December 19, 2017
Reconciled Tax Reform Bill Released: Insurance Impacts
A reconciled tax reform bill has been released! The Senate and House of Representatives came to a consensus on the final provisions of the ‘Tax Cuts and Jobs Act’ on December 15. A majority of the provisions go into effect as of January 2018 pending approval votes expected in both the Senate and the House early this week.
- All corporate taxpayers will be subject to a flat rate of 21%.
- The corporate alternative minimum tax will be repealed. Existing AMT credits can be utilized from 2018 to 2021 to the extent of a taxpayer’s regular tax, and 50% of any remaining credits in excess of the regular tax offset may be refundable.
- Net operating losses (“NOL”) will only be allowed to be carried forward and will only be allowed to offset 80% of taxable income.
- The corporate dividends received deduction (“DRD”) rates decrease anywhere from 15%-20% depending upon the level of stock ownership held.
- Bonus depreciation increases to 100% for assets purchased and placed in service after September 27, 2017, and applicable to all assets, not just new ones.
- Immediate expensing under Section 179 increases to $1 million for taxpayers with total fixed asset additions up to $2.5 million.
- Qualified leasehold improvements are no longer a separate asset class.
- The deduction for business interest will be limited to 30% of adjusted taxable income.
- All meals are now subject to the 50% limitation. No deduction is allowed for entertainment expenses, nor for qualified transportation fringe benefits.
GENERAL CORPORATE OBSERVATIONS
Impact in 2017
The decreased 21% corporate tax rate will have an immediate impact on the December 31, 2017 financial statement presentation of deferred tax assets and liabilities. This is because the deferred inventory is required to be tax-affected at the future rate of realization, which we now know will be 21%, down from 34% or 35% as may have been used in prior years. For companies with net deferred tax asset positions, this adjustment will drive surplus down.
Although the current tax for 2017 remains determinable at the higher rate brackets, the increased bonus depreciation which becomes effective as of September 28, 2017 will provide taxpayers who have invested in fixed assets an opportunity to lower that expected tax bill.
Impact in 2018 and Forward
With a decreased flat rate of 21%, taxpayers may consider – within the realm of what is allowed for tax purposes – the possibility of accelerating expenses into 2017 or deferring income to tax years 2018 and after. Taxpayers can also use the 100% bonus depreciation and increased Section 179 limit to their benefit by investing in qualifying property and thereby further reducing their taxable income base.
On the other hand, a reduced taxable income base will now limit the amount of deductible business interest since such deduction is scheduled at 30% of adjusted taxable income. Any excess non-deductible amounts become an indefinite deferred asset.
The repeal of AMT may lead to additional investing in tax-exempt securities since the income from such securities will no longer be subject to the alternative tax regime. Equity investing which generates dividend income will result, however, in a reduced tax-exempt income load with the reduction to the DRD rates.
Taxpayers may wish to assess company policy with regard to certain expenses which will become non-deductible under the tax reform rules, namely entertainment expenses and qualified transportation fringe benefits. While there still may be a value in providing company outings or reimbursing employees for on-site parking, the fact that these will be non-deductible starting in 2018 may necessitate that certain budgets be put in place to minimize the overall impact to the company.
Further, taxpayers may need to reassess the cumulative benefit to be realized from existing or future-generated NOLs now that an indefinite carryforward is offered. Perhaps prior valuation allowances may need to be modified.
PROPERTY & CASUALTY HIGHLIGHTS
- The proration on tax exempt interest income and the DRD increases from 15% to 25%, however the net tax impact remains the same at 5.25%.
- Taxpayers will be required to discount loss reserves based solely on IRS factors, and no longer by reference to historical payment patterns. The IRS factors will now be determined using a higher interest rate.
- The special estimated tax payment provisions are repealed.
- Existing NOL carryover periods are retained, and P&C taxpayers can offset 100% of taxable income with existing NOLs.
PROPERTY & CASUALTY OBSERVATIONS
Impact in 2017
The presentation of the December 31, 2017 net deferred tax position will be required to be recorded at the future 21% which becomes effective as of January 1, 2018. For insurers with net DTAs, surplus will decrease accordingly. Furthermore, admissibility of the 2017 deferred tax position will be impacted by the reduced tax rate which affects SSAP 101 testing under paragraphs 11.b. and 11.c. by way of reduced values of reversing amounts and overall deferred liabilities.
