Ernst & Young Issues Public Comment on IRS Proposed Rule

WASHINGTON, May 31 -- Chris Ocasal, principal at Ernst and Young LLP, has issued a public comment on the Internal Revenue Service's proposed rule entitled "Computation and Reporting of Reserves for Life Insurance Companies". The comment was written on May 27, 2020, and posted on May 28, 2020:

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On April 2, 2020, the United States (US) Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) published proposed regulations that provide guidance on the computation of life insurance reserves and the effects of a change in basis in computing certain reserves of insurance companies (Proposed Regulations)./1

On behalf of MetLife, Inc., Pan-American Life Mutual Holding Company, Prudential Financial Inc., and Reinsurance Group of America, Incorporated, each of which is the parent of an affiliated group that includes an insurance company taxed under part I of subchapter L/2 (a life insurance company) with extensive operations in the United States and globally, we appreciate the opportunity to submit these comments on the Proposed Regulations.

In the explanation to the Proposed Regulations (Preamble), Treasury and the IRS acknowledged receiving a request to promulgate regulations under section 807 that "generally would provide, for purposes of subchapter L, that the determination of whether a contract issued by a non-United States insurance company and reinsured by a United States insurance company is a life insurance or annuity contract is made without regard to [sections 7702, 101(f), 72(s) and 817(h)] provided that (i) no policyholder, insured, annuitant, or beneficiary with respect to the contract is a United States person and (ii) such contract is regulated as a life insurance or annuity contract by a foreign regulator."/3

Under the requested approach, a United States insurance company may be able to establish life insurance reserves for such a contract that is reinsured by such domestic insurance company even if the contract does not meet these statutory requirements./4

By a letter dated October 11, 2019 (October 2019 Letter), we submitted the request referred to in the Preamble.

In our October 2019 Letter, we noted that the statutory definition of "life insurance contract" under section 7702 and the distribution on death requirement of section 72(s) (collectively, the Life and Annuity Contract Requirements) primarily serve to distinguish life insurance and annuity contracts, which have a saving or investment element, from other types of investments. The purpose of the Life and Annuity Contract Requirements is to limit the tax benefit of the deferral of (or nonrecognition, if paid upon the death of the insured) US federal income tax on earnings credited to life insurance and annuity contracts (i.e., inside buildup), which is afforded to the owners of such contracts as means of promoting the social goals of permitting them to provide for their families in the event of premature death or to provide for their retirements, to contracts that do not provide unduly beneficial treatment of inside buildup to owners of such contracts. In the October 2019 Letter, we also noted that the cross-reference in section 807(c)(1) to the definition of life insurance reserves in section 816(b) can mechanically serve to limit a life insurer's current deduction for additions to life insurance reserves to amounts held in support of contracts that satisfy the Life and Annuity Contract Requirements, i.e., that do not provide owners with unduly beneficial US income tax treatment./5

In other words, the requirement that the reserves be held in support of contracts that satisfy the Life and Annuity Contract Requirements in order to be treated as "life insurance reserves" for purposes of section 807(c)(1) creates a relationship between the benefit afforded to insurers of characterizing such liabilities as life insurance reserves to the limitation on the benefit of favorable US income tax treatment of inside buildup afforded to owners of such contracts. When this latter benefit does not exist, the rationale for importing the Life and Annuity Contract requirements into section 807(c)(1) and creating uncertainty related to the tax treatment of the reserves no longer exists.

Our requested guidance/6 would be consistent with that goal. If the requested guidance is promulgated, the Life and Annuity Contract Requirements would not apply to the reserve held by a domestic insurance company in support of a reinsured contract issued by a foreign insurance company that is not engaged in a US trade or business or does not have a US permanent establishment where the underlying policyholder, insured, annuitant or known beneficiary/7 is not a "United States person" under section 7701(a)(30)/8 as long as such contract is regulated in the foreign insurer's home country as a life insurance or annuity contract (Foreign Life Insurance and Annuity Contract) and is regulated as a life insurance or annuity contract by the regulator of the reinsuring domestic insurance company. Further, we noted that there is no US tax policy reason to create uncertainty for a domestic insurance company in determining whether it is taxed as a life insurance company or when computing and deducting its section 807(c)(1) life insurance reserves (as defined in section 816(b)) in connection with the reinsurance of such contracts. The requested guidance, if promulgated, would be instrumental in enabling domestic life insurance companies to achieve certainty when "importing" pools of foreign insurance business (and their associated profits) into the United States in alignment with one of the primary goals of the Tax Cuts and Jobs Act (TCJA),/9 while preserving Congress' purpose in adopting sections 7702 and 72(s).

Although the guidance requested in the October 2019 Letter was drafted to be consistent with section 953(e)(5) (where a determination of a life insurance or annuity contract is made without regard to sections 7702, 101(f), 72(s) and 817(h)), in this comment letter we focus on sections 7702 and 72(s). Because section 101(f) only applies to contracts issued prior to January 1, 1985, while contracts issued after December 31, 1984, are subject to the requirements of section 7702, section 101(f) only has historic significance and thus is not a focus of this request. In addition, when Foreign Life Insurance and Annuity Contracts are reinsured by a domestic insurance company, policy values are not determined by reference to separate account assets and such contracts are not treated as variable contracts or variable annuity contracts on the books of the domestic insurance company or for US tax purposes. In such cases, section 817 is inapplicable and the domestic insurance company would treat the tax reserves related to such reinsurance contracts as general account reserves . Therefore, a reference to section 817(h) is being stricken from the requested guidance.

