On February 26, House Ways and Means Committee Chairman Dave Camp (R-Mich.) released a “Discussion Draft” of the Tax Reform Act of 2014, which sets forth his much-anticipated tax reform proposals.  Of note, the Discussion Draft aims to transition the corporate tax rate to a flat 25% rate beginning in 2019 and to repeal the corporate alternative minimum tax.  However, as part of the revenue raisers for these proposed changes, the Discussion Draft includes a number of proposals that target insurance companies or that otherwise would have a direct effect on them.  In particular, those proposals would:

In sum, these ten proposals are scored to raise more than $231 billion over 10 years.  We discuss certain of these proposals below and also provide a brief overview of several other relevant proposals contained in the Discussion Draft.  (Additional analyses of the more general proposals in the Discussion Draft can be found on Sutherland’s tax reform blog:  www.TaxReformLaw.com.)

Replacement of the Prescribed Discount Rate for Computing Life Insurance Reserves

Life insurance companies may deduct net increases in life insurance reserves, while net decreases in such reserves are included in gross income.  For purposes of computing changes in reserves, the life insurance reserve for a contract generally is the greater of (i) the net surrender value of the contract or (ii) the reserve determined under rules provided in the Internal Revenue Code, which, for discounting purposes, employ a prescribed interest rate that is equal to the greater of (x) the applicable federal rate or (y) the prevailing state assumed interest rate.  The “prevailing state assumed interest rate” is equal to the highest assumed interest rate permitted to be used in at least 26 states in computing life insurance reserves for regulatory purposes.

Under the Discussion Draft’s proposal, the present-law prescribed discount rate for life insurance reserves would be replaced with the average applicable federal mid-term rate over the 60 months ending before the beginning of the calendar year for which the determination is made, plus 3.5 percentage points.

This proposal would be effective for taxable years beginning after December 31, 2014, and the effect of the proposal on computing reserves for contracts issued before the effective date would be taken into account ratably over the succeeding 8 taxable years.

Repeal of the Special 10-Year Period for Adjustments in Computing Reserves by Life Insurance Companies

For life insurance companies, an adjustment in computing reserves generally may be taken into account over 10 years (regardless of whether the adjustment reduces or increases taxable income).  Under the Discussion Draft’s proposal, the special 10-year period for adjustments to take into account changes in computing reserves by life insurance companies would be repealed.

This proposal would be effective for taxable years beginning after December 31, 2014.

Modification of the Rules Concerning the Capitalization of Certain Policy Acquisition Expenses

The expenses of a life insurance company that are deemed associated with earning a stream of premium income (DAC) generally are required to be spread over 10 years rather than deducted immediately, in order to reflect the fact that such income ordinarily is collected over a period of years.  The expenses that are spread are calculated using a simplified method that reflects expense ratios for three broad categories of insurance contracts:  annuities, group life insurance contracts, and all other specified insurance contracts.  The expenses that must be spread are the lesser of (i) a specified percentage of the net premiums received on each of a company’s three categories of insurance contracts or (ii) the company’s general deductions.  For annuity contracts, the specified percentage is 1.75%; for group life insurance contracts, the specified percentage is 2.05%; and for all other specified insurance contracts, the specified percentage is 7.7%.

Under the Discussion Draft’s proposal, the three categories of insurance contracts would be replaced with two categories:  group contracts and all other specified contracts (including individual annuity contracts).  Furthermore, the percentage of net premiums that would be spread over 10 years would be 5% for group contracts and 12% for all other specified contracts.

This proposal would be effective for taxable years beginning after December 31, 2014.

Modification of the Dividends-Received Deduction for Life Insurance Company Separate Accounts

In the case of a life insurance company, the dividends-received deduction (DRD) is permitted only with regard to the “company’s share” of dividends received, reflecting the fact that some portion of the company’s dividend income is used to fund tax-deductible reserves for its obligations to policyholders.  Likewise, the net increase or net decrease in reserves is computed by reducing the ending balance of the reserve items by the policyholders’ share of tax-exempt interest.  The regime for computing the company’s share and policyholders’ share of net investment income generally is referred to as “proration.”

A life insurance company’s separate account assets, liabilities, and income are segregated from those of the company’s general account in order to support variable life insurance and variable annuity contracts.  As relevant to the determination of the separate account DRD, the company’s share and policyholders’ share of net investment income are computed for the company’s general account and separately for each separate account.  In view of the nuances associated with these computations, the separate account DRD has been the subject of ongoing controversy in IRS audits of life insurance companies.

