On February 17, 2023, the Department of Treasury (Treasury) and the Internal Revenue Service (the IRS) issued Notice 2023-20 (the Notice), to provide guidance that is intended to help avoid unintended adverse consequences to the insurance industry from the application of the new corporate alternative minimum tax (CAMT).

Taxpayers may rely on the guidance contained in the Notice until the issuance of the forthcoming proposed regulations. The IRS provided previous guidance related to the CAMT in Notice 2023-7.

Section 10101 of the Inflation Reduction Act (IRA) amended section 55 of the Internal Revenue Code to impose the new CAMT. The CAMT generally is based on adjusted financial statement income (AFSI), which in essence is the net income reported on a taxpayer’s applicable financial statement (AFS) for the taxable year as adjusted by section 56A. The adjustments under Section 56A have resulted in a number of issues for the insurance industry, some of which are addressed in the Notice.

Separate Account Assets

The Section 56A adjustments with respect to variable contracts accounted for under section 817 result in a potential mismatch of an insurance company’s taxable income and AFSI, which is one of the things the Notice attempts to ameliorate. The provisions of section 817 generally result in a permanent elimination of any effects on company-level taxable income that otherwise would result from the change in value of separate account assets supporting the variable contracts. Under certain financial accounting rules that life insurance companies may be required to use to prepare an AFS, unrealized gains and losses on separate account assets are included in the determination of net income. The change in the company’s obligations to contract holders associated with the change in value of separate account assets results in a corresponding offset to net income. As a consequence, the financial statement results are consistent with the determination of company-level taxable income, before application of the adjustments under section 56A.

Under the section 56A adjustments, unrealized gain or loss on some categories of separate account assets, but not the offsetting change to contract liabilities, is disregarded in determining AFSI. This mismatch could significantly overstate or understate AFSI relative to taxable income. This potential anomaly also exists with certain contracts that are similar to variable contracts accounted for under section 817, such as closed block contracts and contracts a foreign insurance company issues for which the company’s obligations to policyholders must reflect the change in value of assets supporting the contracts.

The Notice provides guidance designed to mitigate any unintended adverse tax consequences associated with the potential mismatch attributable to the section 56A adjustments to variable contracts and similar types of contracts. Specifically, the Notice provides for a section 56A(c)(2) exclusion amount for covered obligations. 

If a change in the value of the separate account assets results in a change in the company’s obligations to contract holders as a result of legal or contractual requirements, and the change in obligations is reflected in the company’s financial statement liabilities taken into account in the determination of net income, then such change is disregarded to the extent of the section 56A(c)(2) exclusion amount for the taxable year. The exclusion amount for a taxable year is equal to the amount of the financial statement gains and losses on the separate account assets that is taken into account in the company’s net income and disregarded under the section 56A adjustments for purposes of determining ASFI.

Assets Held Under Certain Reinsurance Contracts

The Notice also provides adjustments to the determination of AFSI with respect to funds withheld reinsurance and modified coinsurance agreements. Under certain financial accounting rules that life insurance companies may be required to use to prepare an AFS, unrealized gains and losses on assets supporting funds withheld or modified coinsurance reinsurance agreements (withheld assets) generally are accounted for as part of the ceding company’s other comprehensive income (OCI). However, any change to the related payable to the reinsurer (which generally equals the unrealized gain or loss included in OCI) is accounted for in the determination of the ceding company’s net income. 

The reinsurer has a corresponding asset for the withheld assets. The unrealized gains and losses on the receivable generally are accounted for in net income in the reinsurer’s AFS. 

The Notice establishes that the ceding company can exclude from AFSI changes in net income as a result of changes in the amount of the withheld assets payable to the reinsurer that correspond to the unrealized gains and losses on the withheld assets to the extent such unrealized gains and losses on assets are not included in AFSI. For the reinsurer, changes in net income as a result of changes in the amount of the withheld assets receivable from the ceding company that correspond to the unrealized gains and losses on the withheld assets are excluded from AFSI. However, the reinsurer’s exclusion will be reduced to the extent the reinsurer’s withheld assets receivable is offset, and the changes in its net income are reduced, as a result of a retrocession of the underlying risk.

In some circumstances, the ceding company and reinsurer may be able to make “fair value” elections for AFS purposes to change the accounting for one or more items, such that both offsetting items related to the unrealized change in the value of the withheld assets run through OCI or both run through AFS net income. The Notice clarifies that the above exclusions will not apply to the extent that a company makes the election, and the election causes the changes in fair value of each of the offsetting items to run through net income or through OCI on the AFS.

Fresh Start Entities

Finally, prior law changes terminated the federal income tax exemption for certain entities, including Blue Cross or Blue Shield organizations and certain pension business entities. Under fresh start provisions included in the prior tax law changes, the formerly tax-exempt entities increased the tax basis of their assets to fair value as of the time of the tax law changes. The Notice clarifies that for purposes of determining ASFI of such a “Fresh Start Entity,” asset gain or loss is determined using the adjusted tax basis of the asset provided for in the fresh start rules of the prior tax law changes. 

Treasury and the IRS have set an April 3, 2023 deadline for written comments on the Notice.

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