In the Preamble to the Proposed Regulations, Treasury and the IRS stated their intention to evaluate the request, "including whether to address it as part of this [sections 807 and 816] rulemaking." The Preamble accordingly provides:

Comments are requested generally in respect of the requested change, including in respect of statutory interpretation and implication of various contexts and provisions outside of subchapter L such as, for example, the interaction with policies underlying the Federal withholding tax provisions that could apply to reinsurance payments from a United States reinsurer to a non-United States insurer as well as the administrability of requiring a United States reinsurance company to track the residence of direct and indirect beneficial owners of any interest in the contract, policyholder, insured, annuitant, or beneficiary of a contract issued by a non-United States insurance company that is may not administer./10

This letter is in response to the request for comments.

I. Executive Summary

We respectfully request that Treasury and the IRS promulgate a regulation under section 807 that specifically provides that the term "life insurance reserves (as defined in section 816(b))" includes reserves set aside by a domestic insurance company to mature or liquidate future unaccrued claims arising from the reinsurance of a contract issued by a foreign insurance company to a foreign resident, where neither the policyholder, insured, annuitant or known beneficiary is a "United States person" and the reinsured contract is regulated as a life insurance or annuity contract by the regulator in the foreign country where the contract was issued and by the regulator of the reinsuring domestic insurance company, without regard to sections 7702 and 72(s). Appendix A includes suggested regulatory language for your consideration./11

First, the request is consistent with domestic and US international tax policy considerations, including the tax policy underlying the enactment of sections 7702 and 72(s) by being applicable only to contracts owned by or benefiting persons not subject to US federal income tax and by being supportive of the congressional desire to encourage domestic companies to bringing profitable business operations into the United States.

Second, the characterization of the reserve set aside in connection with the reinsurance of Foreign Life Insurance and Annuity Contracts as a "life insurance reserve" notwithstanding its failure to satisfy section 7702 or section 72(s) -

(i) does not affect the character, source and separate category basket in which income derived from the reinsurance is included for US withholding tax or foreign tax credit purposes;

(ii) does not alter the application of any applicable US withholding tax on income from sources within the United States paid by the domestic insurance company to any foreign corporation, including under sections 871(a), 871(m), 881, 1441 and 1442;

(iii) does not affect the treatment under section 59A (BEAT) of any claims and benefits or any other amounts paid by a domestic insurance company to a foreign related party under a reinsurance contract; and

(iv) should not apply to any Foreign Life Insurance and Annuity Contracts issued by a foreign corporation when premiums received from such contracts are treated as effectively connected with the conduct of a trade or business in the United States, or attributable to a permanent establishment within the United States under an applicable tax treaty, of such foreign corporation.

Third, the effect of providing the requested guidance for domestic insurance company tax purposes would primarily be to avoid any negative impact on the qualification as a "life insurance company" taxable under Part I of subchapter L of a domestic insurance company reinsuring Foreign Life Insurance and Annuity Contracts./12

Providing the requested guidance may possibly result in a reduction of available deductions under section 162 due to the application of section 848./13

Tracking the beneficial owners of the reinsured Foreign Life Insurance and Annuity Contracts should be easily administrable if the rules adopted by Treasury and the IRS in the context of the Foreign Account Tax Compliance Act (FATCA) were made applicable. Any deviation from such rules would place a great burden on the domestic insurance company and would not be administrable. We believe the reinsuring domestic insurance company should be able to rely on the identification of a beneficial owner as a US person based on the FATCA requirements applicable to the foreign insurance company.

Finally, we note that the same authority that supports the new regulation under section 816(b) proposed by the Treasury and the IRS and published on April 2, 2020, also supports the guidance requested in this comment letter. That authority is section 7805(a), which authorizes the Secretary to "prescribe all needful rules and regulations for the enforcement of this title, including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue." In the TCJA, Congress not only amended section 807 it also adopted rules designed to encourage US business taxpayers to operate their businesses in the US. Through its amendments to section 807, Congress has provided an opening for new regulations thereunder that will encourage US life insurance companies to reinsure profitable business written by foreign insurers without undermining the goal of preventing life insurers from deducting unaccrued liabilities held in support of contracts that provide undue deferral on inside buildup.

II. Tax Policy Considerations

a. Policy Underlying the Enactment of Sections 7702 and 72(s)

In order to promote the social goal of encouraging people to provide for their retirements or to provide for their families in the event of premature death, the US federal income tax law has provided owners of life insurance and annuity contracts with a tax benefit, i.e., the deferral of investment income credited to such contracts from current taxation (and exclusion from taxation on credited investment earnings if the proceeds of a life insurance contract are paid due to the death of the insured). The Code also permits life insurance companies to deduct currently their unaccrued future liabilities under such contracts. Because of the deduction for unaccrued future liabilities under section 807(c)(1), there is some linkage between amounts held in support of contracts that qualify as life insurance or annuity contracts and the tax benefit on inside buildup afforded to life insurance and annuity owners to the tax benefit.

As discussed in the October 2019 Letter, the Joint Committee Report accompanying the Deficit Reduction Act of 1984 summarizes the concerns of Congress with the tax deferral provided to owners of life insurance products, the emphasis on investment returns of certain products and the solutions adopted.

