42 nd Annual Insurance Tax Conference Primer Federal
- Slides: 51
42 nd Annual Insurance Tax Conference Primer: Federal Income Taxation of Non-life Insurance Companies Insurance Tax Conference November 2 & 3, 2017 Speakers John T. Adney, Partner Davis & Harman, LLP Washington, D. C. Rob Finnegan, Managing Director Pricewaterhouse. Coopers, LLP Chicago, IL Tom Quinn St. Pete Beach, FL.
Table of Contents Federal Income Taxation (FIT) of Non-life Insurance Companies Introduction Statutory Authority for FIT of Non-life Insurance Cos. Ancillary Authorities Condensed History – Non-life Company Taxation Subchapter L Provisions for Non-life Companies Provisions of General Application to Non-life Ins. Comp. Non-Life Insurance Companies vs. Other Corporations State Regulation Tax Accounting i Slide 1 2 3 4 -6 7 8 -9 10 11 12 42 nd Annual Insurance Tax Conference
Table of Contents (cont. ) FIT definition of an Insurance Company What’s insurance? Non-life Insurance company taxation What is a non-life insurance company? Non-life insurance company taxable income Premiums Earned Deferred Acquisition Costs (“DAC”) Schedule E Losses Incurred ii Slide 13 14 15 16 -17 18 -23 24 -25 26 -27 28 29 -39 42 nd Annual Insurance Tax Conference
Table of Contents (cont. ) Slide Proration Schedule F Consolidated Returns What We Have Not Covered 40 -41 42 43 -45 46 iii 42 nd Annual Insurance Tax Conference
Introduction to Federal Income Taxation of Non -Life Insurance Companies • This presentation will focus on the basic federal income tax principles affecting non-life insurance companies • Presentation designed to be of particular interest to those who are new to the industry • Certain legislative proposals by Congressional tax writing committees will also be briefly outlined 42 nd Annual Insurance Tax Conference 1
Statutory Authority for Federal Income Taxation of Non-Life Insurance Companies • • The Internal Revenue Code (“IRC”) Also known as “The Tax Law” or “The Code” IRC written by Congress – Not the IRS Provisions regarding taxation of insurance companies generally found in subchapter L of IRC – Sections 801 -848 (See slides 7 -9) 42 nd Annual Insurance Tax Conference 2
Ancillary Authorities / Information Sources Re: Taxation of Non-Life Insurance Companies • IRS, with active assistance and review by Department of Treasury, promulgates rules and regulations regarding the implementation and interpretation of the IRC • Legislative history of certain provisions sometimes helpful in explaining intent behind the provision • IRS also publishes various pronouncements regarding tax matters generally, including revenue rulings, revenue procedures, notices, and private letter rulings • A number of court decisions also address non-life insurance company tax issues 42 nd Annual Insurance Tax Conference 3
Condensed History of Federal Income Taxation of Non-Life Insurance Companies Stock non-life insurance companies • 1913 – 1920: Generally, non-life insurance companies were taxed as ordinary corporations • 1921 – Stock non-life insurance companies become subject to taxation on terms substantially similar to today. Taxable income linked to NAIC accounting. Moved away from taxation as an ordinary corporation • 1921 -1942 – Several refinements to the Revenue Act of 192, including provisions that returned stock non-life insurance company taxation closer to ordinary corporate taxation • 1954 – Existing law was recodified, no significant changes 42 nd Annual Insurance Tax Conference 4
Condensed History of Federal Income Taxation of Non-Life Insurance Companies (cont. ) Mutual non-life insurance companies • Prior to 1963 – Either exempt from tax, or taxed on portion of investment income. • 1963 -1986 – Tax under a modified total income approach, which was similar to stock non-life insurance companies. Allowed an additional deduction for the “protection against loss (PAL)” account 42 nd Annual Insurance Tax Conference 5
Condensed History of Federal Income Taxation of Non-Life Insurance Companies (cont. ) Tax Reform Act of 1986*# • Generally eliminated any differences between stock and mutual non-life insurance company taxation • Applied taxation to Blue Cross Blue Shield companies • Restructured Subchapter L into its present 3 -part form * 1990 salvage and subrogation provisions added. # Certain dollar limitations have been adjusted since 1986. 42 nd Annual Insurance Tax Conference 6
