Ready for Reform? Key Provisions Affecting Insurance Companies
One of the largest proposed overhauls to the U.S. federal tax code was released on November 2, 2017 by the Ways and Means Committee of the House of Representatives, and later approved with Chairman Kevin Brady’s amendments. The Senate Finance Committee followed suit just over a week later with their own proposed version of tax reform, and mark-up is currently ongoing. Both proposed bills contain provisions specific to the life insurance and property and casualty insurance sectors, as well as provisions regarding foreign transactions and, of course, general income tax provisions. As an insurance professional, what does that mean for you? Here are some highlights you may need to know:
Provisions for life insurance companies:
Both reform bills would revise the Internal Revenue Code to move life insurance companies toward conformity with other corporations by eliminating special taxation rules. For example, current tax law provides that the majority of corporations are allowed to recognize an increase to taxable income resulting from a change in accounting method over a period of 4 years. Life insurance companies, however, are given 10 years over which to recognize an increase in taxable income resulting from a change in the basis of computing reserves. Under the proposed legislation, that 10-year recognition period would be repealed and life insurance companies would conform to the same 4-year window as all other corporate taxpayers.
Another area addressed by proposed legislation is the treatment of operating losses. Currently, life insurance companies receive a carryback period of 3 years and carryforward period of 15 years. This rule is altered under both the House and Senate versions of their respective reform bills. Generally, the opportunity for a life insurance company to carryback any operating loss would be repealed. Further, operating losses would no longer be limited as to their carryforward period, but will be limited to utilization in any future year up to 90% of taxable income.
Both versions of the reform bill also eliminate the 60% deduction for small life insurance companies, also known as SLICD. Currently, this deduction is phased out ratably for operating gains exceeding $3 million and increasing to $15 million, at which point the deduction is phased out completely. Under the proposed legislation, SLICD would be eliminated entirely.
Life insurance companies currently calculate the amount of policy acquisition expenses to be recognized for tax purposes over a 10-year period at the lesser of a company’s total general deductions or the sum certain percentages applied to differing types of insurance contracts. The Senate reform bill increases the applicable percentages and modifies the amortization period for any capitalized expenses previously subject to a 10-year amortization period to a new 50-year amortization period. Before amendments, the House bill had also included a provision to modify these items, but any revisions were withdrawn during mark-up. Clearly, life insurance tax reform is an area that will continue to evolve as both sides attempt to reach compromise.
The current tax rules still contain some vestigial provisions that affect so few taxpayers that prior amendment in the absence of large-scale tax reform would have created more hassle than value. But Congress has taken the opportunity to propose some clean up in this regard. From 1959 to 1984, life insurance companies were allowed to defer taxation on half of their annual operating income until such a time as it was actually distributed to shareholders. That undistributed half of income was tracked via a policyholders’ surplus account, and some life insurance companies still have residual balances in these accounts. Both versions of tax reform bill would require tax to be assessed on the entirety of the policyholders’ surplus account balance, and remitted equally over 8 taxable years.
The House proposed one additional provision specifically applicable to life insurance companies – an additional 8% surtax on life insurance taxable income. The proposed bill would remove the ability for property and casualty insurers to determine their loss reserves by reference to anything other than the IRS-prescribed discount factors. But instead of applying limitation on, or redefining how, life insurance companies must determine their loss reserves, the 8% surtax is inserted in lieu of such possible provisions.
Provisions for property and casualty insurance companies:
Current law provides that all insurance companies must reduce their deductions by a proration factor. The calculation for property and casualty insurers has historically been set at 15% of tax-exempt items of income which generates a net 5.25% effect on a company’s tax liability based on the highest corporate rate of 35%. Both the House and Senate reform bills propose to increase the current proration from 15% to 26.25%. This accounts for the reduction in the highest corporate rate to 20% in order to maintain the same 5.25% net tax effect. While not mentioned in the House bill, the Senate also suggests an automatic adjustment to this rate to account for any future changes in the corporate tax rate. This would effectively maintain the net tax effect of the proration at 5.25% regardless of fluctuations in the corporate tax rate.
The House reform bill makes additional revisions in an effort to simplify taxation of property and casualty insurance companies by modifying the loss discounting rules in three ways. First, instead of applying the federal mid-term rates, the IRS-prescribed discounting factors would be generated by application of a higher interest rate correlated with the corporate bond yield curve. Second, property and casualty insurance companies would be required to use the new IRS-prescribed factors, and would no longer be allowed to use their own historical loss payment patterns. And third, the provision for long-tail lines only which allows the loss payment period to be extended up to an additional 5 years would become applicable to all short- and long-tail lines of business.