In light of the significant tax advantages associated with life insurance products, the Congress reviewed those products and their tax treatment as part of the 1984 Act. Three areas of concern were identified as appropriate for legislation. First, in recent years, companies have begun emphasizing investment-oriented products that maximize the advantages of the deferral provided in the Code. When compared to traditional life insurance products, these products offer greater initial investments or higher investment returns, or both. In response, the Congress adopted a definition of life insurance that treats as currently taxable investments those life insurance policies that provide for much larger investments or buildups of cash value than traditional policies.

Second, with respect to the treatment of annuity contracts, the Congress adopted the view that present-law deferral of tax on investment income of annuities is justified only by the retirement savings purpose of annuities. Thus, an exception to the early withdrawal penalty for amounts earned on investments that are kept in the annuity contract for at least 10 years was viewed as inappropriate, since it permitted penalty-free pre-retirement withdrawals. Similarly, Congress considered that an unlimited deferral should no longer be allowed when the income in an annuity contract is passed to another generation or to a person other than a spouse. Thus, if the owner dies before annuitization, deferred income should be distributed over a limited period (5 years) unless the annuity passes to a spouse, or is annuitized within one year after such death./14

To address these concerns, Congress added sections 72(s) and 7702 to the Code as part of the Deficit Reduction Act of 1984./15

Section 72(s) generally imposes a time limit on how quickly the proceeds of an annuity contract must be paid to the holder's heir when the holder dies either before or during annuitization. If these time limits are not observed (and if there is no applicable exception, such as when the new holder is the spouse of the decedent), then the contract will not be treated as an annuity contract under section 72, thus resulting in the immediate inclusion of earnings credited to the contract (and not previously distributed and taxed to the decedent) in the income of the new holder of the contract. In section 7702, Congress added to the Code a definition of a life insurance contract that requires a contract to be treated as a life insurance contract under "applicable law" and to either (1) meet the cash value accumulation test of subsection 7702(b) or (2) satisfy the guideline premium requirements of section 7702(c) and fall within the cash value corridor test of section 7702(d). The owner of a contract that qualifies as a life insurance contract under "applicable law" but that fails section 7702 is taxed currently on the "income on the contract" during the taxable year and is also taxed during the year of a section 7702 failure on all previously credited income on the contract, which income is treated as ordinary income received or accrued by the policyholder during the taxable year./16

"Income on the contract" is the excess of the sum of the contract's net surrender value and the cost of life insurance protection during the year over the premiums paid during the taxable year./17

Should the insured under a policy that fails section 7702 die during the taxable year, the excess of the amount paid by the reason of the death of the insured over the net surrender value of the contract is treated as paid under a life insurance contract for purposes of section 101 (i.e., generally excluded from the taxable income of the beneficiary)./18

By providing a definition of "life insurance contracts" under section 7702 and predicating annuity contract treatment upon satisfaction of the distribution requirements specified in section 72(s) when the owner has died while restricting life insurance reserve treatment under section 807(c)(1) to liabilities held in support of contracts that qualify as life insurance or annuity contracts, the Code limits the benefit of the deduction for life insurance reserves to only those contracts that do not provide unduly beneficial US tax treatment of inside buildup to the owners of such contracts./19

This linkage is inherent in the cross reference of section 807(c)(1) to the definition of "life insurance reserves" in section 816(b) and the separate references to "life insurance," "annuity" and "noncancellable accident and health insurance contracts" in section 816(b).

The policy underlying adopting a definition of life insurance contracts and restricting annuity contract treatment that excludes contracts with excessive investment income deferral is, however irrelevant for purposes of determining whether the domestic insurance company should hold section 807(c)(1) life insurance reserves - for example, when the policyholder, insured, annuitant or known beneficiary is not a US person and thus is not subject to US federal income tax and the policy is regulated as a life insurance or annuity contract in the home country of the direct issuer. When this latter benefit does not exist, the rationale for importing the Life and Annuity Contract requirements into section 807(c)(1) and creating uncertainty related to the tax treatment of the reserves no longer exists./20

b. TCJA Policy

The requested regulation, if adopted, would remove the tax uncertainty for the treatment of the reserves held by the reinsuring company, which would level the playing field between foreign and domestic reinsurers and thus encourage domestic insurance companies to import profitable reinsurance business into the United States in alignment with one of the primary goals of TCJA./21

As reflected in the final regulations promulgated under section 59A (BEAT), Treasury and the IRS acknowledged Congress' goal under TCJA to bring reinsurance business into the United States and provided an exception from the definition of "base erosion payment" to claims payments made by domestic insurance companies to a foreign related party pursuant to a reinsurance contract.

In general, the exception applies to certain deductible amounts to the extent that such amounts paid or accrued to the related foreign insurance company are properly allocable to amounts required to be paid by such company (or indirectly through another regulated foreign insurance company), pursuant to an insurance, annuity, or reinsurance contract, to a person other than a related party./22

The regulations clarify that "the determination of whether a contract is an insurance contract or an annuity contract is made without regard to sections 72(s), 101(f), 817(h), and 7702, provided that the contract is regulated as a life insurance or annuity contract in its jurisdiction of issuance and no policyholder, insured, annuitant or beneficiary with respect to the contract is a United States person."/23

The requested guidance will further the TCJA expressed policy and congressional intent to encourage movement of reinsurance business from offshore into the United States and will be in line with section 59A guidance recently promulgated.

