American Council of Life Insurers Issues Public Comment on IRS Proposed Rule
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On
A notice of proposed rulemaking was also published in the same issue of the
On behalf of the
1. The general limitation on applicable insurance liabilities should include administrable rules for companies that prepare multiple financial statements
Under Reg. Sec. 1.1297-4(e)(2) of the Final Regulations, the general limitation on applicable insurance liabilities ("AILs") caps the AIL at the lowest of several amounts, determined based on several different measures including the foreign insurance company's statutory accounting statement ("the general limitation rule"). The Preamble requests comments on the expanded definition of an applicable financial statement ("AFS") and the priority rules provided, including (i) whether special rules are needed to properly apply the general limitation on AIL if the statutory accounting statement covers a different period than the AFS, and (ii) whether other more detailed rules are necessary in order to identify the AFS when a foreign corporation operates in multiple jurisdictions and is subject to the authority of more than one insurance regulatory body.
A foreign insurance company that may be subject to a fiscal year end under local rules (for example,
In situations where the foreign insurance company operates in multiple jurisdictions and is subject to the authority of multiple insurance regulatory bodies where each requires filing of a statutory financial statement, ACLI recommends that the regulations provide that the highest amount of AIL required among all of those jurisdictions should be treated as the AIL required by an insurance regulatory body in applying Reg. Sec. 1.1297-4(e)(2). By analogy, the Service has taken a similar approach to the statutory reserve cap for life insurance reserves under section 807. See
2. Adjustment to assets and liabilities in the applicable financial statement
The Proposed Regulations require, or permit, adjustments to assets and liabilities in the AFS for purposes of applying the 25 percent test or the alternative 10 percent test. These adjustments fall in two categories - adjustments arising out of the reinsurance of risk from the tested foreign corporation ("TFC") to a reinsurer, and adjustments required because the TFC's AFS is a consolidated financial statement.
a. Rules related to adjustments to applicable insurance liabilities and assets in the case of reinsurance between unrelated parties should be modified
Treatment of
Under Prop. Reg. Sec. 1.1297-4(f)(2)(i)(D)(3), applicable insurance liabilities ("AILs") are reduced by an amount equal to the assets reported on the TFC's financial statement that "represent amounts relating to those liabilities that may be recoverable from other parties through reinsurance" (the "AIL reduction rule").
The Preamble notes that under GAAP and IFRS 17, in the case of ordinary coinsurance, amounts recoverable from other parties as reinsurance are recorded on the asset side of the balance sheet, rather than reducing balance sheet liabilities. In contrast, under statutory accounting rules, a coinsurance transaction would typically reduce a ceding company's insurance liabilities by the amount reinsured rather than recording the reinsurance recoverable as an asset on the balance sheet.
The operation of this rule can be illustrated through the following example. Assume a life insurance company with 1000 of assets, and liabilities (reserves) of 300. Its net equity is therefore 700 and its AILs as a percentage of assets is 30%.
Now assume this company does a straight coinsurance deal with a reinsurer in which 30% of the business is transferred to the reinsurer. Assume that insurer will pay 90 in premium to reinsurer to assume 90 of risks.
If the life insurer has a GAAP or IFRS AFS, following this transaction the life insurer's reserves will be unchanged at 300, and its assets will consist now of 910 in assets that it retained, plus a reinsurance recoverable of 90. Total assets therefore remain the same at 1000 and the percentage remains at 30%. Equity remains the same at 700.
However, if the life insurer has an AFS based on statutory accounting, liabilities go down by 90, from 300 to 210, and assets go down from 1000 to 910. The reinsurance recoverable is not booked as an asset. Equity stays the same at 700, but the ratio of liabilities to assets is approximately 23% (210/910), lower than the percentage for a GAAP or IFRS 17 taxpayer.
Consequently, a taxpayer whose AFS is prepared on the basis of GAAP or IFRS gets a better result than a taxpayer whose AFS is prepared on the basis of statutory accounting. The Proposed Regulations seeks to equalize these two types of taxpayers by requiring the GAAP/IFRS taxpayer to reduce its liabilities by the amount of its reinsurance recoverable.
