On February 2, the Obama Administration released its fiscal year 2016 budget (FY 2016 Budget). The hallmarks of the FY 2016 Budget are proposals that would impose (i) a minimum tax on the current foreign earnings of U.S. corporations and their controlled foreign corporations (CFCs) and (ii) a one-time 14% tax on earnings accumulated in CFCs and not previously subject to U.S. tax. Moreover, in keeping with the Administration’s past budgets, the FY 2016 Budget includes several proposals that target insurance companies or that otherwise would have a direct effect on them. Specifically, those proposals would:
- Modify the proration rules for life insurance company general and separate accounts;
- Disallow deductions for “excess non-taxed reinsurance premiums paid to affiliates;”
- Impose a “financial fee” on “certain liabilities of large firms in the financial sector;”
- Require information reporting for “private separate accounts” established by life insurance companies; and
- Provide for reciprocal reporting of information in connection with the implementation of the Foreign Account Tax Compliance Act (FATCA).
These five proposals, which are discussed in greater detail in this Legal Alert, have been scored by Treasury as raising a total of more than $126 billion in revenue over 10 years.
|Sutherland Observation: Although many of the proposals included in the FY 2016 Budget are unlikely to gain much traction in the new Congress, it is notable that the FY 2016 Budget and the “Discussion Draft” of the Tax Reform Act of 2014 released by former House Ways and Means Committee Chairman Dave Camp (R-Mich.) in February 2014 (Tax Reform Discussion Draft) share a few common themes. For example, both the FY 2016 Budget and the Tax Reform Discussion Draft propose to modify the proration rules for life insurance company general and separate accounts and to disallow deductions for certain reinsurance premiums paid to “non-taxed affiliates,” while leaving tax-deferred “inside build-up” intact. For a comprehensive discussion of the potential impact of the Tax Reform Discussion Draft on insurance companies, see our Legal Alert of February 28, 2014.|
Modification of the Proration Rules for Life Insurance Company General and 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 generally is referred to as “proration.”
For purposes of the proration rules, the policyholders’ share equals 100% less the company’s share, and the company’s share equals the company’s share of net investment income divided by net investment income. The company’s share of net investment income is the excess, if any, of net investment income over certain amounts, including “required interest,” that are set aside to satisfy obligations to policyholders. Required interest with regard to an account is calculated by multiplying a specified account earnings rate by the mean of the reserves with regard to the account for the taxable year.
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. The company’s share and policyholders’ share are calculated for a life insurance company’s general account and separately for each of its separate accounts. In view of the nuances associated with these calculations, the separate account DRD has been the subject of ongoing controversy in Internal Revenue Service (IRS) audits of life insurance companies.
The FY 2016 Budget proposal, which differs from the version of this proposal included in the fiscal year 2015 budget (FY 2015 Budget), would change the mechanics of the proration regime. As under current law, the company’s share and policyholders’ share would be calculated for a life insurance company’s general account and separately for each of its separate accounts. However, the policyholders’ share would equal the ratio of an account’s mean reserves to its mean assets, and the company’s share would equal 100% less the policyholders’ share.
|Sutherland Observation: In view of these proposed changes, dividends received by a life insurance separate account likely would be entitled to only a very small DRD, if any.|
This proposal would be effective for taxable years beginning after December 31, 2015.
Disallowance of Deductions for “Excess Non-Taxed Reinsurance Premiums Paid to 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 foreign reinsurer that is a CFC may be subject to current taxation in the U.S., the insurance income of a foreign reinsurer that is not a CFC and that is not engaged in trade or business within the U.S. generally is not subject to U.S. federal income tax. However, a foreign reinsurer that reinsures U.S. risks may be subject to a U.S. federal excise tax equal to 1% of the premiums paid under the relevant reinsurance agreement, unless waived by a tax treaty.
According to the General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals (FY 2016 Greenbook), “[r]einsurance transactions with affiliates that are not subject to U.S. Federal income tax on insurance income can result in substantial U.S. tax advantages over similar transactions with entities that are subject to tax in the United States.” The FY 2016 Greenbook also states that “[t]he excise tax on reinsurance policies issued by foreign reinsurers is not always sufficient to offset this tax advantage.”