III. US Withholding Tax and Other Considerations

a. US Withholding Tax

The requested guidance would not alter the character or source, for US withholding tax purposes, of any investment earnings that may be credited to nonresident aliens pursuant to reinsurance of Foreign Life Insurance and Annuity Contracts or of any payments made by the reinsuring domestic companies pursuant to the reinsurance contract to nonresident aliens or foreign corporations./24

The final regulations under section 871 exclude payments made pursuant to "annuity, endowment, and life insurance contracts" issued by domestic and foreign insurance companies from the definition of the term "dividend equivalent" as defined in section 871(m)(2)./25

As discussed above, when Foreign Life Insurance and Annuity Contracts are reinsured by a domestic insurance company, such contracts are not variable contracts or variable annuity contracts on the books of the domestic insurance company or for US tax purposes. Consequently, section 871(m) is inapplicable./26

Finally, whether a payment is subject to US withholding tax is not relevant to the determination of the reserve associated with the issuance or reinsurance of an insurance contract. For example, whether a contract issued by a domestic insurance company to a nonresident alien is subject to US withholding tax is not taken into account in the determination of whether the contract is a life insurance contract for which the domestic life insurance company may establish a reserve or the amount of the reserve under section 807.

b. Foreign Tax Credits Considerations

The requested guidance to treat the reserves related to the reinsurance of Foreign Life Insurance and Annuity Contracts as life insurance reserves in certain circumstances will not change the character, source and separate category basket in which income derived from such reinsurance is included for foreign tax credit purposes when compared to the character, source and separate category basket in which such income is included when such contracts are reinsured by a CFC or by a domestic insurance company under current law.

Underwriting income derived by a CFC from the reinsurance of Foreign Life Insurance and Annuity Contracts would generally be foreign-source income/27 and the related investment income may be either US-source or foreign-source income./28

The underwriting income and related investment income is financial services income (as defined in section 904(d)(2)(D)) and thus treated as general category income./29

Underwriting income derived by a domestic insurance company from the reinsurance of Foreign Life Insurance and Annuity Contracts would likewise be foreign-source income, and the investment income would likewise be either US-source or foreign-source income. Such income is financial services income and, therefore, in the general category income basket./30

Accordingly, if requested guidance is provided, the character, source and the separate category basket in which the income is included for foreign tax credit purposes will remain the same as compared to current law.

c. ECI Considerations

The guidance requested by this comment letter should not apply to any Foreign Life Insurance and Annuity Contracts issued by a foreign corporation when premiums received from such contracts are treated as effectively connected with the conduct of a trade or business in the United States or as attributable to a permanent establishment within the United States under an applicable tax treaty of such foreign corporation. This rule would ensure that any reserves in connection with such contracts will not be treated as life insurance reserves, unless the contracts comply with the requirements of sections 7702 and 72(s). This position is grounded on the principle of horizontal tax equity that policies issued by domestic insurance companies and US insurance branches of a foreign corporation should be taxed in a similar manner.

d. BEAT Considerations

In related party transactions, certain amounts paid or accrued by a domestic insurance company pursuant to a reinsurance contract to a foreign insurance company that is a related party are subject to section 59A (e.g., ceding commissions), while claims and benefits paid under section 805(a) are excluded to the extent that such amounts are properly allocable to amounts required to be paid by such foreign insurance company (or indirectly through another regulated foreign insurance company), pursuant to an insurance, annuity, or reinsurance contract, to a person other than a related party./31

If the requested guidance is provided, section 59A would continue to apply in the same manner as under current law because, as mentioned above, the final regulations under section 59A clarify the determination of whether a contract is an insurance or annuity contract is made without regard to sections 72(s), 101(f), 817(h), and 7702, provided that the contract is regulated as a life insurance or annuity contract in its jurisdiction of issuance and no policyholder, insured, annuitant or beneficiary with respect to the contract is a United States person./32

IV. Domestic Insurance Tax Considerations

a. "Life Insurance Company" Status

Being able to treat section 807(c)(1) life insurance reserves amounts held in support of an insurance contract is paramount in determining whether a domestic insurance company is a "life insurance company" and subject to tax under Part I of subchapter L.

A foreign insurance company that issues Foreign Life Insurance and Annuity Contracts may look to reinsure some or all of its business in order to achieve capital relief, centralized asset management benefits, business and operational efficiencies, and better overall underwriting and investment risk management.

