The Tax Man Cometh For Insurance Cos. In Latest Budget

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1 Portfolio Media. Inc. 860 Broadway, 6th Floor New York, NY Phone: Fax: The Tax Man Cometh For Insurance Cos. In Latest Budget Law360, New York (February 10, 2015, 3:17 PM ET) -- On Feb. 2, the Obama administration released its fiscal year 2016 budget. The hallmarks of the budget are proposals that would impose: (1) a minimum tax on the current foreign earnings of U.S. corporations and their controlled foreign corporations and (2) a one-time 14 percent tax on earnings accumulated in controlled foreign corporations and not previously subject to U.S. tax. Furthermore, in keeping with the Obama administration s past budgets, the fiscal year 2016 budget includes several proposals that target insurance companies or that otherwise would have a direct effect on them. Specifically, those proposals would: impose a financial fee on certain liabilities of large firms in the financial sector, including insurance companies; mandate reciprocal reporting of information in connection with the implementation of the Foreign Account Tax Compliance Act; William R. Pauls modify the proration rules for life insurance company general and separate accounts; disallow deductions for excess nontaxed reinsurance premiums paid to affiliates; and require information reporting for private separate accounts established by life insurance companies. These five proposals, which are examined in greater detail below, have been scored by the U.S. Department of the Treasury as raising a total of more than $126 billion in revenue over 10 years.

2 Imposition of a Financial Fee According to the General Explanations of the Administration s Fiscal Year 2016 Revenue Proposals, the proposed financial fee, which is a modified version of the financial crisis responsibility fee included in the fiscal year 2015 budget, is designed to reduce the incentive for large financial institutions to leverage, reducing the cost of externalities arising from financial firm default as a result of high leverage. Specifically, the fee would apply to banks, bank holding companies and nonbanks, including insurance companies, savings and loan holding companies, asset managers, broker-dealers, specialty finance corporations and financial captives, with worldwide consolidated assets of at least $50 billion. A U.S. subsidiary or a U.S. branch of a foreign entity apparently would be covered by the fee if the subsidiary or branch falls into one of these business categories and has assets of at least $50 billion. A financial entity would not be subject to the fee during any period that its assets fall below the $50 billion threshold. The proposed financial fee would be calculated by reference to a financial entity s covered liabilities. For this purpose, covered liabilities would be equal to the assets less the equity reported in the financial entity s audited financial statements, but with a deduction for separate accounts (primarily for insurance companies). Importantly, with respect to the application of the fee to an insurance company, reserves and other policyholder obligations backed by the company s general account would be taken into account for purposes of determining the company s covered liabilities. In comparison, the financial crisis responsibility fee set forth in the fiscal year 2015 budget generally would have excluded reserves and other policyholder obligations in computing an insurance company s covered liabilities. The proposed financial fee would be applied to a financial entity s covered liabilities at an annual rate of seven basis points (0.07 percent) and would be deductible in computing U.S. corporate income tax. A financial entity would report the fee on its annual U.S. federal income tax return and estimated payments of the fee would be made on the same schedule as estimated income tax payments. The proposed financial fee would be effective as of Jan. 1, Reciprocal Reporting of Information for FATCA The provisions of FATCA became effective on July 1, 2014, more than four years after being added to the Internal Revenue Code through the enactment of the Hiring Incentives To Restore Employment Act.[1] In brief, the FATCA rules generally require that a payor of a withholdable payment withhold 30 percent of such payment, unless: (1) the payee of such payment satisfies the relevant FATCA reporting requirements, (2) the payee fits into an exception to the FATCA rules or (3) the payment satisfies such an exception. For purposes of FATCA, a withholdable payment includes any U.S. source payment of fixed or determinable annual or periodical income (FDAP income). FDAP income includes interest, dividends, royalties and insurance and reinsurance premiums. Thus, the FATCA rules have far-reaching implications for both U.S. and non-u.s. insurance companies. In many cases, foreign law may prevent foreign financial institutions from complying with the relevant FATCA reporting requirements. To date, such legal impediments have been addressed through intergovernmental agreements, specifically Model 1 IGAs, under which the relevant foreign government has agreed to provide the information about U.S. accounts required by FATCA to the Internal Revenue

