Firms Seek Clarity in Calculating BEAT in Midco Transactions

MEMORANDUM TO:
Brent J. McIntosh, General Counsel, U.S. Department of Treasury

CC:
David J. Kautter, Assistant Secretary of Treasury (Tax Policy)
William M. Paul, Acting Chief Counsel and Deputy Chief Counsel (Technical),
Internal Revenue Service
Brett York, Attorney-Advisor, Office of Tax Legislative Counsel

FROM:
Paul D. Clement, Kirkland & Ellis LLP
Russell W, Sullivan, Brownstein Hyatt Farber Schreck, LLP

DATE:
October 17, 2018

RE:
Base Erosion and Anti-Abuse Tax Treatment of Reinsurance Payments for Life & Annuity Insurance

Enacted as part of the Tax Cuts and Jobs Act (the “TJCA”), the base erosion and anti-abuse tax (the “BEAT”) generally applies to deductible payments made by a U.S. taxpayer to a foreign related party. It also applies to reinsurance payments made by a U.S. life and annuity insurance company (the “cedant”) to a related foreign reinsurance company (the “reinsurer”) in the context of modified coinsurance-based (“Modco”) cessions. This memorandum addresses how the BEAT applies to reinsurance payments made in a Modco transaction.

In enacting the TCJA, Congress sought to curb base erosion by, among other measures, subjecting Modco cessions to foreign affiliated reinsurers to the BEAT. The TCJA featured a trade-off: as part of a law that reduced the generally applicable business income tax from 35 to 21 percent, the BEAT brought these cessions “back” into the tax base so that U.S. taxpayers would pay a lower rate on a higher amount of business income. The intent of these provisions was to level the playing field between domestic-only insurance companies and foreign reinsurers related to U.S. insurance companies.

Before the TCJA was enacted, a U.S.-based cedant could reduce its taxable income to the extent it made payments of premiums and other consideration arising out of indemnity reinsurance to a related foreign reinsurer. These payments reflected the difference between two streams of money that never actually changed hands. On one side were the premiums and investment income generated by the U.S. insurer's reserves, to which the reinsurer was entitled. On the other were the amounts needed to maintain the U.S. insurer's reserves, to pay persons insured under the policy, and to reimburse the U.S. insurer for the cost of underwriting the business. These obligations were added and subtracted and settled in a single payment — the “cash settlement payment.” It was the cash settlement payment that reduced the U.S.-based cedant's gross income and eroded the U.S. tax base.

Thus, the BEAT fully accomplishes its statutory purposes when it restores the cash settlement payment to the U.S. tax base. Including in the U.S. tax base more than the cash settlement payments to foreign affiliated reinsurers would inflate the U.S. base and result in effective tax rates far in excess of 21 percent. Such massive overtaxation would be unmoored from Congress' purposes in enacting the BEAT. Fortunately, the best reading of section 59A is consistent with the sensible result that the “base erosion payment” and the “base erosion tax benefit” should be calculated based on cash settlement payments from the U.S. cedant to the foreign related party reinsurer.

The statutory language supports this interpretation for three reasons. First, under section 59A, the definition of a “base erosion tax benefit” contains nearly identical language to the definition of premiums under section 803(a)(1), which pre-dates enactment of the BEAT and reduces life and annuity insurance companies' gross income by the “premiums and other consideration arising out of indemnity reinsurance.” Under section 803(a)(1), those “premiums and other consideration” reflect the cash settlement payment, not gross premiums independent of the other consideration central to the reinsurance contract. Second, under section 59A(d)(3), the definition of “base erosion payment” requires an as-yet undefined term, “reinsurance payment,” which is most sensibly read to reflect the cash settlement payment actually paid or accrued under the reinsurance agreement. Third, section 59A's provisions pertaining to deductions do not apply in this context because the cash settlement payment is not a deduction, but rather a reduction to gross income under section 803(a)(1)(B). That section 59A looks to the cash settlement payment, not solely the gross premiums, is confirmed by statutory purpose, legislative history, and analogous provisions, and an alternative calculation of the BEAT based on gross premiums would risk producing a truly exorbitant tax liability far beyond anything that Congress contemplated when enacting the tax.

The Treasury Department should exercise its specific regulatory authority under section 59A and its general regulatory authority under section 7805(a) to promulgate rules that make clear that the “base erosion payment” relevant to the BEAT calculation is the cash settlement payment from the cedant to the reinsurer. The language in section 59A relating to reinsurance contains two undefined phrases — ”reinsurance payments” and “other consideration” — both of which reinforce that the cash settlement payment is the relevant “base erosion payment” on which to calculate the “base erosion tax benefit.” A regulation to this effect would provide needed certainty and clarity to taxpayers.