Bringing into the United States reinsurance of Foreign Life Insurance and Annuity Contracts may be at high demand and very profitable (e.g., when reinsuring longevity risks). Without the requested guidance and under current law, a domestic insurance company may be deterred from reinsuring such business if the reserves that it would set aside would put pressure on its treatment as a "life insurance company" under section 816(a) should it reinsure large blocks of such business. However, if the requested guidance is provided, the domestic insurance company would be allowed to carry and deduct under section 807(c)(1) life insurance reserves (as defined in section 816(b)) in connection with such reinsured contracts and thus would be encouraged to import foreign reinsurance business into the United States. Its status as a "life insurance company" under section 816(a) that is dependent upon the ratio of the life insurance reserves compared to the company's total reserves would be unaffected.

b. Section 848 (DAC) Impact

The requested guidance would possibly have the effect of a reduction of available deductions under section 162 due to the application of section 848. Under current law, because a contract reinsuring Foreign Life Insurance and Annuity Contracts is not a "specified insurance contract," as defined in section 848(e)(1),/33 the domestic insurance company is not required to capitalize certain policy acquisition expenses under section 848 but rather is able to deduct, on an accrual basis, recurring expenses that are ordinary and necessary business expenses under section 162./34

Under the requested guidance, the reinsurance contract of Foreign Life Insurance and Annuity Contracts should be treated as a "specified insurance contract," as defined in section 848(e)(1) and without regard to section 848(e)(5); thus the domestic insurance company would be required to capitalize certain policy acquisition expenses under section 848./35

When the domestic insurance company reinsures the business from a foreign insurance company that is not subject to US tax under subpart F, it must consider the limitation on taking certain amounts into account when determining its net consideration./36

Any net negative capitalization amount in connection with such foreign reinsurance contracts cannot be utilized to reduce the amount otherwise required to be capitalized under section 848(c)(1) on the domestic insurance company's directly written business or reinsurance contracts that are not subject to Treas. Reg. Sec. 1.848-2(h)./37

V. Administrability of Tracking Beneficial Owners

In the Preamble, Treasury and IRS also requested comments in connection with "the administrability of requiring a United States reinsurance company to track the residence of direct and indirect beneficial owners of any interest in a contract, policyholder, insured, annuitant, or beneficiary of a contract issued by a non-United States insurance company that the US reinsurer may not administer."/38

We do not believe that the identity of the beneficial owner of a contract should affect the characterization of the reserves that a domestic insurance company is required to hold in connection with the reinsured contract. However, if a tracking of residence were to be required, we note the following:

A domestic insurance company that reinsures Foreign Life Insurance and Annuity Contracts does not have a direct contractual relationship with the policyholders, insureds, annuitants, or beneficiaries of such contracts; instead, its relationship is with the ceding foreign insurance company. As part of the reinsurance transaction, the foreign insurance company might provide limited information related to the underlying policyholder or annuitant and might identify the beneficial owner of a reinsured contract as a US person, if such identification is required under applicable FATCA rules. The domestic insurance company would inquire further and obtain documentation (i.e., Form W-9 or Form W-8BEN) to establish whether the policyholder, annuitant, or beneficiary is a US person or request a certification that it is not a US person. The domestic insurance company would rely on the documentation received unless it knows or has reason to know that the information contained in such documentation is unreliable or incorrect and would follow the regulations applicable to determine the status of such a person when there is unreliable or nonexistent documentation.

Foreign insurance companies are similarly required to identify whether the policyholder, annuitant or beneficiary of a cash value life insurance policy is a US or non-US person. FATCA generally requires that when a foreign insurance company issues a policy, it must get certification from the policyholder whether the policyholder is a US or non-US person. The foreign insurance company would rely on the documentation received unless it knows or has reason to know that the information contained in such documentation is unreliable or incorrect. Then, it is appropriate to follow the applicable FATCA rules and regulations to determine the status of such person when there is unreliable or no documentation.

We recommend that the requested guidance permit a domestic insurance company that reinsures Foreign Life Insurance and Annuity Contract to rely on the identification of a beneficial owner as a US person based on the FATCA requirements applicable to the foreign insurance company.

VI. Authority

As noted in the Preamble, both case law and published guidance issued by the Secretary and the IRS and in existence prior to enactment of the TCJA prohibits the use of any factors other than those specifically set forth in pre-TCJA section 807(d)(2), i.e., the prescribed reserving method identified in section 807(d)(3) (i.e., in the case of life insurance contracts, the commissioners' reserve valuation method (CRVM) or, in the case of annuity contracts, the commissioners' annuities reserve valuation method (CARVM)), interest rates and mortality or morbidity tables to compute amounts that will be treated as section 807(c)(1) life insurance reserves. In its explanation of the TCJA's amendments to section 807, the Joint Committee on Taxation acknowledged that current state prescribed principle-based reserve (PBR) computation rules might incorporate factors into CRVM or CARVM that historically were not permitted when computing "life insurance reserves" defined under section 816(b). As stated in the Preamble, "Congress intended that the tax reserve method used to compute life insurance reserves under section 807(d), as amended by the TCJA, could include PBR methods, [but] section 816(b) (by virtue of the reference in section 807(c)(1)) could be interpreted to preclude reserves determined under PBR methods from qualifying as life insurance reserves for purposes of section 807." Therefore, in order to "prescribe all needful rules and regulations ... as may be necessary by reason of any alteration of law in relation to internal revenue," the Secretary determined it necessary to promulgate a new regulation under section 816(b) that would incorporate Congress' implicit approval of PBR, despite the fact that Congress did not actually amend section 816(b).

Elsewhere in the TCJA, Congress enacted provisions to encourage corporations to bring business activities, taxable income and assets onshore (e.g., section 59A, the deduction for foreign-derived intangible income under section 250, and a lower corporate income tax rate)./39

Through its amendments to section 807, Congress has provided an opening for new regulations thereunder that will encourage US life insurers to reinsure profitable business written by foreign insurers without undermining the goal of preventing life insurers from deducting unaccrued liabilities held in support of contracts that provide undue deferral on inside buildup. The requested proposed regulation under section 807(c)(1) is narrow and tailored to permit domestic insurance companies to reinsure in the US profitable business written offshore for the benefit of persons not subject to US federal income taxation without risk of losing qualification as a life insurance company or losing its deductions for required reserves. Thus, the guidance requested in this comment letter is specifically authorized under section 7805(a).

