Required Summer Reading: Guidance Issued on the Tax Treatment of Guaranteed Minimum Benefit Hedges and Identified Mixed Straddles

by Eversheds Sutherland (US) LLP
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The Treasury and the IRS offered two pieces of highly anticipated guidance on July 18 that are particularly relevant to the life insurance industry. Specifically:

  • The IRS Large Business and International Division (LB&I) released a directive (the Directive) providing that LB&I examiners should not challenge (i) the eligibility of an insurance company’s hedges for guaranteed minimum benefits provided under variable annuity contracts to qualify as hedging transactions under Treas. Reg. § 1.1221-2(b); (ii) an insurance company’s mark-to-market values for eligible guaranteed minimum benefit hedges if they conform to the mark-to-market values reported in the company’s Annual Statement; or (iii) an insurance company’s method of accounting for income, deductions, gains, and losses relating to eligible guaranteed minimum benefit hedges for variable annuity contracts issued before December 31, 2009, so long as that method conforms to the method described in the Directive.
  • Treasury and the IRS also published final regulations under IRC § 1092 concerning identified mixed straddles (the Final Regulations). In brief, the Final Regulations (i) maintain the stance of the temporary and proposed regulations published by Treasury and the IRS in August 2013, which sought to eliminate a taxpayer’s ability to selectively trigger capital gains and losses through the use of identified mixed straddles, and (ii) apply to identified mixed straddles established after August 18, 2014.

The Directive and the Final Regulations are described in more detail below.

Sutherland Observations

1. The Directive responds to a nearly four-year-old request under the IRS’s Industry Issue Resolution (IIR) Program for guidance concerning the federal income tax accounting for income, deductions, gains, and losses relating to guaranteed minimum benefit hedges. In general, the IRS’s IIR Program is designed to resolve frequently disputed or burdensome tax issues that are common to a significant number of business taxpayers through the issuance of clear and practical published or other administrative guidance. See generally Rev. Proc. 2003-36, 2003-1 C.B. 859.

2. During the 2008-2009 credit crisis, insurance companies were forced to sell significant amounts of impaired bonds, which resulted in the recognition of large amounts of capital losses. Insurance companies sought to absorb these capital losses, which otherwise expire after five taxable years, with capital gains in their bond portfolios. Historically, one approach to triggering these capital gains was to enter into an identified mixed straddle with respect to an appreciated bond, which, under temporary regulations published in 1985 (the 1985 Temporary Regulations), operated as a deemed sale and repurchase of the bond on the day before the implementation of the identified mixed straddle. See generally Temp. Treas. Reg. § 1.1092(b)-3T (1985) (published in T.D. 8008, 1985-1 C.B. 276). The Final Regulations eliminate this method of triggering capital gains, although the August 18, 2014, applicability date for those regulations should allow identified mixed straddle transactions currently scheduled for implementation to fall under the terms of the 1985 Temporary Regulations.

The Directive

Variable annuity contracts generally provide benefits to the contract holders that vary according to the investment experience of the assets held by an insurance company in a segregated asset account and oftentimes provide one or more guaranteed minimum benefits. Such benefits include guaranteed minimum death benefits, which typically provide a minimum amount in the event of the contract holder’s death, and guaranteed minimum accumulation benefits, which typically provide the contract holder with a minimum account value on a specified date, regardless of the performance of the investment allocations chosen by the contract holder. Thus, a variable annuity contract that offers a guaranteed minimum benefit may subject the issuing insurance company to the risk of incurring liabilities that exceed the value of the segregated account assets for the contract.

Insurance companies usually mitigate the risks associated with guaranteed minimum benefit obligations – by and large, equity and interest rate risks – by entering into hedging transactions (GMxB Hedges). GMxB Hedges are executed pursuant to state insurance regulatory guidelines that insurance companies are required to adopt that specify the types of risks that can be hedged. Insurance companies typically hedge with various derivatives, including equity-index options, exchange-traded futures, and equity and interest rate swaps.

