- Tax Cuts and Jobs Bill: Major Insurance Industry Changes
- November 9, 2017 | Authors: Caroline C. Setliffe; Carol P. Tello; Thomas A. Gick; Susan E. Seabrook; Saren Goldner; William J. Walderman; Michael R. Miles; Dennis L. Allen
- Law Firms: Eversheds Sutherland (US) LLP - Washington Office ; Eversheds Sutherland (US) LLP - New York Office ; Eversheds Sutherland (US) LLP - Washington Office
On November 2, 2017, the House Ways and Means Committee released the “Tax Cuts and Jobs Act” (H.R. 1) (the Bill). The Bill already has been amended and likely will undergo further revision before it is voted on by the full House. In addition, it is expected that the Senate Finance Committee will release its own tax reform bill this week. Eversheds Sutherland will provide updates as the process unfolds.
The Bill (as modified by the Chairman’s mark and a second amendment)1 contains a number of provisions that are generally unfavorable for insurance companies. If enacted in its current form, the Bill could adversely impact the tax treatment of both life and property and casualty (P&C) companies, although the Bill contains more unhelpful changes for life companies than for P&C companies. Despite the overall corporate rate reduction to 20% proposed in the Bill, it is unclear whether the insurance industry will benefit from the rate reduction as a result of the number of insurance industry, life insurance industry in particular, revenue raisers contained in the Bill. Indeed, it is possible that some insurance companies may have a higher tax burden than under current law, depending on their particular circumstances.
In addition to the Bill’s insurance company provisions, the Bill contains international and other provisions that could adversely affect insurance companies. Many of these proposed changes were drawn from prior tax reform proposals, but some of the proposed changes are new and have not been subject to prior input from the insurance industry. As a result, some of the Bill’s negative consequences for the industry may not have been intended or fully understood.
Subtitle H of Title III of the Bill is focused specifically on changes to the tax treatment of insurance companies, including modifications to the reserve provisions for both life and P&C companies, the rules governing capitalization of policy acquisition expenses for life insurance companies, the proration rules for life and P&C companies, and net operating loss carryback/carryforward periods for life insurers. The Bill also repeals certain specialized rules related to small life insurance companies, adjustments arising out of a change in basis for calculating reserves, policyholder surplus accounts held by life insurers, and special estimated tax payments.
Title IV of the Bill contains the Bill’s international provisions. The provisions are broad ranging and include a move to a territorial system and modifications to the subpart F/controlled foreign corporation regime, an excise tax on certain intra-group outbound payments, and an insurance-specific provision that modifies the exception to the PFIC rules for insurance companies.
The potential state tax implications of the Bill are unknown because states that impose income taxes on insurance companies may not conform their tax regimes to be consistent with some of the Bill’s provisions, for example, the amended net operating loss (NOL) rules or the proration rules, discussed below.
According to official revenue estimates, the insurance-specific provisions of the Bill are expected to raise approximately $40.8 billion over a 10-year period. However, the impact on the insurance industry may be greater than the revenue projections.
For a general discussion of the Bill’s non-insurance provisions, see the Eversheds Sutherland general legal alert on the Bill.
Life Insurance Company Provisions
Changes to Life Insurance Tax Reserves
The Bill would fundamentally change the determination of tax reserves for life insurance companies by doing away with the longstanding “federally prescribed reserve” and substituting certain statutory reserve amounts less a 24.5% “haircut.” Instead of computing tax reserves using a prescribed method, interest rate, and mortality table, a life insurance company would determine its tax reserves by multiplying its statutory life insurance, unpaid loss, and other reserves by 76.5%. For this purpose, deficiency reserves, asset adequacy reserves, unearned premium reserves, and any other amount not constituting reserves for future unaccrued claims would be excluded from the statutory reserves.
The provision would generally be effective for taxable years beginning after 2017. Under a transition rule, the effect of the provision on computing reserves for existing contracts would be taken into account ratably over eight taxable years.
Eversheds Sutherland Observations.
The change in the calculation of life insurance company tax reserves generally is expected to increase the discount in a life insurance company’s tax reserves relative to its reserves taken into account for statutory accounting purposes. The resulting tax cost would increase deferred tax assets. Because deferred tax assets cannot be taken into account fully in the determination of statutory surplus, any increase in the discount for tax reserves could increase surplus strain, which could be substantial for some companies.
The “haircut” set forth in the Bill apparently would apply to both general and separate account reserves, and could possibly result in tax reserves being less than the surrender value obligations provided under a company’s contracts.
As currently drafted, the reserve provision in the Bill should eliminate any question about a life insurance company’s ability to include in its tax reserves the stochastic portion of its principles based reserves.
