Scribner Hall & Thompson Issues Public Comment on IRS Proposed Rule

WASHINGTON, May 31 -- Peter H. Winslow, Partner at Scribner Hall and Thompson 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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This letter is filed in response to the request for comments in REG-132529-17 relating to treatment of reserves under section 807 of subchapter L for life insurance or annuity contracts issued by a non-United States insurance company and reinsured by a United States insurance company. I recommend that the Treasury Department and the IRS use their authority under sections 811(a) and 7805(a) to issue regulations that provide that reserves held by a U.S. reinsurer relating to indemnity reinsurance of contracts issued by a foreign insurance company are required to be treated as life insurance reserves for purposes of subchapter L where: (i) the underlying contracts are issued by a foreign insurer; (ii) such contracts are regulated as life insurance or annuity contracts both under the applicable law in the foreign jurisdiction and by the regulator of the reinsuring domestic insurance company; (iii) the National Association of Insurance Commissioners (NAIC) prescribes reserves for such contracts that are computed as reserves applicable to life insurance or annuity contracts; and (iv) the initial issuance of the insurance contract to the policyholder was not through the conduct of a trade or business within the U.S. The life insurance or annuity contract status of the reinsured contract should apply in determining capitalization of policy acquisition expenses under section 848, but not for other purposes of the Code outside subchapter L (e.g., for the foreign insurance company or its policyholders).

The October 2015 edition of the Society of Actuaries Taxing Times contains an article I authored that addresses the same issue on which comments have been requested as it relates to foreign-issued life insurance contracts that do not satisfy the section 7702 tests for life insurance contract qualification. See Peter H. Winslow, Subchapter L: Can You Believe It? Deductible Tax Reserves Might be Greater for Life Insurance Contracts that Flunk I.R.C. Sec. 7702 Than for Those That Do Not, Society of Actuaries Section of Taxation, Taxing Times, Vol. 11, Issue 3, at 46 (Oct. 2015). I pointed out in the article that tax reserves for a "failed" life insurance contract could be greater than a contract that satisfies section 7702. The analysis that could lead to that result is as follows. The amount of the deduction for life insurance reserves is determined under section 807(d). For this purpose, life insurance reserves are classified in section 807(c)(1) "as defined in section 816(b)." To qualify as a life insurance reserve under section 816(b), among other requirements, the reserve must relate to unaccrued claims arising from life insurance, annuity or noncancelable accident and health insurance contracts. Section 7702 provides that a contract that fails to satisfy the requirements of that section is not a life insurance contract "for purposes of this title," which includes sections 807 and 816. Section 7702(g)(3) provides that the failed contract is nevertheless treated as an insurance contract "for purposes of this title." The legislative history explains that "[t]he investment portion of any life insurance contract which fails to meet the definition of a life insurance contract under section 7702 is treated as a reserve under section 807(c)(4)." H.R. Rep. No. 98-432, pt. 2, at 1413 n.128 (1984). The legislative history does not describe how the portion of the reserve for the remaining net amount at risk should be treated. This is the portion of the reserve for the pure insurance element that must be accounted for under section 807 if the contract is to be treated as an insurance contract as required by section 7702(g)(3). This commentator believes that the proper treatment of this portion of the reserve is as a section 807(c)(2) unearned premium reserve subject to a 20% haircut. This treatment finds support in analogous court precedent and IRS rulings that hold that unearned premium reserves encompass reserves that have characteristics of life insurance reserves. See, e.g., Mass. Protective Ass'n. v. United States, 114 F.2d 304 (1st Cir. 1940); Rev. Rul. 55-705, 1955-2 C.B. 280.

Despite this analysis contained in my article and described above, it is not a satisfactory conclusion from a tax policy standpoint. In many scenarios the U.S. reinsurer would be entitled to a larger deduction for its tax reserves where the 7.19% tax adjustment for life insurance reserves provided in section 807(d) that otherwise would apply exceeds the 20% haircut on the unearned premium reserve portion of the reserve for the failed contract. In addition, in these circumstances, capitalization of the reinsurance premium under section 848 would not apply. These favorable tax consequences could have the seemingly unintended result of a U.S. reinsurer seeking higher tax reserve deductions and requesting that the foreign insurance company issue contracts that intentionally fail the section 7702 requirements. Furthermore, because the U.S. reinsurer will be subject to NAIC reserve requirements applicable to life insurance contracts, it makes sense to follow the same tax reserve method under section 807(d) as the basis for the reserves deduction. This would further the goals of consistent treatment for life insurance lines of business as well as simplified tax compliance for both the U.S. reinsurer and IRS auditing agents. As a practical matter, what a U.S. reinsurer desires most is certainty in the application of the tax reserve rules that does not now exist. Guidance that adopts the recommendations in these comments would permit U.S. reinsurers to price their products with confidence as to the tax consequences and would provide IRS auditors with clear guidance in reviewing tax return positions.