The Directive’s intention is to provide an efficient and uniform method of accounting for certain income, deductions, gains, and losses associated with GMxB Hedges. In order to accomplish this objective, the Directive provides that LB&I examiners should not challenge:

  1. The eligibility of an insurance company’s GMxB Hedges to qualify as hedging transactions under Treas. Reg. § 1.1221-2(b). The Directive generally defines a GMxB Hedge as a transaction that is entered into by an insurance company for the purpose of managing the aggregate risks associated with guaranteed minimum benefits under variable annuity contracts (or counteracting such hedging transactions).
  2. An insurance company’s mark-to-market values for “Eligible GMxB Hedges” if they conform to the mark-to-market values reported in the company’s Annual Statement. For purposes of the Directive, a GMxB Hedge qualifies as an Eligible GMxB Hedge if the identification and recordkeeping requirements under Treas. Reg. § 1.1221-2(f) are satisfied with respect to that hedging transaction.
  3. An insurance company’s method of accounting for income, deductions, gains, and losses relating to Eligible GMxB Hedges for variable annuity contracts issued before December 31, 2009, so long as that method conforms to the method described in the Directive. The Directive further provides that insurance companies should use a method “consistent with the matching requirements in Treas. Reg. § 1.446-4(e)(1)” for purposes of accounting for Eligible GMxB Hedges for variable annuity contracts issued on or after December 31, 2009.

Notably, if an insurance company does not meet the requirements of the Directive, regular audit procedures will apply to the GMxB Hedges for all of the company’s variable annuity contracts.

Sutherland Observation: Because there are no current regulations or other formal guidance specifically addressing the tax accounting treatment of GMxB Hedges, the Directive offers useful guidance that likely will reduce the amount of resources spent by both the IRS and insurance companies on auditing and resolving issues concerning those transactions. Overall, we view this development as being favorable to all concerned parties.

The Final Regulations

Insurance companies make long-term promises to pay benefits to policyholders in the future and acquire bonds to fund and ultimately satisfy those long-term liabilities. As a general matter, insurance companies carefully construct the bond portfolios supporting these long-term liabilities after undertaking extensive research in order to meet state insurance regulatory and internal standards with respect to credit risk and diversification. Thus, insurance companies tend to hold bonds to maturity, unless other events compel a disposition. For example, regulatory requirements may compel an insurance company to sell a bond that has deteriorated in credit quality, resulting in a realized loss.

Historically, insurance companies had the ability to recognize capital gains in their bond portfolios to absorb such capital losses by entering into an identified mixed straddle with respect to an appreciated bond. In particular, the 1985 Temporary Regulations treated such a transaction as giving rise to a deemed sale and repurchase of the appreciated bond on the day before the implementation of the identified mixed straddle, thus affording an insurance company the opportunity to recognize a capital gain on account of that transaction. In broad terms, a “straddle” refers to a taxpayer’s acquisition of a position that substantially offsets its risk of loss in another position. Furthermore, a “mixed” straddle generally refers to a straddle where one position involves a regulated futures contract or another type of section 1256 contract (as defined in IRC § 1256(b)).

Sutherland Observation: For state insurance regulatory and financial accounting reasons, an identified mixed straddle transaction often was the most effective way for an insurance company to recognize the capital gains needed to absorb the company’s capital losses, as such transactions typically avoided the risks and costs associated with a sale and repurchase transaction or a sale and acquisition of a suitable substitute bond.

The Final Regulations operate to hold gain or loss recognition in abeyance until the straddled property, i.e., the appreciated bond, is actually sold by the insurance company. Specifically, the Final Regulations direct that any unrealized gain or loss on the day prior to the day that the identified mixed straddle is established with respect to the bond be taken into account at the time provided by the provisions of the Internal Revenue Code that would apply to the gain or loss if the identified mixed straddle were not established. Thus, any unrealized gain on the bond on the day prior to the day that the identified mixed straddle is established will be taken into account as capital gain when that bond actually is sold or otherwise disposed of in a taxable transaction.

The Final Regulations apply to identified mixed straddles established after August 18, 2014.

Sutherland Observation: The decision to delay the applicability date of the Final Regulations until August 18, 2014, i.e., for one month from the publication of the Final Regulations in the Federal Register, is a welcome surprise. In this regard, the temporary regulations published by Treasury and the IRS in August 2013, and subsequently corrected in October 2013, provided that the amendments would apply to identified mixed straddles established after the date of publication of final regulations in the Federal Register. The delayed applicability date offered in the Final Regulations should allow identified mixed straddle transactions that had been scheduled for implementation prior to the July 18 publication of the Final Regulations in the Federal Register to be implemented under the terms of the 1985 Temporary Regulations.

 

 

 

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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