Subchapter L Provisions for Non-Life Insurance Companies Subchapter L, Part II • Section 831 – Tax on insurance companies other than life insurance companies • Section 832 – Insurance company taxable income • Section 833 – Treatment of Blue Cross and Blue Shield organizations (BCBS), etc. • Section 834 – Determination of taxable investment income. • Section 835 – Election by reciprocal 42 nd Annual Insurance Tax Conference 7
Provisions of General Application To Non-Life Insurance Companies Subchapter L, Part III • Section 841 – Foreign tax credit • Section 842 – U. S. branches of foreign insurers • Section 843 – Annual accounting period is calendar year • Section 844 – NOL carryover if change in status • Section 845 – Reinsurance anti-abuse rules • Section 846 – Discounting of unpaid losses 42 nd Annual Insurance Tax Conference 8
Provisions of General Application To Non-Life Insurance Companies (cont. ) Subchapter L, Part III • Section 847 – Election not to discount unpaid losses • Section 848 – Capitalization of policy acquisition expenses (“DAC ”) • Non-life insurance companies file Form 1120 -PC 42 nd Annual Insurance Tax Conference 9
Non-Life Insurance Companies vs. Other Corporations • Non-life insurance companies are so-called subchapter C corporations but are taxed under subchapter L of the IRC • Rationale for separate treatment for non-life insurance companies – Businesses of and products sold by a non-life insurance company are fundamentally different from other corporations – so tax law treatment is different – Long tradition of different rules for non-life insurance companies 42 nd Annual Insurance Tax Conference 10
State Regulation • Non-life insurance companies are generally regulated by the states – not the federal government • State regulation, not federal, generally dictates financial structure of a non-life insurance company, limitations on certain product designs and reserves 42 nd Annual Insurance Tax Conference 11
Tax Accounting • In general, follow “all events” test & “economic performance” rules, but allow reserve deductions • Use National Association of Insurance Commissioners (NAIC) method where not in conflict with federal accrual rules (IRC section 832(b)(1)(A)) • NAIC method determines accounting on annual statements filed with state regulators • “No double counting” (IRC section 832(d)) 42 nd Annual Insurance Tax Conference 12
Federal Income Tax Definition of an Insurance Company • In order to be subject to subchapter L of the IRC, a company must meet the tax law definition of an insurance company • IRC sec. 816 (a) provides the test -- more than half of the business activity for the taxable year must be issuance of insurance or annuity contracts or reinsurance of risks underwritten by insurance companies (cross referenced from 831(c)) • Annual determination 42 nd Annual Insurance Tax Conference 13
What’s Insurance? • Curiously, no definition in IRC or regulations • Court cases have largely defined what is insurance for tax purposes • Basic component – must be risk shifting / risk distribution • Issue continues to be subject of controversy / litigation 42 nd Annual Insurance Tax Conference 14
Non-Life Insurance Company Taxation • • • Primarily taxed under parts II & III of subchapter L Definition of non-life insurance company Insurance company taxable income Premiums earned & DAC Losses incurred & proration Consolidated returns 42 nd Annual Insurance Tax Conference 15
What is a Non-life Insurance Company? • If not a life insurance company, but an insurance company, then taxed under Part II, Subchapter L • Definition of insurance company – IRC 831(c) relies on the meaning given to such term by section 816(a) • Includes a wide range of companies and lines of business – Property, Business liability, Health, Title, Mortgage and Financial Guaranty, and Blue Cross /Blue Shield – Including “life” companies that fail the section 816 qualification test 42 nd Annual Insurance Tax Conference 16
What is a Non-Life Insurance Company? (cont. ) • Blue Cross/Blue Shield organizations – Generally tax-exempt before 1987 – Special, favorable rules apply to such organizations under IRC section 833 if they meet a Medical Loss Ratio (MLR) requirement • Per se stock insurance company • Unearned premium reserve • Special deduction – A legislative proposal would repeal these special rules in 2 stages 42 nd Annual Insurance Tax Conference 17