It seems clear that the best result is to require the U.S. reinsurer to treat the reserves for failed contracts as life insurance reserves subject to section 807(d), but the question remains: Does the IRS have authority to require this result in light of the section 7702 definition of a "life insurance contract" "for purposes of this title?" The most important step in reaching the appropriate tax policy result is recognition that the meaning of section 807(c)(1)'s cross-reference to section 816(b) is ambiguous and subject to several interpretations that can be clarified by an appropriate exercise of regulatory discretion. Although section 807(c)(1) cross-references to section 816(b), the amounts taken into account in the two sections are different, one based on statutory reserves and the other based on a specific tax reserve method under section 807(d)(3), subject to potential recomputation and reduction by a 7.19% factor. One can conclude, therefore, that subchapter L, in fact, potentially has more than one operative life insurance reserve method and reserve amount for the contract, one for purposes of determining taxable income and the other for purposes of life insurance company qualification. Stated differently, there are two operative definitions of life insurance reserves, each of which serves a different purpose.

The legislative history of the Deficit Reduction Act of 1984, Pub. L. No. 98-369 (1984 Act), explains the cross-reference as follows:

The statutory listing of items to be taken into account in computing the net increase or net decrease in reserves refers to life insurance reserves "as defined in section 816(a)." Section 816(a) requires a proper computation of reserves under State law for purposes of qualifying as a life insurance company. This cross reference is intended merely to identify the type of reserve for which increases and decreases should be taken into account and is not intended to superimpose the requirement of proper computation of State law reserves for purposes of allowing increases in such reserves to be recognized.

H.R. Rep. No. 98-432, pt. 2, at 1414 (1984); Staff of the Jt. Comm. on Tax'n, 98th Cong., 2d Sess., General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 598 (1984).

This quote indicates that Congress intended that the definition of life insurance reserves for purposes of determining whether the company qualifies as a life insurance company would remain the same as under pre-1984 law, but for purposes of determining taxable income, the type of reserve that would be subject to the new section 807(d) computation rules would be determined by consideration of the general characteristics of the reserve described in section 816(b), not necessarily by a rigid adherence to the technical section 816(b) criteria. That is, we look to section 816(b) only for general guidance concerning the type of reserves that should be treated as life insurance reserves subject to computation under section 807(d), and do not use section 816(b) in an attempt to reclassify the reserve as something else in determining taxable income merely because the reserve may fail to satisfy all the criteria for life insurance reserve qualification under section 816(b). Moreover, in interpreting section 816(b), it is important to bear in mind that, as a general tax policy matter, Congress did not intend the 1984 Act to result in reclassification of the status of companies under the life-insurance-reserve-50% test under section 816(a), even though the amount of deductible life insurance reserves under section 807(c) had been changed.

The amendments made to section 807(d) in the Tax Cuts and Jobs Act (TCJA), Pub. L. No. 115-97, reinforce this reading of the reserves that are to be treated as life insurance reserves under section 807(c)(1). Congress intended that the NAIC reserve method applicable to the contract as of the valuation date should govern as the tax reserve method under section 807(d)(3). The Preamble to the proposed regulations recognizes the statutory ambiguity inherent in the cross-reference to section 816(b) and notes that the cross-reference could be interpreted to preclude principle-based reserves from being subject to section 807(d), but that such an interpretation would be contrary to the legislative intent of Congress in amending section 807(d) in the TCJA. Accordingly, Prop. Reg. section 1.816-1(a) resolves this ambiguity by providing that a reserve that meets the requirements of section 816(b)(1) and (2) will not be disqualified as a life insurance reserve, provided that the method used to compute the reserve is a tax reserve method as defined in section 807(d)(3). In other words, the proposed regulations reflect a conclusion that Treasury has the authority to clarify the definition of a life insurance reserve for purposes of section 816(b) in response to the TCJA's change in law. Specifically, to give appropriate meaning to the cross-reference in section 807(c)(1), and to properly interpret section 816(b) in light of the cross-reference, the tax reserve method applicable to the contract should be paramount in governing what is considered a life insurance reserve for both purposes where it is necessary to achieve Congress' legislative intent.

A similar analysis could apply to the reserves of a U.S. reinsurer of "failed" life insurance and annuity contracts. In such case, the starting place for determining the reserves deduction is section 811(a) that provides that NAIC accounting principles apply "[t]o the extent not inconsistent with . . . any other provision of [part 1 of subchapter L]." The predecessor of section 811(a) was interpreted by the Supreme Court as requiring NAIC accounting principles to apply to life insurance reserves because accrual accounting is not relevant. See Commissioner v. Standard Life & Accident Ins. Co., 433 U.S. 148 (1977). The most important applicable "other provision" with respect to tax reserves is section 807. Section 807(d) tells us that the NAIC method, the tax reserve method under paragraph (d) applicable to the contract, must be used to compute the U.S. reinsurer's reserves if they are life insurance reserves. They can be treated as life insurance reserves by providing in the final regulations that, if the NAIC tax reserve method for the contract is a reserve method applicable to a life insurance or annuity contract under both U.S. and foreign applicable laws, then the contract will be treated as a reserve held for future unaccrued claims under a life insurance or annuity contract for purposes of subchapter L.

