Recent tax legislation, informally known as the Tax Cuts and Jobs Act (the "Act") contains several changes that affect the insurance industry. A centerpiece of the Act lowers the corporate income tax rate to 21 percent, which generally applies to all corporations. Other reforms not specific to the insurance industry will also significantly affect many insurance companies. These include eliminating the corporate alternative minimum tax, a reduction of the general dividends received deduction, and further limits on deductibility of business interest expense.
In addition, however, several of the Act's changes are specific to the insurance industry. As summarized below, these include changes affecting both life insurance and property and casualty insurance companies, as well as provisions affecting insurance companies in the international context.
Life Insurance Companies
Net Operating Losses
Prior to the Act, a life insurance company's "operations loss deduction" could be carried back or carried forward for three and 15 years, respectively, to offset taxable income. This differed from the general rule applicable to all other corporations (including property and casualty insurance companies) that permitted the carryback or carryforward of unused net operating losses for two and 20 years, respectively. The Act eliminates the carryback of NOLs and provides for an indefinite carryforward under the general rules. Moreover, the deduction for net operating losses was modified by the Act to limit the deduction to 80 percent of a taxpayer's taxable income for tax years beginning after December 31, 2017.
The Act repeals the operations loss deduction for life insurance companies and provides that the general net operating loss (NOL) rules shall apply. Thus, a life insurance company's NOL (generally representing the excess of life insurance deductions over life insurance gross income) may not be carried back to prior tax years but may be carried forward indefinitely without expiration. Consistent with the general rules, a life insurance company's NOL can be used only to offset up to 80 percent of the company's taxable income. Losses incurred prior to 2018 are not subject to the 80 percent limitation.
Repeal of Small Life Insurance Company Deduction
The Act repeals the deduction previously provided under section 806 of the Tax Code that enabled life insurers with assets of less than $500 million to shield a portion of their income from taxation. Prior to repeal, a small life insurance company could deduct 60 percent of its tentative life insurance company taxable income, subject to certain limitations, up to a maximum deduction of $1.8 million. The deduction is no longer available for tax years beginning after December 31, 2107.
Adjustment For Accounting Method Change in Computing Reserves
Prior to the Act, any changes in the basis for determining life insurance company reserves for tax purposes were taken into account ratably over a period of 10 years. The 10-year amortization period applied only to changes in the basis in computing the federally prescribed reserves that are generally based on reserves prescribed by the National Association of Insurance Commissioners (NAIC). In contrast, under rules generally applicable to changes in a method of accounting, any income resulting from the change is taken into income ratably over four taxable years.
Under the Act, income or loss resulting from any change in computing life insurance reserves is recognized under procedures issued by the IRS, generally over a four-year period (instead of 10 years) consistent with other general changes in accounting methods. The change applies to taxable years beginning after December 31, 2017.
Life Company Tax Reserves
Under the Act, a life insurance company must calculate its tax-deductible reserves for any contract (other than certain variable contracts) as the greater of the net surrender value of the contract or 92.81 percent of actuarial reserves determined as required by the NAIC. The change simplifies the calculation of tax reserves previously required under section 807. No amount or item shall be taken into account more than once in determining any reserve, and in no event shall the reserves exceed the amount which would be taken into account in determining statutory reserves. The change applies to taxable years beginning after December 31, 2017. Beginning with the first taxable year beginning after December 31, 2017, the effects of the change with respect to contracts issued in prior years are taken into account ratably over an eight-year period.
Repeal of Special Rule for Distributions of Historic Policyholder Surplus Account
The Act repeals section 815 which provides rules imposing tax on distributions to shareholders from the policyholders surplus account of a stock life insurance company. As a result of the repeal, any deferred tax on a remaining policyholder's surplus account is accelerated and payable in eight annual installments beginning with the first tax year beginning after December 31, 2017.
Modified Proration Rules for Dividends Received Deduction
For life insurance company taxation purposes, a dividends received deduction may be claimed only with respect to the "company's share" of dividends received. "Proration" rules in section 812 establish the relative percentages of dividends attributable to the company's share and the policyholder's share of such dividends. Section 812 was amended by the Act to provide that the company's share of dividends received for purposes of the dividend received deduction is 70 percent (with the remaining 30 percent attributable to the policyholder's share). The fixed percentages simplify the complex calculation required under prior law. The proration rule similarly applies to reserve deductions with respect to untaxed income.
Policy Acquisition Expenses
The Act increases the capitalization percentages and extends the amortization period for specified policy acquisition expenses. The amortization period for specified policy acquisition expenses was extended from 120 to 180 months. The existing special rule for 60-month amortization of the first $5 million of specified policy acquisition expenses (subject to phase-out as total specified policy acquisition expenses exceed $10 million) was not changed.
Percentages used to determine the amount of specified policy acquisition expenses were modified, resulting in an increase of nearly 20 percent of policy acquisition costs that must be capitalized. As modified, the portion of an insurance company's general deductions that does not exceed the following percentages of net premiums for the taxable year must be capitalized: annuity contracts – 2.09 percent, group life insurance contracts – 2.45 percent, and all other specified insurance contracts – 9.2 percent.
