Tax Reserves and Related Items March Proration. Craig Pichette

Transcription

1 Tax Reserves and Related Items March 2011 Proration Craig Pichette

2 Proration What is Proration? The assumption that a portion of every dollar of investment t income or dividend id d received is credited d to policyholder reserves. Since a company receives a deduction for reserves, it should be required to include in income the policyholder share of any tax preferenced income. 2

3 Example of Proration Consider a company whose only source of investment income is taxexempt interest: Tax-exempt interest Less: increase in reserve attributable to tax-exempt interest Add: policyholders share of taxexempt interest Book Income Taxable Income Without Proration With Proration Net Income 38 (62) 0 3 Introduction Historical treatment of interest on reserves Generally not taxable In various forms true since inception of federal income tax on life insurers Treatment follows from conventions of statutory accounting Premiums and investment earnings = income Increase in reserves = expense Proration rules have two purposes Allocate investment income between the company (taxable) and the policyholder (deductible) Avoid double deduction of tax exempt interest and intercorporate dividends 4

4 Free Investment Income The proration rules implement the concept of free investment income as the basis for life company tax Life insurance company has income, properly subject to tax at the company level, only to extent it is not needed in reserves Fundamental element in taxation of life insurance companies is the allocation of investment income between: Required interest Free investment income Allocation Explicit (1921 to 1984) investment income tax base Implicit (currently) increase in reserves is deductible 5 Limitations Major issue is to determine what constitutes: Life insurance companies share, not deductible, and Policyholder share, deductible Limitation necessary Permitting company to deduct additions to reserves based on its own assumed interest rate would in effect allow the company to set its own tax liability Variations Direct deduction of reserves Exclusion of some or all of reserve interest Currently federally prescribed reserves based on AFIR or PSAR 6

5 Proration Concept of proration introduced in 1959 Act to allocate investment income between: Life insurance company share Policyholder share Used to allocate all items of investment income, including tax-exempt income and intercorporate dividends Only the life insurance company share taken into account in determining i taxable income If policyholder share was 75%, company share would be 25%; as a result only 25% of tax-exempt income would be recognized tax-free 7 Atlas Life For tax-exempt income and dividends received Purpose of proration rules is to avoid double deduction for policyholder share of the income 1959 Act treatment of proration challenged as impermissible tax on income from tax-exempt municipal bonds Supreme Court held Because no tax imposed on policyholder share, to allow full amount of tax exempt interest would be double deduction Tax exempt income and dividends received remained subject to proration 8

6 1984 Act The concept of proration in the 1984 Act Because reserve increases might be viewed as being funded proportionately out of taxable and tax-exempt income, the net increase and net decrease in reserves are computed by reducing the ending balance of the reserve items by the policyholders share of tax-exempt interest. Similarly, a life insurance company is allowed a dividends-received deduction for intercorporate dividends from nonaffiliates only in proportion to the company s share of such dividends House Report, 1431; 1984 Senate Report Act (cont.) Application of proration practically limited to: tax exempt bonds dividends received other untaxed income, including COLI Proration rules carried forward from 1959 Act In 1988, Supreme Court held that imposing federal tax on state bonds was constitutionally permissible No change was made to proration A higher company share generally decreases tax 10

7 Company Share Section 812(a)(1): Company Share = Company Share of Net Investment Income divided by Net Investment Income Section 812(b)(1): Company Share of Net Investment Income = Net Investment Income less Policy Interest Net investment income = 90% of gross investment income or 95% of separate account income Section 812(b)(2)(A): Policy interest = required interest at the greater of the PSAR or the AFIR Required interest applied to mean reserves to determine policy interest 11 General Account Proration Simplified formula: GII-RI Company share = GII 12

8 Definition of Required Interest Policy interest includes required interest at the greater of Prevailing State assumed rate, or Applicable Federal rate (plus some other interest items) If neither prevailing State assumed interest rate nor applicable Federal rate is used in the calculation of reserves In that case another appropriate rate is used for this calculation No statutory definition of another appropriate rate is provided, law is unclear as to what this rate is Generally been assumed that separate account earnings were an example of another appropriate rate Separate Accounts Principal effect of proration rules is in treatment of dividends received deduction related to separate accounts Fundamental issue is who is the tax owner of the assets Significant issue since 1984 Act History Application has created: Controversy between Taxpayers and IRS Proposed legislation 14

9 Dividends Received Deduction The dividends received deduction is 70% of company share, for qualifying dividends from unaffiliated companies. Under proration rules, life insurance company allowed the full 100% dividends received deduction for 80% subsidiaries, but subject to proration on all other dividends 15 Separate Accounts and Dividends Received Dividend income one element of separate account earnings Each segregated asset account computes its own company share Treas. Reg provides rules for separate accounts Developed under the 1959 Act In LTR , IRS adopted general method of 1959 Act to determine required interest in separate account, consistent with Regs. method LTR adopted a broad view of fees in amounts retained 16

10 Separate Account Policyholder Share NII ((NII/MA AR/MR) x MR) Company share = NII where: MR = Mean of Reserves MA = Mean of Account Values AR = Amounts Retained by Company (e.g., asset fees) 5% GII GII = Gross Investment Income NII = Net Investment Income =.95 (GII) 17 Revenue Ruling Rev. Rul required use of 807(d)(2) interest rates in computing separate account required interest Did not use rate based on separate account earnings Exempted policies: Reserve interest rate not used as basis for tax reserve Includes contracts where tax reserve equal to cash surrender value Method resulted in required interest that was unrelated to actual investment earnings in separate account Generally significantly reduced separate account dividends received deduction 18

11 Revenue Ruling Rev. Rul suspended by Rev. Rul , in which the IRS and the Treasury Department stated that the issues would more appropriately be addressed by regulation No regulations have been issued to date Rev. Rul still applied on audit thru 2010 Appeals conceded the issue LMSB directive not to raise the issue on audit 19 Administration Proposals Administration has proposed a legislative change in proration rules 85% general account percentage Basically eliminate separate account DRD Overall approach Not provided in much detail Intended to limit separate account DRD in proportion to separate account surplus over total separate account assets 20

12 Administration Proposals (cont.) Proposal would: Substitute ratio based on mean surplus in separate account to mean separate assets for current company share calculation Eliminate separate account earnings rate from calculation Net effect would be to reduce separate account dividends received deduction 21