Under the AIL reduction rule the AILs of a TFC with a GAAP or IFRS AFS, liabilities are decreased by the amount of the reinsurance recoverable (90), from 300 to 210. The Proposed Regulations allow the TFC to reduce its assets by the amount by which its liabilities were reduced, so assets are reduced from 1000 to 910, and the GAAP/IFRS taxpayer's percentage is now approximately 23% (210/910), the same as the taxpayer whose AFS is prepared on the basis of statutory accounting.
The Preamble to the Proposed Regulations say that modified coinsurance ("modco") is not subject to this rule because modco arrangements "do not create an amount recoverable from another party." Presumably the rationale is that in modco the ceding company retains the assets, therefore there is no need for the ceding company to book a reinsurance recoverable. Therefore, as in the case with a taxpayer whose AFS is prepared on the basis of statutory accounting, there is no amount by which the AILs of the TFC could be reduced.
We perceive several issues, however, in the rationale presented in the Proposed Regulations as to why the rule requiring adjustment to AILs does not apply to modco. First, we suggest that the true reason why no adjustment to AILs is necessary in the case of modco is not because there is no reinsurance recoverable (although that is the effect of the Proposed Regulations as currently written) but rather that there is not a different result depending on whether the TFC's AFS is prepared based on GAAP or IFRS or based on statutory accounting. This is because in the case of modco, reserves as well as assets are generally retained in the ceding company under GAAP, IFRS and US statutory accounting.
Second, a modco transaction generally requires numerous adjustments to be made over the life of the policy as between the cedant and the assuming company, and in fact modco transactions do give rise to a reinsurance recoverable under GAAP or IFRS accounting. We are concerned that if the non-application of the rule to modco rests solely on the contention that modco does not give rise to a reinsurance recoverable, there may be a lack of clarity as to whether the rule does in fact apply to modco, since the "exception" for modco is not an exception at all, it is merely an aside in the Preamble.
This concern arises in part due to the fact that the language used in the regulation - "assets reported on the corporation's financial statement ... that represent amounts relating to those liabilities that may be recoverable from other parties through reinsurance" - is susceptible to different interpretations that may cause taxpayers to doubt that the AIL reduction rule does not apply to modco. Therefore, we suggest that the exclusion of modco from the application of the rule be made explicit in the regulations rather than merely a comment in the Preamble.
An additional issue that
Interaction between adjustments to AILs and the general limitation rule should be clarified
One final comment pertains to the interaction between the proposed adjustment to applicable insurance liabilities and the cap on applicable insurance liabilities under section 1297(f)(3)(B) and Reg. Sec. 1.1297-4(e)(2) (i.e., the general limitation rule discussed above). The Proposed Regulations state that AILs are reduced by an amount equal to the reinsurance recoverables reported as assets on the financial statement. If the TFC files or is required to file a financial statement with the applicable insurance regulatory body, however, the final regulations also cap applicable insurance liabilities at the amount of liabilities shown on that financial statement under the general limitation rule.
It is unclear how these rules would interact. Using the same coinsurance example above, if a life insurance company has 1000 of assets and reserves of 300, its AILs as a percentage of assets is 30%. If the company does a straight coinsurance deal in which the insurer pays 90 in premium to the reinsurer for it to assume 90 of risks, if the life insurer has a GAAP or IFRS applicable financial statement, following this transaction absent the adjustment in the Proposed Regulations the life insurer's reserves will be unchanged at 300, and its assets will consist now of 910 in assets that it retained, plus a reinsurance recoverable of 90. With the adjustment in the proposed regulations, liabilities are decreased by the amount of the reinsurance recoverable (90), from 300 to 210.
However, if we suppose that the taxpayer files a statutory financial statement with the insurance regulator, liabilities would be capped at 210. If the cap is applied first, and then the reduction to liabilities, liabilities would first be capped at 210 and then reduced by 90 to 120. If the adjustment is applied first and then the cap, the liabilities are reduced to 210 and capped at the same amount. The Proposed Regulations do not clarify how this would apply. The Proposed Regulations do provide that "No item or amount shall be taken into account more than once in determining applicable insurance liabilities," but it is not clear that subjecting the AILs to a cap is the same "item or amount" as the adjustment.