VII. Summary Conclusion

We respectfully request that you promulgate a regulation under section 807 that specifically includes in the definition of "life insurance reserves (as defined in section 816(b)" any reserves that are set aside by a domestic insurance company to mature or liquidate future unaccrued claims arising from the reinsurance of a contract issued by a foreign insurance company to foreign residents, where no policyholder, insured, annuitant, or known beneficiary is a US person, and the reinsured contract is regulated as a life insurance or annuity contract by the applicable insurance regulatory body in the jurisdiction where issued and by the regulator of the reinsuring domestic insurance company, without regard to sections 72(s) and 7702./40

The requested proposed regulation under section 807 is narrow and tailored to permit domestic insurance companies to reinsure in the United States profitable business written offshore by foreign insurance companies for the benefit of persons not subject to US federal income tax, without the risk of losing qualification as a life insurance company. Ensuring a domestic insurance company continues to be treated as a life insurance company while bringing offshore business into the Unites States is the key reason and overwhelming outcome that lead us to seek this guidance, because permitting life insurance reserves treatment will have no other meaningful impact on the US federal income tax or US withholding tax applicable to income derived or paid by the domestic insurance company in connection with such reinsurance contract.

We appreciate the opportunity to provide comments. If you would like to discuss this letter further, please contact Chris Ocasal at [email protected], (202) 327-6868 or Revital Gallen at [email protected], (949) 437-0302.

Respectfully submitted,

Chris Ocasal

Principal, Ernst & Young, LLP

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Footnotes:

1/ REG-132529-17, 85 Fed. Reg. 18496 (April 2, 2020) (the Proposed Regulations).

2/ Unless otherwise noted, all Code and "section" references are to the Internal Revenue Code of 1986, as amended (the Code), and all "Treas. Reg. Sec." references are to the Treasury Regulations promulgated thereunder.

3/ Preamble, 85 Fed. Reg. 18503.

4/ See 2019 TNTI 210-14 (the October 2019 Letter).

5/ We recognize that, with respect to a life insurance contract that does not meet the requirements of section 7702, the investment portion of the contract is treated as a reserve under section 807(c)(4) rather than section 807(c)(1). See H.R. Rep. No. 98-432, pt.2, at 1413, n. 128 (1984). Similar language does not exist for an annuity contract that does not satisfy the requirements of section 72(s).

6/ Although we are requesting in this letter that the requested guidance be incorporated into the proposed regulations defining "life insurance reserves" under section 807, we would certainly have no objection should you deem it a better fit as part of the proposed regulations under section 816. A new regulation under section 816(b) can also create a narrow exception to the rules specified in section 816(b) for qualifying as a life insurance reserve that similarly effects the congressional purposes underlying the TCJA while not undermining the purpose of the reference in section 816(b) to life insurance and annuity contracts.

7/ In the context of an insurance contract, the contractual relationship is between the issuing insurance company and the policyholder. Unless the beneficiary is the policyholder, if it is unwilling to provide the identity of the underlying beneficial owners of the contract due to privacy concerns or other legal obligations, the issuing insurance company would not be able to force the beneficiary to provide such information because it is not a party to the insurance contract and most insurance contracts do not have any mechanism for obtaining such information.

8/ For these purposes, the term "United States person" should have the meaning assigned to it by section 7701(a)(30) except that such term should not include an individual who is a bona fide resident of Puerto Rico, Guam, American Samoa, or the Northern Mariana Islands, as these individuals are not subject US federal income tax. See also section 957(c).

9/ P.L. 115-97.

10/ Preamble, 85 Fed. Reg. 18503.

11/ As stated above, we request that guidance be incorporated into the proposed regulations defining "life insurance reserves" under section 807(c)(1), but such guidance may similarly be part of proposed regulations under section 816(b). Therefore, we include as part of Appendix A suggested regulatory language under section 807 and alternatively under section 816.

12/ Section 816(a) requires that more than 50 percent of the insurance company's "total reserves" (as defined in section 816(c)) consist of life insurance reserves (as defined in section 816(b) plus unearned premiums and unpaid losses on noncancellable life, accident, or health policies not included in life insurance reserves) for it to be taxed as a life insurance company.

13/ Section 848 imposes a 180-month amortization period on the deduction of "specified policy acquisition expenses," which is specifically defined under section 848(c) and generally is a proxy amount determined by applying the specified percentage rates to the net premiums of the insurer or reinsurer attributable to certain kinds of life insurance and annuity contracts issued or reinsured by the taxpayer. For annuity contracts the specified percentage is 2.09 percent, and for life insurance contracts the specified percentage rate is either 2.45 percent (for group life insurance contracts) or 9.2 percent (for all other life insurance contracts).

14/ See Joint Committee on Taxation, "General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984" at 586. The third area of concern discussed on page 586 involves limitations on the amount of group term insurance that may be provided to retired employees without inclusion of such insurance in the income of the employee.

15/ P.L. 98-369.