Life Settlement Contract Reporting, Tax Basis of Life Insurance Contracts & Exception to Transfer for Value Consideration Rules
New reporting requirements are imposed by the Act with respect to certain life insurance contracts as well as payment of certain death benefits. A purchaser of a life insurance contract that insures the life of a person unrelated to the purchaser must report information concerning the purchase to the IRS as well as the issuer and seller of the contract. In addition, the issuer of a life insurance contract who receives reporting information from a purchaser or who receives notice of a transfer of a life insurance contract to a foreign person is required to report information to the IRS that includes the tax basis or investment in the contract. If death benefits are paid on a contract that is transferred in a reportable sale, the payor of such benefits must report information concerning the payment to both the IRS and the payee.
Reversing a prior position adopted the by IRS, the Act provides that no adjustment shall be made to the basis of a life insurance or annuity contract for the "cost of insurance" (i.e., mortality, expenses, or other reasonable charges incurred under the contract). Moreover, exceptions to the transfer for value rules do not apply in the case of a transfer in a reportable policy sale. As a result, some portion of the death benefit ultimately payable under a life insurance contract may be includable in income.
Property & Casualty Insurance Companies
Net Operating Losses
As noted above, the general rules governing the deduction of NOLs were modified to eliminate NOL carrybacks and provide no expiration for NOL carryovers. However, a special provision was included for the treatment of non-life insurance companies. In particular, an insurance company remains subject to the same rules under prior law whereby NOLs may be carried back or carried forward for two and 20 years, respectively. Moreover, the NOL deduction for insurance companies is not subject to the 80 percent of taxable income limitation that otherwise applies under the general rules.
Modified Proration Rules
The Act modifies the proration rule used to calculate the deductible amount of a property and casualty insurance company's reserve for losses incurred. The proration rule reflects the concept that reserves are generally funded in part from tax-exempt interest, deductible dividends, and other untaxed amounts. Under the new provision, losses must be reduced by an amount representing the percentage determined by dividing 5.25 percent by the top corporate tax rate. Thus, based on the new corporate rate in effect for 2018, the percentage by which losses must be reduced equals 25 percent (i.e., 5.25 percent / 31 percent). Upon future changes in the corporate income tax rate, the proration percentage will be automatically adjusted under this calculation.
Discounting Rules for Loss Reserves
A property and casualty insurer's additions to reserves for losses must be discounted for purposes of determining the corresponding amount that is deductible for federal income tax purposes. As modified by the Act, property and casualty insurers are required to use a higher discounting rate that is based on the corporate bond yield curve. In addition, companies may no longer elect to rely on their own historical loss payment patterns in determining loss reserves. Rather, the Act requires that all companies use the aggregate industry-experience-based loss payment patterns as determined and prescribed by the IRS.
PFIC Insurance Exception
The Passive Foreign Investment Company (PFIC) rules historically have included an exception from their application to foreign companies that are actively engaged in the insurance business. In what was viewed as an abuse of this exception, managed investment funds would establish purported foreign reinsurance companies in order to defer and reduce the tax that otherwise would be due with respect to investment income (avoiding the adverse implications of the PFIC rules).
The Act limits the scope of the insurance exception to the PFIC rules to only those foreign corporations that would be taxed as an insurance company if they were a U.S. corporation and if insurance liabilities (i.e., loss or loss adjustment expenses and reserves) constitute more than 25 percent of the foreign corporation's total assets. If a corporation does not meet this threshold, it may nevertheless be treated as a qualifying insurance corporation if insurance liabilities constitute at least 10 percent of its total assets, the corporation is predominantly engaged in an insurance business, and the facts and circumstances establish that its failure to satisfy the 25 percent threshold is due solely to runoff-related or rating-related circumstances.
Base Erosion Anti-Abuse Tax
The Act introduced a new minimum tax that directly impacts many reinsurance and captive insurance operations. Targeting corporations that use tax-deductible payments to reduce their U.S. tax liability, the new Base Erosion Anti-Abuse Tax (BEAT) imposes a minimum tax on certain "base erosion payments" (i.e., generally deductions from payments made to a related foreign person). Both cross-border reinsurance premiums as well as insurance premiums paid by a non-insurance U.S. corporation to a foreign insurance affiliate (including a captive insurer) is a base erosion payment. The new BEAT provision applies to any U.S. or non-U.S. corporation that has average annual gross receipts over a three-year look-back period of at least $500 million and which has a "base erosion percentage" of at least 3 percent. The base erosion percentage is the percentage determined by dividing the taxpayer's base erosion tax benefits (e.g., deductions from payments to non-U.S. related persons) by the taxpayer's total deductions. The BEAT generally imposes a minimum tax of 10 percent on a calculated taxable income base that excludes base erosion payments and any net operating loss deduction attributable to base erosion payments. For 2018 the BEAT is imposed at a 5 percent rate, and for years after 2025 increases to 12.5 percent.
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