1. Statutory and Insurance Background

The TCJA reduced the generally applicable business income tax rate for corporations from 35 to 21 percent. The TCJA also sought to curb “base erosion” and other forms of tax planning by imposing, as an alternative minimum tax, a “base erosion and anti-abuse tax.” Base erosion refers to a strategy by which a taxpayer seeks to shrink the “base” income that is subject to generally applicable business income taxation.

(a) Overview of Modco Transaction

Once an insurer issues a life or annuity insurance policy, it can then reinsure a portion of that policy with an affiliate — a process known as coinsurance. When the affiliate is a foreign entity, however, the assets and reserves that the cedant (i.e., the insurer) maintains remain in the United States. That is what makes this arrangement a modified coinsurance-based cession, rather than a traditional cession, in which some or all of the assets and reserves are transferred to the reinsurer. Because the reserves stay in the United States and earn income, the reinsurer is entitled to a percentage of both the premiums and the investment income generated by the reserves. The U.S. cedant, in turn, is entitled to a portion of both the amount needed to maintain its reserves and the payments made to persons insured under the policy, as well as expense reimbursements for underwriting costs.

These various obligations are not settled individually, though. Each quarter, the cash flows are added and subtracted and settled in a single payment — the “cash settlement payment.” Neither party in this arrangement is entitled to anything other than the quarterly obligation. The question is whether, under the new tax law, the base erosion tax benefit is based on the payment actually owed to the insurer or instead on the gross reinsurance premiums, without regard to any of the other consideration that is part and parcel of the reinsurance agreement.

(b) Pre-BEAT Scheme

The best place to start the statutory analysis is with the tax scheme before the BEAT went into effect. Before the BEAT was enacted, a cedant's taxable income excluded the cash settlement payment to the reinsurer. That is because section 803(a)(1) defines “life insurance gross income” as the sum of premiums, decreases in certain reserves, and certain other revenues. The category “premiums” is defined as:

(A) The gross amount of premiums and other consideration on insurance and annuity contracts, less

(B) return premiums, and premiums and other consideration arising out of indemnity reinsurance.

§803(a)(1).

Before the BEAT was enacted, U.S.-based cedants could reduce their taxable income only to the extent they made payments to related foreign reinsurers. In other words, a cedant could not obtain a tax benefit for the entire gross amount of its premium and investment income obligations under a reinsurance agreement, because it received other consideration from the reinsurer. Thus, only the actual cash settlement payments reduced a cedant's gross income and tax base.

(c) The BEAT Scheme

To calculate the “base erosion minimum tax amount,” the taxpayer multiplies the taxpayer's “modified taxable income” by an applicable percentage. §59A(a). The taxpayer then pays the higher of this product or what the taxpayer's tax liability would be under the 21 percent generally applicable tax.

There are several key statutory definitions under section 59A. The term “modified taxable income” means the taxable income for the taxpayer, determined without regard to “any base erosion tax benefit with respect to any base erosion payment.” §59A(c)(1)(A).

The term “base erosion payment” has two elements relevant here. The statute begins with a general definition in section 59A(d)(1), which reads:

The term “base erosion payment” means any amount paid or accrued by the taxpayer to a foreign person which is a related party of the taxpayer and with respect to which a deduction is allowed under this chapter.

Subsection 59A(d)(3) adds that a “base erosion payment” “also include[s]”:

any premium or other consideration paid or accrued by the taxpayer to a foreign person which is a related party of the taxpayer for any reinsurance payments which are taken into account under section[ ] 803(a)(1)(B). . . .

Finally, a “base erosion tax benefit” has two relevant definitions. First, a base erosion tax benefit includes “any deduction described in subsection (d)(1) which is allowed under this chapter for the taxable year with respect to any base erosion payment.” §59A(c)(2)(A)(i). Second, “in the case of a base erosion payment described in subsection (d)(3),” a base erosion tax benefit is “any reduction under section 803(a)(1)(B) in the gross amount of premiums and other consideration on insurance and annuity contracts for premiums and other consideration arising out of indemnity insurance.” §59A(c)(2)(A)(iii)(I). The bolded statutory phrases are nearly identical to the terms used in the calculation of “premiums” in section 803(a)(1)'s definition of “life insurance gross income.”

2. The best reading of section 59A is that the “base erosion payment” and the “base erosion tax benefit” should be calculated based on the cash settlement payments from the U.S. cedant to the foreign related party reinsurer.