The FY 2016 Budget proposal, which is a carryover from the FY 2015 Budget and is similar to proposals that have been sponsored by Rep. Richard Neal (D-Mass.) on multiple occasions and submitted by former House Ways and Means Committee Chairman Dave Camp (R Mich.) and former Senate Finance Committee Chairman Max Baucus (D-Mont.) for public discussion and comment, (i) would deny an insurance company a deduction for premiums and other amounts paid to an affiliated foreign reinsurer with respect to reinsurance of property and casualty risks to the extent that the affiliated foreign reinsurer (or its parent company) is not subject to U.S. federal income tax with respect to the premiums received; and (ii) would exclude from the insurance company’s income (in the same proportion in which the premium deduction was denied) any return premiums, ceding commissions, reinsurance recovered, or other amounts received with respect to reinsurance policies for which a premium deduction is wholly or partially denied.
|Sutherland Observation: The reinsurance premiums paid to the affiliated foreign reinsurer apparently would remain subject to the potential application of the 1% U.S. 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 reinsurer that is paid premiums from an affiliated insurance company 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. Furthermore, for purposes of the foreign tax credit, the 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 in order to prevent cross-crediting of the foreign taxes imposed on that income.
The proposal would be effective for policies issued in taxable years beginning after December 31, 2015.
Imposition of a “Financial Fee”
According to the FY 2016 Greenbook, this proposed fee “is designed to reduce the incentive for large financial institutions to leverage, reducing the cost of externalities arising from financial firm default as a result of high leverage.” The proposed fee, which is a modified version of the “financial crisis responsibility fee” included in the FY 2015 Budget, generally would apply to banks, both U.S. and foreign, and also would apply to bank holding companies and “nonbanks,” including insurance companies, savings and loan holding companies, exchanges, asset managers, broker-dealers, specialty finance corporations, and financial captives. Firms with worldwide consolidated assets of less than $50 billion would not be subject to the fee for the period when their assets are below this threshold. U.S. subsidiaries and branches of foreign entities that fall into these business categories and that have assets in excess of $50 billion also would be covered by this proposed fee.
The fee would be calculated by reference to the company’s “covered liabilities.” For this purpose, covered liabilities would be equal to “assets” less “equity” for banks and nonbanks based on audited financial statements, with a deduction for separate accounts (primarily for insurance companies).
|Sutherland Observation: With respect to the application of the proposed fee to insurance companies, it does not appear that reserves and other policyholder obligations backed by the company’s general account would be deducted in calculating the company’s covered liabilities.|
The fee would be applied to covered liabilities at a rate of seven basis points (0.07%) and would be deductible in computing corporate income tax. A company subject to the fee would report it on its annual U.S. federal income tax return, and estimated payments of the fee would be made on the same schedule as estimated income tax payments.
The proposed fee would be effective as of January 1, 2016.
Required Information Reporting for “Private Separate Accounts” Established by Life Insurance Companies
Investments through a separate account of a life insurance company generally give rise to tax-free or tax-deferred income. This favorable tax treatment for investing through a life insurance company is not available, however, if the policyholder has so much control over the investments in the separate account that the policyholder, rather than the insurance company, is treated as the owner of those investments. According to the FY 2016 Greenbook, “information reporting will enable the IRS to identify more easily which variable insurance contracts qualify as insurance contracts under current law and which contracts should be disregarded under the investor control doctrine.”
The FY 2016 Budget proposal, which is a carryover from the FY 2015 Budget, would require life insurance companies to report the following information to the IRS with respect to each contract whose cash value is partially or wholly invested in a “private separate account” for any portion of the taxable year and represents at least 10% of the value of the private separate account:
- The policyholder’s taxpayer identification number (TIN);
- The policy number;
- The amount of accumulated untaxed income;
- The total contract account value; and
- The portion of that value that was invested in one or more private separate accounts.
For this purpose, a private separate account would be defined as any account with respect to which a related group of persons owns policies the aggregate cash values of which represent at least 10% of the value of the separate account. Whether a related group of persons owns policies whose cash values represent at least 10% of the value of the account would be determined quarterly, based on information reasonably within the issuer’s possession.
This proposal would be effective for private separate accounts maintained on or after December 31, 2015.
Reciprocal Reporting of Information in Connection With the Implementation of FATCA
In many cases, foreign law may prevent foreign financial institutions from complying with FATCA by reporting information about U.S. accounts to the IRS. To date, such legal impediments have been addressed through intergovernmental agreements (IGAs) under which the relevant foreign government (rather than the financial institution) has agreed to provide the information required by FATCA to the IRS (i.e., a Model 1 IGA). According to the FY 2016 Greenbook, requiring financial institutions in the U.S. to report similar information to the IRS with respect to nonresident accounts “would facilitate the intergovernmental cooperation contemplated by the intergovernmental agreements.”
The FY 2016 Budget proposal, which is a variation on the proposal included in the FY 2015 Budget, would:
- Require financial institutions to report the account balance (including, in the case of a cash value insurance contract or annuity contract, the cash value or surrender value) for all financial accounts maintained at a “U.S. office” and held by foreign persons;
- Expand the current reporting required with respect to U.S. source income paid to accounts held by foreign persons to include “similar” non-U.S. source payments; and
- Require financial institutions that are required under FATCA or this proposal to report to the IRS information with respect to financial accounts to furnish a copy of that information to the account holders. Notably, this last requirement, which is a new addition in the FY 2016 Budget, would not extend to financial institutions in jurisdictions that have entered a Model 1 IGA with the U.S.