The Bill also would make life insurance company tax reserves easier to compute and to audit as they will become a percentage of the statutory reported annual reserve.
Change to Policy Acquisition Expense Rules
The Bill would significantly increase the percentages of policy acquisition expenses (DAC) that must be deferred and amortized over 10 years under section 848.2 Under the Bill, the three categories of insurance contracts to which DAC currently applies (annuity contracts, group life insurance contracts and others) would be reduced to two categories (group contracts and other). For group contracts (whether group life, annuity or non-cancellable accident and health contracts), the percentage of premium taken into account in computing DAC would increase to 4%, and for all other contracts (i.e., all individual contracts), the percentage would increase to 11%. The greatest increase would be for individual annuity contracts, which would increase from the current 1.75% rate for annuity contracts to the 11% rate for all individual contracts. The provision would be effective for taxable years beginning after 2017.
Eversheds Sutherland Observation.
The Bill's increase in DAC capitalization percentages for life insurance companies seems to run counter to the other Bill provisions that increase current expensing for non-insurance companies.
Changes to Life Insurance Company Proration Rules
In the case of a life insurance company, the dividends-received deduction is permitted only with respect 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 “policyholder’s share” of tax-exempt interest. The regime for computing the company’s share and the policyholder’s share of net investment income generally is referred to as “proration.” Section 812(a) defines “company’s share” and “policyholder’s share” for purposes of proration through complicated formulas roughly designed to identify the portion of a life insurance company’s net investment income attributable to assets backing policyholder obligations. The Bill would amend section 812(a) to define the company’s share as 40% and the policyholder’s share as 60%. The provision would be effective for taxable years beginning after 2017.
Eversheds Sutherland Observation.
The Bill replaces a complicated calculation of the company’s share and the policyholder’s share with a simplistic 40/60 split between the company’s share and the policyholder’s share. According to the Ways and Means Committee section-by-section summary of the Bill, the split is based on the industry average. Query whether use of an average is a fair and reasonable approach to proration given the variations in investments and business written across the life insurance industry.
Change to NOL Carryforward and Carryback Periods for Life Insurance Companies
The Bill would repeal the special carryback (three years) and carryforward (15 years plus an additional three years for a new company) provision applicable to life insurance company NOLs and would conform the treatment of life insurance companies’ NOLs to the general treatment of NOLs applicable to other companies. Under the Bill, the general rule for NOLs would be amended to limit a company’s NOL deduction to 90% of taxable income (determined without regard to the deduction) and to adjust carryovers to other years to take account of this limitation. In addition, NOLs could be carried forward indefinitely with an inflation adjustment, but could not be carried back. The provision would be effective for losses arising in taxable years after 2017.
Repeal of Small Life Insurance Company Deduction
The Bill would repeal section 806, which provides a deduction of up to $1.8 million to small life insurance companies (with assets of less than $500 million as determined on a controlled group basis). Section 806 permits a life company to deduct 60% of its first $3 million of life insurance-related income, phasing out for companies with income between $3 million and $15 million. The repeal would be effective for taxable years beginning after 2017.
Repeal of 10-Year Spread for Changes in Basis of Computing Reserves and Application of the General Change in Accounting Method Spread Period
Under Section 807, a life insurance company that changes the basis for computing its reserves generally takes into account over 10 years any resulting reserve adjustment (regardless of whether the adjustment reduces or increases taxable income). The Bill would amend section 807 to repeal the 10-year spread period and in its place would apply the general income adjustment rules applicable to changes in methods of accounting. As a result, a change in basis of computing reserves that reduces taxable income generally would be taken into account in the taxable year of the change, and adjustments that increase taxable income generally would be taken into account over four taxable years, beginning with the taxable year in which the change occurs. The provision would be effective for taxable years beginning after 2017.
Repeal of Rules for Pre-1984 Policyholder Surplus AccountsThe policyholder surplus account rules in section 815 are a vestige of the old three-phase tax system applicable to life insurance companies in the Internal Revenue Code of 1959. Under those rules, certain operating income of life insurance companies was credited to a policyholder surplus account and subject to tax only when treated as distributed. Life insurance companies established policyholder surplus accounts to track the undistributed income. The three-phase tax system was eliminated by the Deficit Reduction Act of 1984, but life insurance companies are permitted to defer the pre-1984 operating income held in their policyholder surplus accounts until such income is treated as distributed to policyholders (or there is a corporate dissolution). The Bill would repeal the rules for deferring tax on remaining pre-1984 policyholder surplus accounts. Remaining policyholder surplus accounts would be treated as distributed and subject to tax over an eight-year period. The provision would be effective for taxable years beginning after 2017.