The regulations should make clear that the adjustment is applied first, before the cap. The regulations could say this explicitly or could achieve the same result by amending Prop. Reg. Sec. 1.1297-4(f)(2)(i)(D)(3) to provide "Amounts of liabilities determined under paragraphs (e)(2), (f)(2)(i)(A) through (C) and (D)(1) and (2) are reduced by an amount equal to the assets reported on the corporation's financial statement as of the financial statement end date that represent amounts relating to those liabilities that may be recoverable from other parties through reinsurance" (emphasis added).
New regulations should be issued in proposed form so as to provide taxpayers the opportunity to further comment.
b. Reinsurance related adjustments required because of a consolidated AFS should be allowed to be made using reasonable methods
The Proposed Regulations require a number of adjustments necessitated by a situation in which the AFS is prepared based on a consolidated basis.
First, if a foreign corporation's AFS is prepared on a consolidated basis, total assets may be reduced by the amount equal to the amount of insurance liabilities of affiliated entities that are reported on the AFS and would be included in AIL if its definition did not limit AIL to the AIL of the subject foreign corporation. See Prop. Reg. Sec. 1.1297-4(e)(4)(i).
In addition, Prop. Reg. Sec. 1.1297-4(f)(2)(i)(D)(3) clarifies that, if a TFC's financial statement is prepared on a consolidated basis, liabilities of the TFC must be reduced (to the extent not reduced under other provisions) by an amount equal to the assets relating to those liabilities that may be recoverable through reinsurance from another entity included in the consolidated financial statement, regardless of whether the reinsurance transaction is eliminated in the preparation of the consolidated financial statement.
The Proposed Regulations provide no guidance as to how the above adjustments may be made in the case of a consolidated AFS. We propose that the Proposed Regulations be revised to provide that these adjustments may be made using any reasonable methodology, consistently applied.
3. Determination of applicable financial statement in the case of a consolidated financial statement should be further clarified
Proposed Treas. Reg. Sec. 1.1297-4(f)(1) provides complex ordering rules for determining which of a foreign corporation's financial statements (where the foreign corporation has multiple financial statements) are treated as the AFS.
As a general matter, audited GAAP financials of a publicly traded company will take precedence over IFRS financials or a regulatory annual statement. A "financial statement" is defined to mean a complete balance sheet, income statement, and cash flow statement, or the equivalent statements under the relevant accounting standard, and ancillary documents typically provided together with such statements.
Where the only financial statement available is a consolidated financial statement where the TFC is not the parent company, the rules in the proposed regulations for determining the AFS should be clarified. Instances where such clarifications are needed are provided below:
- The Proposed Regulations state that such a financial statement may be used as the AFS if "it is the only financial statement described in paragraph (f)(1)(iii)." Paragraph (f)(1)(iii) describes a financial statement "required to be filed with the applicable insurance regulatory body that is not prepared in accordance with GAAP or IFRS." A financial statement prepared in accordance with GAAP or IFRS would not be "described in paragraph (f)(1)(iii)" and therefore could not be the AFS. It is not clear that this was the intent of
- As noted, a statement is "described in paragraph (f)(1)(iii)" if it is "required to be filed with the applicable insurance regulatory body." Presumably therefore a statement filed with the regulator but not "required" to be filed would not be "described in paragraph (f)(1)(iii)". This is inconsistent with the statement in the Preamble that a consolidated financial statement where the TFC is not the parent company can be used as the AFS if "it is the only financial statement of the tested foreign corporation and is provided to an insurance regulator."
- The statement in the Preamble is also inconsistent with the regulations in that the regulations state that the consolidated financial statement can be used as the AFS if it is the only financial statement that is required to be filed with the applicable insurance regulatory body, while the Preamble states that the financial statement must be the only financial statement of the TFC and is provided to an insurance regulator.
4. Comments with respect to qualifying domestic insurance corporations
Proposed Reg. Sec. 1.1297-6(b)(2) and (c)(2) of the final regulations provide that income and assets, respectively, of a qualifying domestic insurance corporation ("QDIC") are non-passive for purposes of determining whether a non-
We provide below our recommendations with respect to the application of the QDIC Rule in the Proposed Regulations with reasons for why they should be modified to address certain issues unique to our industry. We believe these recommendations will assist you to issue guidance effectively and efficiently to implement the PFIC rules for the life insurance industry.