It is also noteworthy that both bills would repeal the elective deduction related to the current special estimated tax rules. Any residual balances generated by prior application of this election would be taken into account in the first tax year following adoption. While not directly impacting the calculation of loss reserves, this provision is also intended to simplify taxation of affected property and casualty insurers.
Just as the rules related to the treatment of life insurance operating losses are up for revision, so are those for property and casualty insurers – but the House and Senate diverge in their recommendations. The House proposes conformity for property and casualty insurance corporations with that of all non-insurance corporations by suggesting that the 2-year carryback option be repealed, and an unlimited carryforward period be instated with a limit on annual utilization of no more than 90% of taxable income. Conversely, the Senate bill proposes these same rule changes but only for non-insurance corporations and would allow property and casualty taxpayers to retain the existing carryback and carryforward rules.
Foreign provisions for insurance companies:
Whether or not a foreign corporation is classified as a controlled foreign corporation (“CFC”) is often of importance to taxpayers. Relative to this classification, the proposed bills from both the House and Senate introduce a slight, but impactful, modification to the attribution rules. Currently, the Internal Revenue Code does not allow for downward attribution of ownership from a foreign person to a U.S. person. An almost identical provision in both tax reform bills could change that and allow for such downward attribution. Doing so would trigger CFC status to many more foreign corporations with an immediate tax impact to the U.S. shareholders.
Another provision affecting CFC classification is the 30-day control rule. Currently, it is required that foreign corporations be controlled by U.S. shareholders for 30 consecutive days before classification as a CFC at which point the Subpart F rules apply, but this minimum time period holding requirement has been repealed under both the House and Senate bills.
Even when a foreign corporation is not at risk of being classified as a CFC, it must still be concerned with classification as a passive foreign investment company (“PFIC”). Foreign corporations which are predominately engaged in an insurance business generally are exempted from the PFIC rules that would otherwise require U.S. shareholders of such companies to pay tax on deemed foreign corporate distributions. However, the House and Senate reform bills both include a narrower definition of a “qualifying insurance corporation” to outline who can be excluded from classification as a PFIC. Not only will foreign corporations be required to be predominately engaged in an insurance business, but the proposals would require that “qualifying insurance corporations” also have “applicable insurance liabilities constitute more than 25% of” total assets. Further narrowing of this definition will be realized due to the fact that unearned premiums and deficiency or contingency reserves will no longer be included as applicable insurance liabilities. This could be a challenge for insurance companies just starting out or insurance companies on the tail-end of their life cycle. For that reason, the bill does include an additional 3-prong test that could exempt companies from being classified as a PFIC depending on their facts and circumstances.
Another provision of interest included in the House proposal would affect insurance companies making any payments, other than interest payments, to related foreign corporations which would otherwise be tax deductible. Whether related to reinsurance, shared expense arrangements, management fees or any of a number of other intercompany dealings, a 20% excise tax would be imposed on the corporations making these types of payments. Of course, the option out is to have the foreign corporation elect to treat such income received as effectively connected income and thus, subject themselves to U.S. taxation. Absent such an election, though, the domestic payor corporation is subject to the excise tax at the highest corporate rate. And unlike the currently administered federal excise tax which is tax deductible, this proposed excise tax would not be deductible by the payor.
General provisions for insurance companies:
The House and Senate agree on proposals that deductible interest expense should be limited to 30% of a corporation’s adjusted taxable income, and any excess allowed as a carryforward. However, there is neither a current consensus on the basis for calculating a corporation’s “adjusted taxable income”, nor on an acceptable carryforward period.
The House and Senate also agree on a proposal to repeal corporate alternative minimum tax, or AMT. Under both bills, corporations would either be allowed to use up any AMT credit carryovers or be refunded the amount of any carryover unused by a specified date.
Last, but not least, is perhaps one of the most notable changes that will affect insurance companies, and that is the reduction in the corporate tax rates. The reform bills propose a flat 20% tax rate for corporations, thus replacing the graduated tax brackets currently in effect.
As a whole, it appears a majority of the provisions affecting insurance companies are very similar between the House and the Senate. If ratified tax reform is adopted in similar form to these proposals, insurance companies will have real changes to consider related to their deferred tax positions, statutory admissibility, and surplus, in general. Although there seems to be an obvious trend to move insurance company taxation toward simplicity and conformity with other corporations, simple or not, the ripple effect to taxpayers will be significant.
If you have any questions about how these provisions will specifically affect your company, please contact us.