(a) Statutory Interpretation: Text and Context

The BEAT fully accomplishes its statutory purposes if it is calculated based on the cash settlement payment because, before passage of the TCJA, U.S.-based cedants reduced their gross income only by that amount. By contrast, calculating the BEAT based on the theoretical amount of gross reinsurance premiums, before those premiums are reduced to reflect the other consideration in a reinsurance arrangement, would result in massive overtaxation unmoored from Congress' purposes in enacting the BEAT.

Fortunately, the statutory text and context support the more sensible construction of the statute. In particular, three statutory features underscore why the best construction of section 59A is that only the cash settlement payments made pursuant to a reinsurance agreement qualify as “base erosion payments” producing “base erosion tax benefits.”

(i) Section 803(a)(1)'s calculation of premiums, which is nearly identical to section 59A's definition of “base erosion tax benefit,” refers to the cash settlement payments arising out of reinsurance.

Section 803(a)(1)(B)'s calculation of “life insurance gross income” is directly relevant to the calculation of the BEAT because section 803(a)(1)(B) contains nearly identical language to the definition of “base erosion tax benefit” in the BEAT calculation. Compare §803(a)(1)(B) (“premiums and other consideration arising out of indemnity reinsurance”), with §59A(b)(2)(A)(iii)(I) (“premiums and other consideration arising out of indemnity insurance”). As relevant here, premiums under section 803(a)(1) are calculated by subtracting “premiums and other consideration arising out of indemnity reinsurance” from “[t]he gross amount of premiums and other consideration on insurance and annuity contracts." Because of the substantial similarities between the two provisions, section 803(a)(1)'s calculation of premiums, which predates enactment of the BEAT, guides construction of section 59A.

Three aspects of section 803(a)(1) strongly suggest that the phrase “premiums and other consideration arising out of indemnity insurance” reflects the cash settlement payment to the reinsurer, not simply the gross premiums that constitute one component of the consideration exchanged in a reinsurance agreement.

First, section 803(a)(1)'s first clause demonstrates that Congress knows how to base a calculation on gross premiums, yet Congress chose not to do the same when defining the reduction for premiums and other consideration arising out of indemnity reinsurance. Congress expressly includes in gross income the “gross amount of premiums and other consideration on insurance and annuity contracts,” §803(a)(1)(A), but when describing the reduction to gross income it uses only the phrase “premiums and other consideration arising out of indemnity reinsurance.” Had Congress intended to subtract the gross amount of premiums and other consideration arising out of indemnity reinsurance, it could have done so in precisely the manner it did in the immediately preceding phrase.

Second, section 803(a)(1)(B) refers to “premiums and other consideration.” Consideration is a two-way street, and any artificial attempt to dissect a cohesive payment into some components going to the cedant and other components going to the reinsurer is plainly inconsistent with basic economic reality. After all, if the cedant receives consideration, then it will pay higher premiums; but if the cedant were to pay consideration, then the resulting premiums paid would be lower. Thus, the premiums and other consideration are inextricably related, and only together do they capture the entirety of the reinsurance transaction.

Third, the phrase “arising out of indemnity reinsurance” suggests a broader view of the reinsurance transaction than just reinsurance premiums. Here, again, comparison to the first part of the calculation of “premiums” is helpful. That part looks only at the “gross amount of premiums and other consideration on insurance and annuity contracts.” §803(a)(1)(A). Congress chose a broader phrase when referring to indemnity reinsurance to account for all of the inflows and outflows of premiums and other consideration resulting from the entirety of the reinsurance arrangement. While one might quibble about how much broader the phrase “arising out of' is than the word “on,” it is reasonable to conclude that the distinction reflects the idea that the total of premiums and other consideration may not all be the product of premiums and associated fees on the reinsurance agreement, but rather on the whole slate of exchanges arising from that agreement. Particularly when coupled with the absence of the term “gross” and the inclusion of “other consideration,” the phrase “arising out of' suggests that section 803(a)(1)(B) accounts for not only the gross premiums owed to the reinsurer, but the other consideration, in both directions, connected with reinsurance.

By defining the base erosion tax benefit based on the cash settlement payments, as section 803(a)(1)(B) does, the Treasury Department and IRS can ensure that the “modified taxable income” on which the BEAT is calculated matches identically the income that would have been taxed had the cedant not entered into a Modco transaction.

(ii) Section 59A's definition of “base erosion payment” is a broad concept that requires an actual “reinsurance payment.”