Non-Life Insurance Company Taxable Income • Taxable income equals gross income as defined in IRC section 832(b) less deductions specified in IRC section 832(c) • Small company election – taxed only on “taxable investment income” if less than $2. 2 million in premiums (IRC section 831(b) and 834) • Tax-exempt status for very small companies (IRC section 831(d) and section 501(c)(15) 42 nd Annual Insurance Tax Conference 18
Non-Life Insurance Company Taxable Income (cont. ) • General Rule - Gross income defined in IRC section 832(b): investment income (including gain on sale of property) plus “underwriting income” • Underwriting income equals “premiums earned” less “losses & expenses incurred”, computed on the basis of the underwriting and investment exhibit of the annual statement approved by the NAIC 42 nd Annual Insurance Tax Conference 19
Non-Life Insurance Company Taxable Income (cont. ) 42 nd Annual Insurance Tax Conference 20
Non-Life Insurance Company Taxable Income (cont. ) • Allowable deductions specified in IRC section 832(c): all “ordinary & necessary” / section 162, plus capital losses, tax-exempt interest, dividends to policyholders, DRD, etc. • Special rules for title insurance, mortgage guarantee insurance, certain mutual companies • Special rule for “abnormal insurance losses” 42 nd Annual Insurance Tax Conference 21
Non-Life Insurance Company Taxable Income (cont. ) 42 nd Annual Insurance Tax Conference 22
Non-Life Insurance Company Taxable Income (cont. ) 42 nd Annual Insurance Tax Conference 23
Premiums Earned • Tax basis Premiums Earned defined as gross premiums written during year, net of return premiums & amounts paid for reinsurance, plus or minus change in unearned premiums / UPR (IRC section 832(b)(4)) • Tres. Reg. 1. 832 -4 provides tax definitions for the components noted above • Tax basis premium earned includes any reserves for life insurance contracts 42 nd Annual Insurance Tax Conference 24
Premiums Earned (cont. ) • Treas. Reg. 1. 832 -4: – Only amounts received on insurance contracts considered – Gross premiums written includes accrual for amounts under retrospectively rated contracts – Advance premiums treated as gross written premium – Premium received in installments may result in acceleration of the entire contract premium 42 nd Annual Insurance Tax Conference 25
DAC • Impacts tax basis premium earned • IRC section 832(b)(4) – reduction in the tax basis of unearned premium / Form 1120 PC, Schedule E • Proxy calculation, which attempts to match expense recovery with income recognition • Generally, 20 -percent of any increase in UPR increases tax basis earned premium, 20 -percent of decrease in UPR decreases tax basis earned premium 42 nd Annual Insurance Tax Conference 26
DAC (cont. ) • Must apply the Treas. Reg. 1. 832 -4 regulations, which complicates the calculation • Advance premiums treated as UPR, which increases revenue acceleration • Revenue acceleration may be offset by acceleration of premium acquisition expenses (Rev. Proc. 2002 -46), “pro forma policy acquisition expenses” 42 nd Annual Insurance Tax Conference 27
Schedule E 42 nd Annual Insurance Tax Conference 28
Losses Incurred • Tax basis losses incurred defined as losses paid during year plus or minus change in “discounted” unpaid losses, adjusted for salvage & reinsurance recoverable (IRC section 832(b)(5)) • Reported on Form 1120 PC, Schedule F 42 nd Annual Insurance Tax Conference 29
Losses Incurred (cont. ) • Unpaid losses – Broadly, a liability recognized by the insurer, which reflects the company’s estimate of the ultimate cost to settle the claim – Case basis – Incurred but not reported (IBNR) • Determined by actuaries following professional standards and NAIC accounting guidance / reported on annual statement Schedule P • Liability covers cost to pay the loss and any expenses of determining the amount of the loss (loss adjustment expenses / LAE) 42 nd Annual Insurance Tax Conference 30
Losses Incurred (cont. ) • Depending upon the nature of the claim, the liability may not be paid for months, years or even decades • IRC requires liability for unpaid losses to be adjusted for time value of money 42 nd Annual Insurance Tax Conference 31
Losses Incurred (cont. ) 42 nd Annual Insurance Tax Conference 32
Losses Incurred (cont. ) • IRC section 846 prescribes discounting approach, utilizing prescribed interest rate & industry based loss payment patterns, which results in industry based discount factors • IRS publishes industry based discount factors by line of business • Company may elect (determination year) to create its own discount factors using company payment patterns 42 nd Annual Insurance Tax Conference 33