Impact in 2018 and Forward
Modification to the proration calculation applicable to tax exempt interest and the DRD has been set such that there will be no net tax impact for any future year regardless of fluctuations in the corporate tax rate. Instead, it will be calculated to 5.25% divided by the highest corporate rate in effect at the time. For 2018, this results in a 25% proration.
Property and casualty insurers will also see no change to the net operating loss rules of “old” which provide for a 2-year carryback, 20-year carryforward, and the ability to offset 100% of taxable income in the year of utilization. However, now that the NOL rules diverge between P&C insurers and regular corporations, additional questions arise. What rules are applicable to consolidated groups with both insurance and non-insurance companies? What does it mean, anymore, when a tax-sharing agreement refers to tax-sharing based on separate company taxable income?
What is more impactful to property & casualty insurers are the changes intended to simplify loss reserve discounting. Taxpayers will henceforth be required to use the IRS-prescribed factors to determine the loss discount. Going forward, the IRS will use a corporate bond yield curve to determine the discount factors, and this is expected to generate higher discounts (that is, more taxable income). The election to use a company’s own historical payment pattern is repealed. Transition rules will require that taxpayers recalculate the 2017 reserve discount as if the 2018 tax reform rules had been in effect at that time, compare it to the actual 2017 reserve discount, and amortize the difference into taxable income over 8 years beginning in 2018. Interestingly, the 2017 tax year is an election year to use historical payment patterns. It may still be worth making the election in 2017 if company experience results in a favorable discount, even though the change will be reversed in future years. By doing so, taxpayers can minimize their discount in this last year of the higher tax brackets and shift the recovery of the taxable difference to future years with a lower rate.
Also, the elective deduction related to the special estimated tax rules is repealed. Any residual balances generated by prior application of this election will be fully taken into account in 2018. Generally, this will result in additional refundable “payments” being applied against the 2018 tax liability.
- The small life insurance company deduction (“SLICD”) is repealed.
- Tax deductible life reserves will be 92.81% of that which is actuarially determined.
- Changes in the basis for determining reserves will be amortized over 4 years.
- Changes in policy acquisition costs will result in an increased deferral and longer amortization periods.
- Any remaining balances in pre-1984 policyholder surplus accounts will be taxed 21% and the tax remitted over 8 years beginning in 2018.
- Instead of a complicated formula, the company’s share of income will be 70%.
Impact in 2017
As with property & casualty insurers, life insurers can expect an immediate impact to the presentation of their December 31, 2017 net deferred tax position. For insurers with net DTAs, surplus will also decrease, and admissibility of the 2017 deferred tax position will be impacted not only by the reduced values under paragraphs 11.b. and 11.c., but also by the effective elimination of amounts admissible under 11.a. since future NOLs will no longer be allowed to be carried back.
Impact in 2018 and Forward
To date, life insurance companies which had taken the SLICD were also subject to a 20% alternative minimum tax rate on taxable income plus 75% of the small life insurance company deduction. Repeal of the SLICD will increase taxable income, and even though a reduced flat 21% rate will apply, absent other adjustments, it’s likely that a larger tax liability will be due under the reconciled tax reform package.
Other adjustments of interest to life insurers include the change in determining tax deductible loss reserves. Currently, deductible reserves are determined as the greater of a) net surrender value or b) the reserves determined under Federally prescribed rules. The Federally prescribed method is generally understood to mean the tax reserves as determined by an actuary using applicable interest rates and mortality and morbidity tables. The reconciled reform bill changes part b) of this test to be 92.81% of the tax reserve method otherwise applicable. Many life insurance taxpayers have historically taken the position that their tax reserves were equal to their book reserves and thus, realized no discount addback. Under the new guidance, there will be book to tax difference resulting in greater taxable income. Similar to the transition rules for P&C insurers, life insurers will be required to recalculate the 2017 reserve discount as if the 2018 tax reform rules had been in effect at that time, compare it to the actual 2017 reserve discount, and amortize the difference into taxable income over 8 years beginning in 2018.
Further, any changes in the basis of computing reserves will now be required to be taken into income over a 4-year period, rather than the previous 10-year recognition period. This is meant to conform to the same period provided to all types of corporations for any effect of a change in accounting method.
