectively connected with a U.S. trade or business. One factor used in making that determination is whether the income is derived from assets used in or held for use in a U.S. trade or business. In 1996 final section 864 regulations were issued providing that stock is not considered an asset used in, or held for use in, the conduct of a trade or business in the U.S. However, those regulations reserved on whether the general rule applied to stock held by foreign insurance companies. The proposed regulations would extend the general rule to foreign insurance companies unless the company owns -- directly, indirectly, or constructively -- less than 10 percent of the vote or value of the company's stock. The 10 percent threshold distinguishes portfolio stock investments commonly held by insurance companies from direct investments. The IRS has asked for comments on whether the 10 percent threshold is adequate. It may be noted that section 805(a)(4)(E) contemplates that a foreign life insurance company could receive effectively connected dividends from its wholly owned subsidiary. It is not clear how or whether this statutory provision is affected by the regulatory change in section 864. Barbados Treaty Changes Section IV -- Other International Developments Affecting Insurance Companies Citations: For the Department of Treasury's news release announcing protocol amending the Barbados-U.S. tax treaty, Office of Public Affairs (Dec. 20, 2004), see Doc [PDF] or 2004 TNT For the protocol, see Doc [PDF] or 2004 TNT Overview: The Treasury Department announced December 20 the entry into force of a protocol amending the Barbados-United States tax treaty (treaty); the protocol was negotiated to prevent double taxation while eliminating the tax advantages of corporate inversion transactions. Discussion: The 2004 protocol significantly limits the ability of a Barbados insurance company to qualify for treaty protection, particularly if it is subject to a special tax regime under Barbados law, such as the Exempt Insurance Act. The 2004 protocol also changed the limitation on benefits provisions to disqualify a Barbados company that is owned by a publicly traded U.S. company. Its shares must be publicly traded in Barbados or it must be a subsidiary of a company whose shares are publicly traded in Barbados. Also, the general ownership/base erosion rule applies only if Barbados ownership exceeds the 50 percent threshold. Previously, U.S. ownership also counted. A company that fails the ownership test can still qualify for treaty benefits under the active trade or business test, but that requires that the Barbados insurance company have its own operational and managerial employees. Even if that test is satisfied, an exempt insurance company would not be entitled to reduced withholding tax rates on its U.S.-source interest, dividends, or royalties. The 2004 protocol basically eliminates Barbados as a tax-favorable jurisdiction for U.S.-owned insurance companies, which can now obtain better protection by incorporating in Bermuda than in Barbados. Barbados companies owned by Canadian or other third-country residents have seen their U.S. treaty benefits slashed even if they continue to qualify for treaty protection under the active trade or business test. U.K. Publishes Overseas Life Insurance Company Regulations Citations: For 2004 S.I. No. 2200, (Aug. 27, 2004), see The Insurance Tax Review, Oct. 2004, p. 707, Doc [PDF], or 2004 WTD Overview: The U.K. Treasury has published the Overseas Life Insurance Companies Regulations 2004, which change the tax treatment of non-u.k. life insurance companies in the wake of amendments to the method of calculating U.K. profits that should be assigned to those companies' permanent establishments. Discussion: In 2003 the Finance Act changed the tax rules for non-u.k. life insurance companies. As a result of that change, the U.K. Treasury published the Overseas Life Insurance Companies Regulations 2004, which changes the tax treatment of non-u.k. life insurance companies concerning the method of calculating U.K. profits that should be assigned to a U.K. permanent establishment. The regulations entered into force September 17, 2004.

5 Conclusion Thank you for staying with us to the end. We sincerely hope we have alerted you to something new or provoked some private insight on your part. We look forward to doing it all again next year. Comment on this story Tax Analysts Information Code Section: Section Life Insurance Company Tax; Section Tax on Other Insurance Companies Geographic Identifier: United States Subject Area: Insurance company taxation Industry Group: Insurance Author: Cohen, Jim; Gillmarten, Mary; Safranek, Richard Institutional Author: Deloitte Tax LLP Tax Analysts Document Number: Doc [PDF] Tax Analysts Electronic Citation: 2005 TNT Use this link to bookmark or link to this document