Under the Discussion Draft’s proposal, the portion of the dividends and tax-exempt interest received by a life insurance company that is set aside for obligations to policyholders would be determined separately for the company’s general account and for each separate account.  In addition, the formula for determining this portion would be modified so that it compares mean reserves to mean assets of each account, rather than computing the respective shares of net investment income that belong to the company and to the policyholders.

This proposal would be effective for taxable years beginning after December 31, 2014.

Modification of the Discounting Rules for P&C Insurance Companies

A P&C insurance company may deduct unpaid losses that are discounted using applicable federal mid-term rates and based on a loss payment pattern.  The loss payment pattern for each line of insurance business is determined by reference to the industry-wide historical loss payment pattern applicable to such line of business, although companies may elect to use their own particular historical loss payment patterns.

The loss payment pattern is computed based upon the assumption that all losses are paid (i) in general, during the accident year and the three calendar years following the accident year, or (ii) in the case of lines of business relating to auto or other liability, medical malpractice, workers’ compensation, multiple peril lines, international coverage, and reinsurance, during the accident year and the 10 calendar years following the accident year.  In the case of long-tail lines of business, a special rule extends the loss payment pattern period, so that the amount of losses that would have been treated as paid in the tenth year after the accident year is treated as paid in the tenth year and in each subsequent year (up to 5 years) in an amount equal to the amount of the losses treated as paid in the ninth year after the accident year.

Under the Discussion Draft’s proposal:

Sutherland Observation: With respect to the loss payment pattern period, the proposal would have the following effects. In general, the amount of losses that otherwise would have been treated as paid in the third year after the accident year would be treated as paid in the third year and in each subsequent year in an amount equal to the amount of the losses treated as paid in the second year after the accident year. Furthermore, in the case of lines of business relating to auto or other liability, medical malpractice, workers’ compensation, multiple peril lines, international coverage, and reinsurance, the amount of losses that otherwise would have been treated as paid in the tenth year after the accident year would be treated as paid in the tenth year and in each subsequent year in an amount equal to the amount of the losses treated as paid in the ninth year after the accident year.

This proposal would be effective for taxable years beginning after December 31, 2014, with a transition rule that would spread adjustments relating to pre-effective date losses and expenses over such taxable year and the succeeding 7 taxable years.

Modification of the Proration Rules for P&C Insurance Companies

As in the case of the rules applicable to life insurance companies, the “proration” rules applicable to P&C insurance companies reflect the fact that reserves generally are funded in part by certain untaxed income.  Under the current rules, P&C insurance companies are required to reduce reserve deductions for losses incurred by 15% of the sum of (i) the company’s tax-exempt interest, (ii) the deductible portion of dividends received, and (iii) the increase for the taxable year in the cash value of life insurance, endowment, or annuity contracts held by the company.

Under the Discussion Draft’s proposal, the fixed 15% reduction in the reserve deduction for P&C insurance companies would be replaced with a formula whereby the reserve deduction is reduced by a percentage that is equal to the ratio of the tax-exempt assets of the company to all assets of the company.  For purposes of this proposal, the term “tax-exempt assets” means assets “of the type which give rise to income” described in IRC § 832(b)(5)(B), i.e., tax-exempt interest, the deductible portion of dividends received, and the increase for the taxable year in the cash value of life insurance, endowment, or annuity contracts held by the company.

Sutherland Observation: In view of the broad language used for purposes of the definition of the term “tax-exempt assets,” it seems reasonable that the definition could be read to include items that are not explicitly enumerated in IRC § 832(b)(5)(B).

This proposal would be effective for taxable years beginning after December 31, 2014.

Disallowance of Deductions for Reinsurance Premiums Paid to “Non-Taxed Affiliates”

As a general matter, insurance companies are allowed a deduction for premiums paid for reinsurance.  If a reinsurance transaction results in a transfer of reserves and reserve assets to a reinsurer, the potential tax liability for the earnings associated with those assets generally is shifted to the reinsurer as well.  Although the insurance income of a controlled foreign corporation may be subject to current taxation in the U.S., insurance income of a foreign-owned foreign company that is not engaged in trade or business within the U.S. generally is not subject to U.S. tax.  However, reinsurance policies issued by foreign reinsurers with respect to U.S. risks generally are subject to a U.S. federal excise tax equal to 1% of the premiums paid, unless waived by a tax treaty.