16/ Section 7702(g)(1)(A) and (C).

17/ Section 7702(g)(1)(B).

18/ Section 7702(g)(2).

19/ See footnote 5 for the tax reserves deduction of life insurance and annuity contracts that do not meet sections 7702 and 72(s).

20/ For further discussion related to the policy behind the enactment of the Life and Annuity Contract Requirements, see the October 2019 Letter.

21/ See the Senate Committee on Finance explanation in connection with the portion of TCJA that became section 59A:

"The Committee is also concerned about U.S. and foreign corporations outsourcing their U.S. business operations to foreign jurisdictions at the expense of the American workers. The Committee believes that this level playing field, along with a globally competitive corporate rate, will encourage economically efficient foreign direct investment. Such investment, whether foreign or domestic, is the national interest of the Unites States and its workers." S. Prt. No. 115-20, at 396.

22/ Treas. Reg. Sec. 1.59A-3(b)(3)(ix).

23/ Id.

24/ When the source of an item of income is not specified by statute or by regulation, courts have determined the source of the item by comparison and analogy to classes of income specified within the statute. See, e.g., Bank of America v. United States, 680 F.2d 142, 147. In Rev. Rul. 2009-14, 2009-21 IRB 1031, a life insurance contract issued by a domestic insurance company to a US citizen residing in the United States (A) insuring the life of A, was purchased by B, a foreign corporation. Upon the death of A, the domestic insurance company paid the death benefits to B. Noting that there is no authority in the Code on the source of death benefits paid pursuant to a life insurance contract, the IRS ruled that the death benefit was income that was treated as US-source FDAP income subject to US withholding tax on the basis of A being a US citizen residing in the United States and the insurer being a domestic corporation. See also Rev. Rul. 2004-75, 2004-2 CB 109. ("The revenue ruling applies only to annuity payments and withdrawals of cash value that are gross income to the extent provided under section 72, and does not apply to amounts received under life insurance contracts by reason of the death of the insured that are excludible from gross income under section 101.") The IRS determined that income received by nonresident aliens under annuity contracts is US-source income if the issuer is a US corporation. It also concluded that the income that had accrued to the cash value of the life insurance contract was subject to the tax imposed by section 871(a) upon surrender of the policy, where the determination of such income is provided in section 72. See also the American Council of Life Insurers' letter commenting on the proposed 871 regulations https://www.regulations.gov/document?D=IRS-2012-0002-0057. Using the same analysis, it follows that payments made pursuant to Foreign Life Insurance and Annuity Contracts from the issuing-foreign insurance company to foreign residents should generally be foreign-source income. As it relates to making various determinations under the Code with respect to reinsurance contracts, numerous authorities look through to the reinsured contract. For example, when a domestic insurance company reinsures Foreign Life Insurance and Annuity Contracts from the issuing-foreign insurance company, generally the reinsurance contract is treated in the same manner as the reinsured contract for purposes of computing deferred acquisition costs. See section 848(e)(5). In making determinations as to the status of a reinsurance contract as an insurance contract for US federal income tax purposes, look-through principles have also been applied. See, e.g., Alinco Life Insurance v. United States, 373 F. 2d 336 (178 Ct. Cl. 1967) (company issuing a single reinsurance contract treated as insurance company based on the number and diversity of risks being reinsured); Rev. Rul. 2009-26, 2009-28 IRB 366 (a company reinsuring a single insurance company pursuant to a single reinsurance agreement was held to be an insurance company because risk distribution was achieved in essence by looking through the ceding insurance company to its policyholders); PLR 200520035 (a company reinsuring a single reinsurance policy from anther reinsurer (i.e., a retrocession) was not found to be an insurance company because risk distribution was not achieved on account of there being only five individual policyholders insured by the ceding company and reinsured by the retrocedant). See also Treas. Reg. Sec. 1.59A-3(b)(3)(ix) (providing an exception to the definition of base erosion payment for claim payments paid to a related foreign insurer pursuant to a reinsurance contract where the claims are attributable to insurance policies issued by the related foreign insurer to unrelated parties); Rev. Rul. 79-138, 1979-1 CB 359 (premiums paid for purposes of section 4371 is the proportionate share of the premium received by the domestic insurer and paid to the foreign insurer); Rev. Rul. 58-612, 1958-2 CB 850 (a policy of reinsurance issued by a foreign insurer covering any of the hazards, risks, losses or liabilities covered by contracts taxable under section 4371(1) and (2) is subject to the tax imposed on reinsurance policies by section 4371(3), regardless of whether the primary insurer was a domestic or foreign insurer). On the basis of the above authorities, premiums received by the domestic insurance company under a reinsurance contract would be foreign-source income under section 862(a)(7) because it is appropriate to look to the risks that the foreign insurance company insured, i.e., foreign residents' lives, to determine the source of the income, regardless of whether the reinsurer is a domestic or foreign company. Similarly, the character and source of claims payments made under the reinsured contract should carry over to determine the character and source of such payments made under the reinsurance contract. Consequently, claims payments made pursuant to Foreign Life Insurance and Annuity Contracts from the issuing-foreign insurance company to foreign residents should be foreign-source income and likewise such payments made from the domestic insurance company to the foreign insurance company should be foreign-source income.