Losses Incurred (cont. ) • IRC section 846 discounting approach requires application by line of business and accident year (vintaging approach) • Must “rebuild” discount factor table each tax year • Allowed to adjust statutory unpaid losses for embedded discount and accrued salvage & subrogation before discounting 42 nd Annual Insurance Tax Conference 34
Losses Incurred (cont. ) 42 nd Annual Insurance Tax Conference 35
Losses Incurred (cont. ) • Importantly, loss event must be “incurred” in order for unpaid loss reserve to be established – No deduction for future catastrophe reserves (contingency reserves) • Unpaid Losses must be “fair and reasonable” – Not enough that reserves are reported on annual statement – Not enough that reserves are attested to by actuaries – Significant audit issue for IRS is whether reserves have an explicit or implicit “margin” 42 nd Annual Insurance Tax Conference 36
Losses Incurred (cont. ) • More than one way to determine present value - recent legislative proposal would alter interest rate and loss payment pattern rules – Interest rate based on corporate bond yield curve – Loss payment patterns extended – Repeal of company payment pattern election 42 nd Annual Insurance Tax Conference 37
Losses Incurred (cont. ) • Salvage & Subrogation (“Salvage”) – Defined as the residual value of property obtained by the insurance company during claim settlement. Think scrap value of automobile. This value reduces the ultimate cost of the insurance claim. – Statutory accounting permits but does not require • Netters – statutory unpaid losses reduced by estimate • Grossers – statutory unpaid losses NOT reduced 42 nd Annual Insurance Tax Conference 38
Losses Incurred (cont. ) • Salvage & Subrogation (“Salvage”) – IRC section 832(b)(5) requires that salvage value be used to determine losses incurred and amount be discounted – IRS publishes industry based discount factors, separate from 846 discount factors – No election for company based factors – Mechanically similar to 846 calculation – Impact to tax basis losses incurred • Netters – impact is favorable • Grossers – impact is unfavorable 42 nd Annual Insurance Tax Conference 39
Proration • Proration (IRC section 832(b)(5)) – rationale similar to life company rules. Allocation of tax benefits between company and policyholder • Reported on Form 1120 PC, Schedule F • “Policyholder Share” – fixed 15% of tax-exempt interest & dividends received deduction (DRD) (and certain cash surrender value increases) • Impact - Reduction in the deduction for losses incurred • Company Share = _____ 42 nd Annual Insurance Tax Conference 40
Proration (cont. ) • More than one way to allocate - legislative proposal would have determined proration impact based on ratio of tax exempt assets to total assets 42 nd Annual Insurance Tax Conference 41
Schedule F 42 nd Annual Insurance Tax Conference 42
Consolidated Returns • Non-life insurance companies may join in a consolidated return with other non-life insurance companies (non-life, non-life return) and with noninsurance companies (“mixed” return) (IRC section 1501 et. seq. ) • A life insurance company may join in a consolidated return with other life insurers (life, life return) (IRC section 1504(c)(1)) 42 nd Annual Insurance Tax Conference 43
Consolidated Returns • If life insurer is in consolidated return with non-life insurers or non-insurance companies (mixed return), restrictions apply: 5 -year “waiting” rule & 35% limit on use of operating losses (IRC sections 1504(c)(2) & 1503(c)) • Classification of an insurance company as a life or non-life company is therefore important for consolidated return purposes 42 nd Annual Insurance Tax Conference 44
Consolidated Returns (cont. ) • A “tacking” rule applies for purposes of measuring whether the 5 -year waiting period is satisfied. – “Tacking” issues are encountered frequently in the context of insurance M&A • Consolidated returns are extremely complex, See Treasury Regulation 1. 1502 -47 for insurance specific rules 42 nd Annual Insurance Tax Conference 45
What we have not covered • Special insurers – Health insurers generally, mortgage guaranty insurers, title insurers, captive insurance arrangements, etc. • Affordable Care Act – Changes to Subchapter L were minimal – Some provisions have considerable impact (Health Insurance Provider Fee) • Tax reform, apart from some legislative proposals 42 nd Annual Insurance Tax Conference 46
Thank You 47 42 nd Annual Insurance Tax Conference
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