a. QDIC Limitation Rule - Capping of Assets should be eliminated
The Preamble to the Final Regulations provides: "
The Preamble to the proposed regulations states that the
Prop, Reg. Sec. 1.904-4(e)(2)(ii) imposes the same caps as described above on the amount of an insurance company's income from investments that are considered ordinary and necessary to the proper conduct of the insurance business and therefore that may be treated as active financing income. Like the proposed regulations under section 904, the proposed PFIC regulations do not explain how these percentages were arrived at, including the differences in insurance liabilities for life and nonlife insurance companies. To be a QDIC, Reg. Sec. 1.1297-6(e)(1) of the final regulations requires that the company be subject to tax as an insurance company under subchapter L of the Internal Revenue Code. The approach of capping investment income based on insurance liabilities is a departure from how subchapter L applies to domestic insurance companies. In general, the term "insurance company" means any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies under section 816(a). If more than half its activities were deemed to be investment activity that is unrelated to its insurance business, the company fails to be an insurance company. As a company can be an insurance company only if it meets the section 816(a) definition of an insurance company, ACLI believes that to the extent a company meets that test, its investment income should not be subject to further limitation. Therefore, the QDIC Limitation Rule is not necessary. It may be noted that subchapter L generally treats what is reported on the annual statement as investment income, which forms part of the insurance company's gross income, without any limitation.
Furthermore, the proposed definition is problematic for insurance companies that have significant assets relative to their liabilities in a start-up or run-off mode. The proposed tests would also add compliance burdens on insurance companies, as they would have to develop systems to test each company within the group every year.
b. QDIC Limitation Rule - Future changes to Percentages, if any, should be treated as regulatory changes
Comments are also requested on whether final regulations should specifically allow for the applicable percentages to be adjusted or supplemented in subregulatory guidance (for example, to reflect possible future changes in industry practice). If
c. Broader access to the QDIC Rule should be provided
To be a QDIC, final Reg. Sec. 1.1297-6(e)(1) requires that the corporation be a look-through subsidiary of a tested foreign corporation. A subsidiary of a tested foreign corporation is treated as a look-through subsidiary if both an asset test and an income test are satisfied (Reg. Sec. 1.1297-2(g)(3) of the final regulations).
Regulation Sec. 1.1297-2(b)(2)(iii) of the final regulations provides a rule for coordination of section 1297(c) with section 1298(b)(7). Under that rule, a tested foreign corporation is not treated under section 1297(c) and Reg. Sec. 1.1297-2(b) as holding its proportionate share of the assets of a domestic corporation, or receiving directly its proportionate share of the gross income or loss of the domestic corporation, if the stock of the domestic corporation is treated as an asset that is not a passive asset (as defined in Reg. Sec. 1.1297-1(f)(5)) that produces income that is not passive income (as defined in Reg. Sec. 1.1297-1(f)(6)) under section 1298(b)(7) (concerning the treatment of certain foreign corporations owning stock in certain 25-percent-owned domestic corporations).
Accordingly, if section 1298(b)(7) and section 1297(c) both apply with respect to a domestic insurance corporation that otherwise meets the requirements of final Reg. Sec. 1.1297-6(e), the above rule would require treating the stock of the domestic corporation as a non-passive asset under section 1298(b)(7), instead of being able to take advantage of the QDIC rule - whereby the underlying assets are treated as non-passive. On the other hand, if only 1297(c) applies, the taxpayer must use the QDIC rule. Thus, the ownership structure dictates which rule applies.
ACLI requests that a rule be provided where taxpayers may elect to apply the more beneficial rule, irrespective of their structure. Taxpayers should not reach different results simply because of the ownership structure within the organization, where taxpayers are otherwise similarly situated. As the QDIC rule is wholly a creature of the regulations, the
5. Comments with respect to the activities of a QIC
Section 1297(b)(2)(B) provides that passive income does not include income derived in the active conduct of an insurance business by a QIC. The proposed regulations provide elaborate rules with respect to meeting the active conduct standard.
a. Denominator of the active conduct percentage test should exclude commissions for insurance as well as reinsurance
Proposed Reg. Sec. 1.1297-5(b)(1) provides that a QIC is treated as engaged in the active conduct of an insurance business if it satisfies either the factual requirements test under Prop. Reg. Sec. 1.1297-5(c) or the active conduct percentage test under Prop. Reg. Sec. 1.1297-5(d).