3 Service. According to the fiscal year 2016 Greenbook, requiring financial institutions in the U.S. to report information to the IRS with respect to the financial accounts of nonresidents would facilitate the intergovernmental cooperation contemplated by the intergovernmental agreements. Following this line of thought, the fiscal year 2016 budget proposal, which is a variation of the reciprocal reporting proposal included in the fiscal year 2015 budget, would: require financial institutions to report the account balance (including, in the case of a cash value insurance contract or annuity contract, the cash value or surrender value) of all financial accounts maintained at a U.S. office and held by foreign persons; expand the current reporting required with respect to U.S. source income paid to financial accounts held by foreign persons to include similar non-u.s. source payments; and direct financial institutions that are required under FATCA or this proposal to report information to the IRS with respect to a financial account to furnish a copy of that information to the account holder. Notably, this last requirement, which is a new addition to the reciprocal reporting proposal, would not extend to foreign financial institutions in jurisdictions that have entered a Model 1 IGA with the U.S. Finally, under this proposal, the Treasury Department would be granted authority to issue regulations to require financial institutions to report: 1. the gross proceeds from the sale or redemption of property held in, or with respect to, a financial account; 2. information with respect to financial accounts held by certain passive entities with substantial foreign owners; and 3. such other information that is necessary to carry out the purposes of the proposal. This proposal seemingly would result in the imposition of full reverse FATCA reporting obligations on U.S. financial institutions. Although this result would add another layer of complexity to the already onerous FATCA regime, it nevertheless would be consistent with the information exchange contemplated in reciprocal Model 1 IGAs and the Organization for Economic Co-operation and Development's common reporting standard. Notably, a case with potential implications on this proposal Florida Bankers Association v. Treasury[2] is being appealed to the D.C. Circuit and is scheduled for oral argument on Feb. 13, In that case, the district court upheld Treasury Department regulations promulgated in 2012 requiring U.S. banks, credit unions and securities firms to report interest paid to some nonresident aliens to the IRS.[3] This proposal would be effective for returns required to be filed after Dec. 31, 2016.

4 Modification of the Proration Rules for Life Insurance Companies' General and Separate Accounts In the case of a life insurance company, the dividends-received deduction is permitted only with respect to the company s share of dividends received, reflecting the fact that some portion of the company s dividend income is used to fund tax-deductible reserves for its obligations to policyholders.[4] Likewise, the company s net increase or net decrease in reserves is computed by reducing the ending balance of the reserve items by the policyholders share of tax-exempt interest.[5] The regime for computing the company s share and policyholders share generally is referred to as proration. For purposes of the proration rules, the policyholders share equals 100 percent less the company s share, and the company s share equals the company s share of net investment income divided by net investment income.[6] Furthermore, the company s share of net investment income is the excess, if any, of net investment income over certain amounts set aside to satisfy obligations to policyholders.[7] A life insurance company s separate account assets, liabilities and income are segregated from those of the company s general account in order to support variable life insurance and variable annuity contracts.[8] Accordingly, the company s share and policyholders share are calculated separately for each of the company s separate accounts.[9] In view of the nuances associated with these calculations, the separate account DRD has been the subject of ongoing controversy in IRS audits of life insurance companies. The fiscal year 2016 budget proposal, which is a modified version of the proposal included in the fiscal year 2015 budget, would change the mechanics of the proration regime. As under current law, the company s share and policyholders share would be calculated for a life insurance company s general account and separately for each of its separate accounts. However, the policyholders share would equal the ratio of an account s mean reserves to its mean assets, and the company s share would equal 100 percent less the policyholders share. In view of these proposed changes, dividends received by a life insurance company separate account likely would be entitled to only a very small DRD, if any. This proposal would be effective for taxable years beginning after Dec. 31, Disallowance of Deductions for Excess Nontaxed Reinsurance Premiums Paid to Affiliates As a general matter, insurance companies are allowed to deduct premiums paid for reinsurance.[10] If a reinsurance transaction results in a transfer of reserves and reserve assets to the reinsurer, the potential tax liability for the earnings associated with those assets generally is shifted to the reinsurer as well. Although the insurance income of a foreign reinsurer that is a CFC may be subject to current taxation in the U.S.,[11] the insurance income of a foreign reinsurer that is not a CFC and that is not engaged in trade or business within the U.S. generally is not subject to U.S. federal income tax. However, if such a nontaxed foreign reinsurer reinsures U.S. risks, the foreign reinsurer may be subject to a U.S. federal excise tax equal to 1 percent of the premiums paid under the relevant reinsurance agreement,[12] unless the excise tax is waived by an applicable income tax treaty. According to the fiscal year 2016 Greenbook, Reinsurance transactions with affiliates that are not subject to U.S. [f]ederal income tax on insurance income can result in substantial U.S. tax advantages over similar transactions with entities that are subject to tax in the United States. The fiscal year 2016 Greenbook also states that [t]he excise tax on reinsurance policies issued by foreign reinsurers is not always sufficient to offset this tax advantage.