In analyzing this issue, it is important to note that section 7702 merely defines the term "life insurance contract" for purposes of the title; it does not define "life insurance reserves." The latter term is defined in section 816(b). If, as noted in the legislative history of the 1984 Act, the cross-reference in section 807(c)(1) to section 816(b) "is intended merely to identify the type of reserve for [purposes of determining taxable income]," it seems reasonable to conclude that Treasury has the authority to interpret the definitions of life insurance reserves in sections 807(c)(1) and 816(b) where necessary to properly implement subchapter L.

One issue in considering the recommendations in this comment letter is the need to address the legislative history of the 1984 Act quoted above that suggests that the reserve for the investment portion of a "failed" life insurance contract is treated as an amount held at interest in connection with insurance and annuity contracts under section 807(c)(4). A determination can be made in addressing this comment letter's recommendations that the 7.19% haircut applicable to life insurance reserves in amended section 807(d) reflects a new tax policy adopted in the TCJA that suggests a reconsideration of the 1984 legislative history is warranted. That is, it is more consistent with the legislative intent of the TCJA to have reserves, for which the NAIC guidance treats as reserves for life insurance or annuity contracts, be subject to the 7.19% haircut (and DAC under section 848) rather than obtaining the potentially more favorable treatment as reserves under section 807(d)(4) for the investment portion and section 807(c)(2) for the net amount at risk portion (with no DAC).

Adoption of this reserve treatment in the final regulations should be accompanied by a conforming amendment to the regulations under section 848 for policy acquisition expenses (DAC). If unearned premium reserve treatment subject to a 20% haircut does not apply because the contract is treated as a life insurance or annuity contract for tax reserve purposes, then the contract should also be a life insurance or annuity contract for DAC purposes. Section 848(d)(4) grants authority to Treasury to provide regulations that are necessary to ensure consistency in the treatment of premiums and other consideration under reinsurance contracts. Treasury construed this grant of regulatory authority broadly in promulgating special DAC rules for reinsurance in Treas. Reg. section 1.848-2 (i.e., in the case of certain types of reinsurance, the regulations compute premiums subject to capitalization differently for DAC purposes than for other purposes of computing taxable income). A similar exercise of regulatory authority could be applied here to require the DAC rules to apply to a foreign contract that is reinsured by a U.S. insurance company if it qualifies as a life insurance or annuity contract under both NAIC and foreign law.

The Preamble asks for comments on the interaction with potential Federal withholding tax provisions that could apply to reinsurance payments from the U.S. reinsurer to the non-U.S. insurer, as well as the administrability of requiring a U.S. reinsurance company to track the residence of direct and indirect beneficial owners of any interest in the contract. Whether or not the recommendations in this comment letter are adopted, there would not be any withholding obligation for indemnity reinsurance. The U.S. reinsurer's obligations would still relate to insurance contracts and the tax treatment as a reinsurance contract would still apply. Subchapter L, and the relevant regulations, provide detailed rules as to how to treat the payments made to a ceding company. These rules apply whether or not the ceding company is a non-U.S. company, and withholding taxes generally are not applicable. It is important to note, however, that the recommendations in this comment letter relate only to indemnity reinsurance where the U.S. reinsurer does not acquire a direct contractual obligation to the underlying owner or policyholder of the contract issued by the non-U.S. insurer. A withholding obligation presumably could arise in the unlikely event that the reinsurance is by assumption reinsurance.

Adoption of the recommendations in this comment letter should not be conditioned on verification that the policyholder, insured, annuitant, or beneficiary is not a U.S. person. The tax reserve method applicable to the contract may be based on aggregate principle-based reserves that do not lend themselves to parsing out portions attributable to particular policyholders.

It is unlikely that a U.S. life insurance company would steer U.S. customers to foreign companies to purchase "failed" life insurance contracts in order to reinsure the business back to the U.S. in order to obtain life insurance reserve deductions under section 807(c)(1). To repeat the point made in my Taxing Times article, tax reserve deductions are still available for a failed contract in any event, just in a different amount (more or less) than would be the case with life insurance reserve treatment. So, adoption of the recommendations in these comments is not likely to give rise to abuse.

The recommendations in this comment letter address the most appropriate determination of the taxable income of a U.S. reinsurer of contracts issued in a foreign jurisdiction by a nonU.S. company. The U.S. reinsurer's taxable income for the assumed risks should be determined by the tax reserve method applicable to the contract, not the U.S. tax status of the policyholder, insured, annuitant or beneficiary under the contract to which the reinsurance relates.

Sincerely yours,

Peter H. Winslow

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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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