25/ Treas. Reg. Sec. 1.871-15(c)(2)(iv). Some conditions must be met for this exception to apply. Treas. Reg. Sec. 1.871-15(c)(2)(iv)(C) also provides an exception to dividend equivalent treatment for payments under insurance contracts held by foreign insurance companies ("a payment made pursuant to a policy of insurance (including a policy of reinsurance) does not include a dividend equivalent if it is made to a foreign corporation that would be subject to tax under subchapter L if it were a domestic corporation").

26/ The preamble to the final section 871 regulations provides that "[a]lthough comments suggested other modifications to certain terms and the addition of certain defined terms, these final regulations do not make these additional changes. The Treasury Department and the IRS have determined that the scope of entities and contracts described in the temporary regulations as eligible for the exception is appropriate for section 871(m), and that it is beyond the scope of these regulations to define terms relating to insurance." See 82 FR 8146. While some of the questions left open might well be within the scope of the Proposed Regulations at hand, the requested guidance is consistent with section 871(m), therefore, we do not ask for any clarification in that regard.

27/ See, e.g., section 862(a)(7). Generally, a deduction for reserve increases under section 807(b) and death benefits and other section 805(a)(1) amounts are treated as items which cannot definitely be allocated to an item or class of gross income and thus are allocated, for purposes of foreign tax credit purposes, under section 818(f).

28/ Investment income that supports the insurance reserves associates with the reinsurance of the Foreign Life Insurance and Annuity Contracts is generally designed to match the different elements of the reserves. In this case, the investments would generally be debt instruments, thus the source of income from such investments is determined based on the issuer of the debt instrument. If the issuer is US then the income is US-source income, and if the issuer is foreign then the income is foreign-source income. The source of such income would not change if the contract is held by a foreign or a US reinsurer.

29/ Section 904(d)(2)(C)(i). Treasury and the IRS are urged to consider the comments submitted in this regard https://www.regulations.gov/document?D=IRS-2019-0055-0033 related to the proposed foreign tax credit regulations, REG-105495-19, 84 Fed. Reg. 69124 (December 17, 2019). In very rare cases, the reinsurance income may be treated as income in the GILTI basket if deferred from inclusion under section 951(a).

30/ In very rare cases, the reinsurance income may be treated as income in the foreign branch income basket when reinsured to a foreign branch of a US company.

31/ See Treas. Reg. Sec. 1.59A-3(b)(1) for the general rule and Treas. Reg. Sec. 1.59A-3(b)(3)(ix) for the exception provided to claims payments.

32/ Treas. Reg. Sec. 1.59A-3(b)(3)(ix).

33/ Section 848(e)(1) defines the term "specified insurance contract" to mean, generally, any life insurance, annuity or noncancelable, accident and health insurance contract (or any combination thereof). A reinsurance agreement that reinsures the risks under a specified insurance contract is treated in the same manner as the reinsured contract. Treas. Reg. Sec. 1.848-1(b)(i). See also section 848(e)(5).

34/ See also section 811.

35/ Generally, for purposes of section 848, the term "net premiums" means, with respect to any specified insurance contract, the excess of (A) the gross amount of premiums and other consideration on such contracts over (B) return premiums on such contracts and premiums and other consideration incurred for reinsurance of such contracts. Section 848(d)(1). A special rule applies in the case of net negative consideration (where the amount determined under (B) exceeds the amount determined under (A) with respect to a category). Section 848(f)(1). A carryover of excess negative capitalization amount is allowed under Treas. Reg. Sec. 1.848-2(i).

36/ See section 848(d)(4) and Treas. Reg. Sec. 1.848-2(h).

37/ See Treas. Reg. Sec. 1.848-2(h)(7) and -2(h)(8), Example 1. See also required election for this purpose in Treas. Reg. Sec. 1.848-2(h)(3).

38/ Preamble, 85 Fed. Reg. 18503.

39/ See House Report to Accompany H.R. 1, H.R. Rept. 409, 115th Cong., 1st Sess. (Nov. 13, 2017), at 370 ("The Committee believes that the current tax system puts American workers and companies at a severe disadvantage to foreign workers and companies. This is primarily because the United States is one of the few industrialized countries with a worldwide system of taxation and has the highest corporate tax rate among OECD member countries. The worldwide system of taxation with deferral provides perverse incentives to keep funds offshore because dividends from foreign subsidiaries are not taxed until repatriated to the United States. The Committee believes that a territorial system with appropriate anti-base erosion safeguards, combined with a lower corporate tax rate, will make American workers and companies competitive again, and also will remove tax-driven incentives to keep funds offshore.") See also H. Con. Res. 71, S. Prt. 115-20, December 2017, at 375 ("The Committee believes that the current U.S. system of worldwide taxation (with deferral), and its 35 percent corporate tax rate, encourages U.S. corporations to locate intangible income abroad, particularly in low or zero tax jurisdictions. The location of intangible income in those jurisdictions may require or be facilitated by the location of valuable economic activity in those jurisdictions. One of the Committee's goals in tax reform is to remove the tax incentive to locate intangible income abroad and encourage U.S. taxpayers to locate intangible income, and potentially valuable economic activity, in the United States.")

40/ As mentioned above, the requested guidance can also be promulgated under section 816(b). See Appendix A for suggested regulatory language under section 807 and alternatively under section 816.

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The proposed rule can be viewed at: https://www.regulations.gov/document?D=IRS-2020-0003-0001

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