5 The fiscal year 2016 budget proposal, which is a carryover from the fiscal year 2015 budget and is similar to proposals that have been sponsored by Rep. Richard Neal, D-Mass., on multiple occasions and submitted by former House Ways and Means Committee Chairman Dave Camp, R-Mich., and former Senate Finance Committee Chairman Max Baucus, D-Mont., for public discussion and comment, would: (1) deny an insurance company a deduction for premiums and other amounts paid to an affiliated foreign reinsurer with respect to reinsurance of property and casualty risks to the extent that the affiliated foreign reinsurer (or its parent company) is not subject to U.S. federal income tax with respect to the premiums received; and (2) would exclude from the insurance company s income (in the same proportion in which the premium deduction was denied) any return premiums, ceding commissions, reinsurance recovered or other amounts received with respect to reinsurance for which a premium deduction is wholly or partially denied. Under this proposal, the reinsurance premiums paid to the affiliated foreign reinsurer apparently would remain subject to the potential application of the 1 percent U.S. federal excise tax, and it appears that the ceding company still would be required to reduce its tax reserves by the amount ceded to the reinsurer. The latter result effectively would put the ceding company on a cash basis for deducting losses on the business reinsured, unless the affiliated foreign reinsurer elects to treat such reinsurance premiums as effectively connected income (as discussed below). A foreign reinsurer that is paid premiums from an affiliated insurance company that otherwise would be denied a deduction under this proposal would be permitted to elect to treat those premiums and the associated investment income as income effectively connected with the conduct of a trade or business within the U.S. and attributable to a permanent establishment for income tax treaty purposes. For purposes of the foreign tax credit, the income treated as effectively connected under this proposal would be treated as foreign source income and would be placed into a separate category within Section 904 in order to prevent cross-crediting of the foreign taxes imposed on that income. This proposal would be effective for policies issued in taxable years beginning after Dec. 31, Required Information Reporting for Private Separate Accounts Established by Life Insurance Companies Investments through a separate account of a life insurance company generally give rise to tax-free or tax-deferred income. This favorable tax treatment is not available, however, if the policyholder has so much control over the investments in the separate account that the policyholder, rather than the life insurance company, is treated as the owner of those investments. According to the fiscal year 2016 Greenbook, information reporting will enable the IRS to identify more easily which variable insurance contracts qualify as insurance contracts under current law and which contracts should be disregarded under the investor control doctrine. In keeping with this reasoning, the fiscal year 2016 budget proposal, which is a carryover from the fiscal year 2015 budget, would require life insurance companies to report the following information to the IRS with respect to each contract the cash value of which: (1) is invested, in whole or in part, in a private separate account for any portion of the taxable year; and (2) represents at least 10 percent of the value of the private separate account: policyholder s taxpayer identification number; policy number; amount of accumulated untaxed income; total contract account value; and

6 portion of that value that was invested in one or more private separate accounts. For purposes of this proposal, a private separate account would be defined as any separate account with respect to which a related group of persons owns policies the aggregate cash values of which represent at least 10 percent of the value of the account. This determination would be made quarterly, based on information reasonably within the issuer s possession. This proposal would be effective for private separate accounts maintained on or after Dec. 31, Additional Proposals of Note The fiscal year 2016 budget contains a number of other proposals that are relevant to insurance companies. In brief, those proposals, many of which have been carried over from the fiscal year 2015 budget, would pursue the following policies: Reform the U.S. International Tax System Specifically, in addition to imposing: (1) a minimum tax on the current foreign earnings of U.S. corporations and their CFCs and (2) a one-time 14 percent tax on earnings accumulated in CFCs and not previously subject to U.S. tax, the fiscal year 2016 budget would: restrict deductions for excessive interest of certain members of financial reporting groups ; repeal the delay in the implementation of worldwide interest allocation; make the exceptions under Subpart F for certain active financing income and active insurance income permanent; make the look-through exception under Subpart F permanent; limit the shifting of income through intangible property transfers; modify the tax rules for dual capacity taxpayers ; tax gain from the sale of a partnership interest on a look-through basis; extend Section 338(h)(16) to certain asset acquisitions; remove foreign taxes from a Section 902 corporation s foreign tax pool when earnings are eliminated; create a new category of Subpart F income for transactions involving digital goods or services; amend the CFC attribution rules; eliminate the 30-day grace period before Subpart F inclusions; restrict the use of hybrid arrangements that create stateless income; limit the application of the exceptions under Subpart F for certain transactions that use reverse hybrids to create stateless income; and limit the ability of domestic entities to expatriate. Create a New Category of Qualified Private Activity Bonds for Infrastructure Projects Exempt Certain Foreign Pension Funds from the Application of the Foreign Investment in Real Property Tax Act Modify the Treatment of Derivative Contracts and the Rules Related to the Identification of Hedges