The Discussion Draft proposal – which is similar to proposals that have been included in recent budget proposals from the Obama Administration, sponsored by Rep. Richard Neal (D-Mass.) on several occasions, and submitted by former Sen. Max Baucus (D-Mont.) for public discussion and comment – (i) would deny a U.S. insurance company a deduction for premiums and other amounts paid to affiliated foreign companies with respect to the reinsurance of risks (other than risks giving rise to life insurance reserves under IRC § 816(b)(1)) to the extent that the foreign reinsurer (or a U.S. shareholder of that company) is not subject to U.S. tax with respect to the premiums received, and (ii) would exclude from the ceding company’s income any return premiums, ceding commissions, reinsurance recovered, or other amounts received with respect to a reinsurance transaction for which a premium deduction is wholly or partially denied.  However, an innovative aspect to this proposal directs that, if the U.S. insurance company demonstrates to the IRS that a foreign jurisdiction taxes the reinsurance premiums at a rate as high as or higher than the U.S. corporate tax rate, the deduction for the reinsurance premiums generally would be allowed.

Sutherland Observation: The reinsurance premiums paid to the foreign reinsurer to which this proposal applies would remain subject to the federal excise tax, and it appears that the ceding company still would be required to reduce its tax reserves by the amount ceded to the reinsurer. The latter result effectively would put the ceding company on a cash basis for deducting losses on the business reinsured, unless the affiliated foreign reinsurer elects to treat such reinsurance premiums as effectively connected income (as discussed below).

A foreign corporation that is paid premiums from an affiliate that otherwise would be denied a deduction under this proposal would be permitted to elect to treat those premiums and the associated investment income as income effectively connected with the conduct of a trade or business within the U.S. and attributable to a permanent establishment for tax treaty purposes.  For purposes of the foreign tax credit, reinsurance income treated as effectively connected under this proposal would be treated as foreign source income and would be placed into a separate category within IRC § 904.

This proposal would be effective for taxable years beginning after December 31, 2014.

Excise Tax Imposed on “Systemically Important Financial Institutions”

Sections 113 and 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act define a “systemically important financial institution” (SIFI) as (i) any bank holding company with at least $50 billion in total consolidated assets, or (ii) any non-bank financial institution designated for SIFI treatment by the Financial Stability Oversight Council and thus subject to oversight by the Federal Reserve.  SIFI status subjects a financial institution to more stringent prudential standards than those that apply to non-SIFIs, and such status also requires regulators and the financial institution to agree on a resolution plan to ensure an orderly process in the event that the financial institution fails or suffers financial distress.  The Federal Reserve and other agencies conduct annual stress tests on SIFIs to ensure that the SIFIs have adequate capital to absorb losses that result from economic downturns.

Under the Discussion Draft’s proposal, every SIFI would be required to pay a quarterly excise tax of 0.035% (3.5 basis points) of the SIFI’s total consolidated assets (as reported to the Federal Reserve) in excess of $500 billion.  After calendar year 2015, the $500 billion threshold would be indexed for increases in gross domestic product (GDP).

This proposal would apply to calendar quarters beginning after December 31, 2014.

Creation of a Participation Exemption System for the Taxation of Foreign Income

In brief, Title IV of the Discussion Draft would:

We discuss several of these proposals in greater detail below.

1.         Proposed Exemption System

Under the Discussion Draft’s proposal, the present-law system of taxing U.S. corporations on the foreign earnings of their foreign subsidiaries when those earnings are distributed would be replaced with a dividend-exemption system.  Under the proposed exemption system:

Sutherland Observation: This proposal potentially would eliminate the need for U.S. companies to separately track E&P that was accumulated by their foreign subsidiaries prior to the adoption of the dividend-exemption system.

This proposal generally would be effective for taxable years of foreign corporations beginning after December 31, 2014, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign subsidiaries end.

2.         Active Insurance Income Exception Extended

For taxable years of foreign subsidiaries beginning before 2014, and taxable years of U.S. shareholders in which or with which such taxable years of the foreign subsidiary end, there was an exception from Subpart F income (specifically, insurance income and foreign personal holding company income) for income that was derived in the active conduct of an insurance business (active insurance income).  Under the Discussion Draft’s proposal, this exception would be extended for 5 years for active insurance income that is subject to a foreign effective tax rate of 12.5% or higher.  Active insurance income that is subject to a lower foreign effective tax rate would not be exempt, but would be subject to a reduced U.S. tax rate of 12.5%, before the application of foreign tax credits.

This proposal would be effective for taxable years of foreign corporations beginning after December 31, 2013, and before January 1, 2019, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign subsidiaries end.

Additional Proposals of Note

In addition to the proposals discussed above, the Discussion Draft contains a number of other proposals that are relevant to insurance companies, or that otherwise have a broader application to corporate taxpayers.  In particular, the Discussion Draft would:

We will continue to monitor the status of these proposals and keep you updated on any significant developments as they occur.