Life insurance taxpayers will also be capitalizing a greater amount of policy acquisition costs pursuant to the increased percentages applicable to various types of contract revenue received in years 2018 and forward. The determination rates for annuities increase from 1.75% to 2.09%; for group life contracts, the rate increases from 2.05% to 2.45%; and for all other contracts, the rate increases from 7.7% to 9.2%. The amortization period for the deferral of the first $5 million of these costs is retained over 60 months, but all remaining costs are amortized over 180 months – up from 120 months in prior years. Overall, this will result in greater taxable income in the year capitalization as well as in the years of amortization since the spread is longer.
Perhaps not as widely applicable, but still of import to those affected by it is the repeal of the special rule for distributions from pre-1984 policyholder surplus accounts. Instead, taxpayers with any residual balances will calculate tax on the remainder at the 2018 tax rate and remit the tax equally over 8 years beginning in 2018.
FOREIGN PROVISION HIGHLIGHTS
- Dividends received by a domestic corporation owning 10% or more of a foreign corporation will receive a 100% DRD.
- Foreign corporation stock owned by a foreign person will be attributed to a U.S. stockholder related to the foreign person.
- The definition of a U.S. shareholder for purposes of determining controlled foreign corporation (“CFC”) status of a company will be expanded to a vote and value.
- CFC reporting obligations are expanded to controlling shareholders with ownership of any time period, not just 30 consecutive days.
- The passive foreign investment company (“PFIC”) rules narrow the definition of a “qualifying insurance corporation” by adding that insurance liabilities must constitute more than 25% of total assets.
FOREIGN PROVISION OBSERVATIONS
Impact in 2017
Although there is no tax impact to structures existing and returns due for the 2017 tax year, the remainder of 2017 should be used by any and all US persons (including individuals, corporations and other entities) with investment(s) in foreign corporations to evaluate the structure and impact of these changes. Possible areas to consider include the determination of CFC status; the obligation to file Forms 3520, 5471, 8865, FINCEN 114; the obligation to assess tax on SubPart F income or related person insurance income; the applicability of the passive foreign investment company tax and interest regime and related reporting on Form 8916; and other reporting of foreign financial assets as may become necessary.
Impact in 2018 and Forward
With a decreased flat rate of 21%, taxpayers may consider the possibility of accelerating expenses into 2017 or deferring income to tax years 2018 so long as such tax planning is within the confines of allowable tax accounting methods.
The good news from these foreign provisions is the offering of a 100% DRD to U.S. corporations owning 10% or more of a foreign corporation and receiving dividends in 2018 and later years. A minimum holding period of at least 365 out of 731 days must be met, but this is a deduction never before allowed under the DRD rules.
The trickier news comes from the remaining provisions, however, which are intended to further rein in offshore activity under the reach of federal taxation. Attribution of ownership to a U.S. person of foreign corporation stock owned by a foreign person related to the U.S. person serves to increase the U.S. person’s ownership and increase the likelihood of the foreign corporation being classified as a CFC. As does the expansion of the definition of a U.S. shareholder, which includes now a 10% value test in addition to the 10% vote test.
As more foreign corporations fall under the category of a CFC, the requirement to file information forms, like Form 5471, is triggered. U.S. persons who are officers and directors in a foreign corporation with a U.S. shareholder, U.S shareholders themselves, and controlling U.S. persons all must file regardless now of the amount of time they have owned the foreign stock during the year.
Foreign corporations with U.S. persons owning 10% or more generally fall under SubPart F taxation. Thus, the more qualifying CFCs and the more qualifying U.S. shareholders, the more foreign corporation earnings will be taxed before distributions are ever made. Even if a foreign corporation can escape CFC status, the rules for passive foreign investment income taxation must be revisited.
Previously, foreign insurance companies were exempted from PFIC classification if they were predominantly engaged in an insurance business which would be taxed as such if it were subject to U.S. tax. The reconciled tax reform bill narrows this exemption to further require that foreign corporation insurance reserves – excluding unearned premiums – must generally be more than 25% of total assets. Facts and circumstances may be applicable in limited situations (i.e. run-off), but this provision is meant to further subject foreign corporation earnings to current U.S. taxation.
The observations provided herein are preliminary and may variably apply to your situation. Not all provisions of the House and Senate reconciliation have been elaborated here.
Questions about how these provisions will directly affect your company can be sent through our contact form or to your specific Johnson Lambert LLP tax engagement advisor.