7 Under this proposal, derivative contracts, which would be defined broadly to include any contract the value of which is determined, directly or indirectly, in whole or in part, by the value of actively traded property, generally would be required to be marked to market at the end of each taxable year, and any gains or losses from marking the derivative contract to market would be treated as ordinary income or loss. Mark-to-market accounting would not be required, however, for a transaction that qualifies as a business hedging transaction. Require Information Reporting for Certain Life Settlement Transactions Restrict the Exception to Pro Rata Interest Expense Disallowance for Corporate-Owned Life Insurance to 20-Percent Owners Conform the Net Operating Loss Rules Applicable to Life Insurance Companies to those Applicable to Other Corporations This would allow a life insurance company s loss from operations to be carried back up to two taxable years prior to the loss year, and carried forward up to 20 taxable years following the loss year. Conform the Control Test of Section 368 with the Affiliation Test of Section 1504 Prevent the Elimination of Earnings and Profits through Distributions of Certain Stock with Basis Attributable to Dividend Equivalent Redemptions Prevent the Use of Leveraged Distributions from Related Foreign Corporations to Avoid Dividend Treatment Treat Purchases of Hook Stock by a Subsidiary as Giving Rise to Deemed Distributions Repeal the Boot-Within-Gain Limitation of Current Law (In the case of any reorganization transaction if the exchange has the effect of a distribution of a dividend, as determined under Section 356(a)(2).) Require Accrued Market Discount on Bonds to be Taken into Income Currently in the Same Manner as Original Issue Discount Repeal the Nonqualified Preferred Stock Provision of Section 351(g) and Cross-Referencing Provisions that Treat Nonqualified Preferred Stock as Boot Repeal the Rules Under Section 708 Concerning Technical Terminations of Partnerships Repeal the Anti-Churning Rules Under Section 197 Repeal Section 847 Section 847 allows insurance companies that are required to discount unpaid losses to claim an additional deduction up to the excess of: (1) undiscounted unpaid losses over (2) related discounted unpaid losses.

8 The proposal to make permanent the exceptions under Subpart F for certain active financing income and active insurance income is notable in view of the fact that those exceptions expired at the end of In this regard, discussions have continued in the new Congress regarding possible extenders legislation, and the inclusion of these proposals in the fiscal year 2016 budget may offer further impetus for those discussions. Conclusion With the 2014 midterm elections in the rear view mirror and the arrival of Rep. Paul Ryan, R-Wis., as the new chairman of the House Ways and Means Committee and Sen. Orrin Hatch, R-Utah, as chairman of the Senate Finance Committee, both of whom have indicated that tax reform is a significant legislative priority, it seems inevitable that the fiscal year 2016 budget s tax proposals will receive further consideration in Although most of the proposals included in the fiscal year 2016 budget are unlikely to gain much traction in the new Congress, it is notable that the fiscal year 2016 budget and the discussion draft of the Tax Reform Act of 2014 released by former House Ways and Means Committee Chairman Dave Camp, R-Mich., in February 2014 share a few common themes. For example, both the fiscal year 2016 budget and the tax reform discussion draft propose to modify the proration rules for life insurance company general and separate accounts and to disallow deductions for certain reinsurance premiums paid to nontaxed affiliates, while leaving tax-deferred inside build-up intact. Taking into account the magnitude of the changes contemplated in both the fiscal year 2016 budget and tax reform discussion draft, and the potentially detrimental interactions between changes designed to apply to insurers and those intended to impact regular corporations, insurers would be well-served to heed the tax reform discussions taking place on Capitol Hill during By William R. Pauls, Sutherland Asbill & Brennan LLP William Pauls is a partner in Sutherland Asbill & Brennan's Washington, D.C., office. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. [1] Pub. L. No , 124 Stat. 71 (2010). [2] 19 F. Supp. 3d 111 (D.D.C. 2014). [3] See T.D. 9584, I.R.B [4] See 805(a)(4). [5] See 807(a)(2), (b)(1). [6] See 812(a). [7] See 812(b).

9 [8] See generally 817(c), (d). [9] See 817(c). [10] See, e.g., 832(b)(4)(A); cf. 803(a)(1); 805(a)(6). [11] See generally 951(a); 952(a); 953; 954(a), (c), (i). [12] See All Content , Portfolio Media, Inc.