Finally, under this proposal, Treasury would be granted authority to issue regulations to require financial institutions to report:
- The gross proceeds from the sale or redemption of property held in, or with respect to, a financial account;
- Information with respect to financial accounts held by certain passive entities with substantial foreign owners; and
- Such other information that “is necessary to carry out the purposes of the proposal.”
The proposal would be effective for returns required to be filed after December 31, 2016.
Additional Proposals of Note
The FY 2016 Budget contains a number of other proposals that are relevant to insurance companies or that otherwise have a broader application to corporate taxpayers. In particular, those proposals, many of which have been carried over from the FY 2015 Budget, would:
- Reform the U.S. international tax system. Specifically, in addition to imposing (i) a minimum tax on the current foreign earnings of U.S. corporations and their CFCs and (ii) a one-time 14% tax on earnings accumulated in CFCs and not previously subject to U.S. tax, the FY 2016 Budget would:a. Restrict deductions for “excessive interest” of certain members of “financial reporting groups;”
b. Repeal the delay in the implementation of worldwide interest allocation;
c. Make the exceptions under Subpart F for certain active financing income and active insurance income permanent;
d. Make the “look-through” exception under Subpart F permanent;
e. Limit shifting of income through intangible property transfers;
f. Modify the tax rules for “dual capacity taxpayers;”
g. Tax gain from the sale of a partnership interest on a “look-through” basis;
h. Extend IRC § 338(h)(16) to certain asset acquisitions;
i. Remove foreign taxes from an IRC § 902 corporation’s foreign tax pool when earnings are eliminated;
j. Create a new category of Subpart F income for transactions involving digital goods or services;
k. Expand foreign base company sales income to include manufacturing services arrangements;
l. Amend the CFC attribution rules;
m. Eliminate the 30-day “grace period” before Subpart F inclusions;
n. Restrict the use of “hybrid arrangements” that create “stateless” income;
o. Limit the application of exceptions under Subpart F for certain transactions that use “reverse hybrids” to create “stateless” income; and
p. Limit the ability of domestic entities to expatriate.
- Create a new category of qualified private activity bonds for infrastructure projects (referred to as “qualified public infrastructure bonds”).
- Exempt certain foreign pension funds from the application of the Foreign Investment in Real Property Tax Act (FIRPTA).
- Modify the treatment of derivative contracts and the rules related to the identification of hedges. Under this proposal, derivative contracts, which would be defined broadly to include any contract the value of which is determined, directly or indirectly, in whole or in part, by the value of “actively traded property,” generally would be required to be marked to market at the end of each taxable year, and any gains or losses from marking the derivative contract to market would be treated as ordinary income or loss. Mark-to-market accounting would not be required, however, for a transaction that qualifies as a “business hedging transaction.”
- Require information reporting for certain life settlement transactions.
- Restrict the exception to pro rata interest expense disallowance for corporate-owned life insurance to “20-percent owners.”
- Conform the net operating loss rules applicable to life insurance companies to those applicable to other corporations, thus allowing a life insurance company’s loss from operations to be carried back up to two taxable years prior to the loss year, and carried forward 20 taxable years following the loss year.
- Conform the “control” test of IRC § 368 with the “affiliation” test of IRC § 1504.
- Prevent the elimination of earnings and profits through distributions of certain stock with basis attributable to dividend equivalent redemptions.
- Prevent the use of leveraged distributions from related foreign corporations to avoid dividend treatment.
- Treat purchases of “hook stock” by a subsidiary as giving rise to deemed distributions.
- Repeal the “boot-within-gain” limitation of current law in the case of any reorganization transaction if the exchange has the effect of a distribution of a dividend, as determined under IRC § 356(a)(2).
- Require accrued market discount on bonds to be taken into income currently in the same manner as original issue discount (OID).
- Repeal the “non-qualified preferred stock” provision of IRC § 351(g) and the cross-referencing provisions of the Internal Revenue Code that treat non-qualified preferred stock as boot.
- Repeal the rules under IRC § 708 concerning technical terminations of partnerships.
- Repeal the anti-churning rules under IRC § 197.
- Repeal IRC § 847, which allows insurance companies that are required to discount unpaid losses to claim an additional deduction up to the excess of (i) undiscounted unpaid losses over (ii) related discounted unpaid losses.
|Sutherland Observation: The proposal to make permanent the exceptions under Subpart F for certain active financing income and active insurance income is notable in view of the fact that those exceptions expired at the end of 2014. In this regard, discussions have continued in the new Congress regarding possible “extenders” legislation, and the inclusion of these proposals in the FY 2016 Budget may offer further impetus for those discussions.|