The Proposed Regulations provide a definition of total costs that is used to apply the active conduct percentage test. Ceding commissions paid with respect to reinsurance contracts and commissions paid to brokers or sales agents to procure reinsurance contracts are excluded from the definition of total costs. ACLI recommends that the exclusion includes such costs with respect to insurance contracts as well as reinsurance contracts.
b. Clarify that run-off companies do not require underwriting for the active conduct test
Section 1297(f)(2)(B)(i) adds another requirement to the alternative facts and circumstances test (when the ratio of liabilities to assets fail the 25 percent test), that the foreign corporation be predominantly engaged in an insurance business under regulations provided by the Secretary based upon the applicable facts and circumstances. A run-off company may or may not meet this test. The final regulations provide in Reg. Sec. 1.1297-4(d)(3)(i) that a company in run-off that is seeking to meet the alternative facts and circumstances test, be in the process of terminating its pre-existing, active conduct of an insurance business under the supervision of its applicable insurance regulatory body or any court-ordered receivership proceeding (liquidation, rehabilitation, or conservation), which covers a broader array of circumstances than the proposed regulation. Furthermore, Reg. Sec. 1.1297-4(d)(3)(ii) requires that the company must have no plan or intention to enter into any insurance, annuity, or reinsurance contract other than in the case of a contractually obligated renewal.
As noted above, proposed regulations require all insurance companies to meet the active conduct test by one of two ways: a factual requirements test or a percentage test. Proposed Reg. Sec. 1.1297-5(c) provides that the factual requirements test is satisfied if the QIC's officers and employees carry out substantial managerial and operational activities on a regular and continuous basis with respect to all of its core functions and perform virtually all of the active decision-making functions relevant to underwriting. A QIC's core functions are generally defined to include underwriting, investment, contract and claim management, and sales activities. ACLI requests that in applying the predominantly engaged in an insurance business and active conduct tests to an insurance company in run-off, appropriate exceptions are provided that take into account its limited activities. The Conference Report to the Act describes a company with runoff-related circumstances as "not taking on new insurance business" and "using its remaining assets to pay off claims with respect to pre-existing insurance risks on its books." See H.R. Rep. No. 115-466, at 671 (2017) (Conf. Rep.). Accordingly, a run-off company seeking to meet the alternative facts and circumstances test, should be able to satisfy the predominantly engaged in an insurance business and active conduct tests through the activities of managing its claims and investments only. If a company is in run-off, but is not seeking to meet the alternative facts and circumstances test, it should be able to satisfy the active conduct test through the activities of managing its claims and investments only.
6. The election to apply alternative facts and circumstances test should apply more broadly
In response to the
In response to those comments, the final regulations provide that a shareholder in a publicly traded foreign corporation who owns stock (either directly or indirectly) with a value of
We note that despite the comments from taxpayers, no exception from the positive obligation to file the election has been permitted with respect to shareholders in non-publicly traded companies.
As for shareholders whose obligation to file the election is relieved if the value of the stock is below
We also propose that the threshold be set at 10% of the stock by vote or value, which tracks the definition of a
7. The rule in Reg. Sec. 1.1297-4(f)(2)(ii) should be limited
Under the final regulations, AIL includes the aggregate amount of reserves (excluding deficiency, contingency, or unearned premium reserves) held as of the financial statement end date to mature or liquidate potential, future claims for death, annuity, or health benefits that may become payable under contracts providing, at the time the reserve is computed, coverage for mortality or morbidity risks.
However, the regulations Sec. 1.1297-4(f)(2)(ii) go on to say that the term AILs also does not include the amount of any reserve for a life insurance or annuity contract the payments of which do not depend on the life or life expectancy of one or more individuals.
It is not clear what the additional exclusion for life insurance or annuity contract the payments of which do not depend on the life or life expectancy of one or more individuals is intended to accomplish that is not already accomplished by the general definition of AILs which requires that reserves relate to contracts that provide coverage for mortality or morbidity risks.
We thank you for considering our comments and welcome the opportunity to discuss our recommendations.
Sincerely,
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Footnote:
1/ The Code was last amended by "an Act to Provide for Reconciliation pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018," P.L. 115-97 (more commonly referred to as the Tax Cuts and Jobs Act, or "TCJA").
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The proposed rule can be viewed at: https://www.regulations.gov/document/IRS-2021-0003-0001
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