Managing Tax Accounting Requirements for Investments

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2 Managing Tax Accounting Requirements for Investments ARF Program Track, Session #106 Speakers: Dave Knight, VP, Product Manager, State Street Global Exchange Drew Westall, Senior Manager, Johnson Lambert LLP

3 Agenda Learning Objectives Understand the tax implications of investment accounting Address streamlining your investment and tax accounting processes Review how other insurance companies are addressing these issues

4 Common Book/Tax Differences Tax-Exempt Interest Bond Market Discount OID Due & Accrued Dividends Dividends Received Deduction Capital Gains/Losses OTTI Wash Sales Interportfolio Transfers Alternative Investments Treasury Inflation Protected Securities (TIPS)

5 Security Trading Primary Market Market where securities are created and purchased directly from the issuing company Where new stocks and bonds are sold to the public for the first time Secondary Market The market where investors trade previously issued securities with other investors without the issuing companies involvement e.g. NYSE, NASDAQ, etc.

6 Bond Concepts Bond Definition A debt security issued in a transaction where the investor loans money to an entity to be repaid at a future (maturation) date In exchange, the borrowing company pays a specified rate of interest during the life of the bond Examples: U.S. government securities, municipal bonds, corporate bonds, mortgage-backed securities Market Premium Market Discount Original Issue Discount (OID) Acquisition Premium Tax-Exempt Bonds

7 Tax-Exempt Municipal Bonds Generally, interest on obligations of states and their political subdivisions are exempted from regular federal tax Gain on sale of tax-exempt securities is taxable Reduction of loss deduction (proration) 15% for P&C insurance companies The goal of prorating (reducing) the TEI deduction is to prevent the company from funding loss reserves with tax-free income Effect of market discount and market premium Effect of Alternative Minimum Tax (AMT) regime

8 Bond Market Discount Occurs when a bond is purchased on a secondary market for a price below the face value of the bond Generally due to an increase in market interest rates from the coupon rate Could also result from a weakening of the issuer s credit rating Tax Treatment Taxpayer is not required to include accretion of the market discount in taxable income but may elect to do so Deferred market discount recognized as ordinary income when the bond matures or is disposed

9 Bond Market Discount Market Discount Deferral Election Tax Treatment Upon Disposition Ordinary Income Capital Gain/Loss

10 Original Issue Discount (OID) Occurs when a bond is sold at a discount on the primary market and will be later redeemed for full face value An investor can invest less up front, while anticipating full repayment at maturity e.g. Zero-coupon bonds Tax Treatment OID is included in income over the term of the security, under a constant yield method Exception: De minimis OID Primary difference from market discount is that no election can be made to defer recognition of OID in income

11 Original Issue Discount (OID) Example OID

12 De minimis Market Discount De minimis Rule 1278(a)(2)(c) Market Discount. If the market discount is less than 1/4 of 1 percent of the stated redemption price of the bond at maturity multiplied by the number of complete years to maturity (after the taxpayer acquired the bond), then the market discount shall be considered to be zero. Bonds that are purchased with a de minimis market discount are carried at cost and the discount will not be accreted.

13 De minimis Market Discount

14 De minimis Market Discount Bonds that are purchased with a de minimis market discount are carried at cost and the discount will not be accreted

15 De minimis Market Discount Discount bonds that are purchased without a de minimis market discount are accreted

16 Stock Concepts Stock Definition An ownership share in a corporation Different classes of stock may have different rights Common vs. preferred Distribution and liquidation rights Voting vs. nonvoting Tax Treatment of Dividends An insurance company is not currently required to accrue dividends that have not been received Accrued dividends are required for GAAP and STAT, but not for tax Tax adjustment reverse the book change in accrued dividends

17 Stock Concepts (DRD) Tax Treatment of Dividends (cont.) Dividends-Received Deduction (DRD) A deduction is allowed for dividends equal to: 70% for less than 20% owned domestic corporations 80% for 20% or more owned domestic corporations 100% for dividends from affiliated companies The following are not eligible for DRD: Foreign dividends Real estate development trust (REIT) dividends Mutual fund dividends which represent interest income (confirm DRD eligibility from mutual fund) Reduction of loss deduction (proration) 15% for P&C insurance companies 100% DRD is not subject to proration Effect of Alternative Minimum Tax (AMT) regime

18 Capital Gains/Losses Generally: Book Calculation Consideration less Adjusted Carrying Value (ACV) Tax Considerations Market Discount Deferral Difference between ACV and Cost taxable as ordinary income upon sale or maturity Other Than Temporarily Impaired Investments (OTTI) Tax prohibits recognition of capital loss until investment either sold or deemed wholly worthless Wash Sales Interportfolio Transfers

19 Wash Sales Wash Sales Defined In the case of any loss from any sale of securities where it appears that, within a period beginning 30 days before the sale date and ending 30 days after such date, the taxpayer has acquired substantially identical securities, then no deduction shall be allowed under section 165

20 Wash Sales Example - Sale then repurchase within 30 days = Wash Sale

21 Interportfolio Transfers Transfer at market and Defer GL At time of Transfer - Defer Market Discount Defer Gain/Loss

22 Interportfolio Transfers Transfer at market and Defer GL At time of Disposition - Recognize Market Discount Recognize Gain/Loss

23 Alternative Investments Alternative Investments Examples Master Limited Partnership Interests Real Property Private Equity Funds Hedge Funds Tax Treatment Generally receive K-1 based on actual activity of the pass-through Creates book/tax basis difference Must be tracked properly

24 Treasury Inflation Protected Securities TIPS STAT Unrealized no income statement effect GAAP Inflationary increases/decreases recorded as ordinary income/loss Tax Inflationary increases/decreases recorded as ordinary income/loss Decreases only recognized to the extent that cumulative effect of increases/decreases over the life of the investment does not drop below zero

25 Questions? Dave Knight State Street Global Exchange (609) Drew Westall Johnson Lambert LLP (847)

26 Please Complete the Session Evaluation Form on the Conference App