Section 59A treats the cash settlement payment to reinsurers as a “base erosion tax benefit” for a second reason — a “base erosion payment” takes into account all the flows between the cedant and the foreign reinsurer and requires an actual “reinsurance payment.” A “base erosion payment” is defined as:

any premium or other consideration paid or accrued by the taxpayer to a foreign person which is a related party of the taxpayer for any reinsurance payments which are taken into account under sections 803(a)(1)(B) or 832(b)(4)(A).

§59A(d)(3).

The IRS has the authority to construe the terms “other consideration” and “reinsurance payments” because there is no definition in section 59A of either term. “Other consideration” is also used sections 59A(c)(2)(A)(iii)(I) and 803(a)(1)(B). As noted above, the term broadly captures the flows between the parties that ultimately result in the cash settlement payment when it is not modified by the phrase “gross amount of.” Interpreting section 59A(d)(3) and (c)(2)(A)(iii)(I) differently from section 803(a)(1)(B) would produce logical inconsistency in the tax code.

The proper construction of “other consideration” is confirmed by Treasury regulations promulgated under section 848, which calculates the basis of insurance policies for purposes of computing deductible acquisition costs. Those regulations interpret the phrase “other consideration” to mean all of the components that determine the cash settlement payment. See 26 CFR § 1.848-2(f)(9), Ex. (4). Thus, “other consideration” in section 59A must mean the component amounts taken into account by the parties in calculating the cash settlement payment arising from indemnity reinsurance.

While there is an established meaning for “other consideration” in the insurance context, there is no existing definition of “reinsurance payments” under section 803 or other tax laws applicable to reinsurance. The definition of reinsurance payments must reflect the cash settlement payment, which is what is actually paid or accrued under reinsurance contracts. Thus, the term should be defined to capture what was actually paid by the reinsurer, not an artificial “gross premium” number that does not reflect economic reality. Because the gross ceded premiums and investment income are never actually paid to the reinsurer, they cannot constitute “reinsurance payments.” The phrase “paid or accrued,” which when read in the context of how reinsurance transactions with affiliates (and non-affiliates) are actually structured, confinns that section 59A takes into account only the money that ultimately changes hands — the cash settlement payment — rather than deconstructing a single cohesive transaction into some portions that result in gross income and others that reduce it. This definition of “reinsurance payments” is most consistent with the plain language of section 59A(c)(2)(A)(iii)(I).

(iii) Section 59A's deduction-related provisions do not apply in this context because the payments at issue are not taken as deductions.

Because no component of the cash settlement payment to a reinsurer qualifies as a deduction under section 805, the payment itself also does not qualify as a “base erosion payment” under section 59A(d)(1), which treats as such a payment “any amount paid or accrued by the taxpayer to a foreign person which is a related party of the taxpayer and with respect to which a deduction is allowable under this chapter.” A cedant pays only premiums, investment income, and interest maintenance reserves, none of which are listed under section 805. Indeed, the only mentions of reinsurance under section 805 are an express exclusion of “consideration arising out of indemnity reinsurance,” §805(a)(6), and a provision governing policyholder benefits paid by the reinsurer, a situation that does not arise in the Modco context.

The fact that the deduction-related BEAT provisions do not apply in the reinsurance context is confirmed by the BEAT's drafting history. The original versions of the TCJA did not contain any reference to reinsurance premiums as reductions to gross income. See H.R. Rep. No. 115-466, at 649-56 (2017) (Conf. Rep.) (overview of House and Senate bills originally passed in each chamber). Those provisions were added only in Conference Committee, see id. at 656-59, once there was a concern that, absent the reinsurance-specific provision, a reinsurer may be able to avoid classifying the cash settlement payments from the cedant to the reinsurer as a “base erosion payment” because no part of that payment qualified as a deduction. The drafting history therefore suggests that the deduction-related provisions do not bear on the amount of the base erosion payment or tax benefit.

(b) Statutory purpose

The BEAT'S purpose coincides perfectly with treatment of only the cash settlement payment as a base erosion payment. The purpose of the BEAT was to tax the base-erosion benefit resulting from the reinsurance transaction. Absent the reinsurance transaction, the cedant's taxable income would be what it reports as net income plus the settlement amount. In other words, before the BEAT was enacted, the only income that was not taxable as a result of the reinsurance transaction was the cash settlement payment — or the sum of the premiums and other consideration under the reinsurance policy. Indeed, that settlement amount was the only money that changed hands at all. Thus, to restore the tax base to the same level it would have been absent the reinsurance transaction, the only addition to the base required is the cash settlement payment associated with the reinsurance transaction.

(c) Analogous Provisions

Three other statutes aid in interpreting sections 59A and 803. First, for purposes of calculating excise taxes in the international context, return premiums are deducted from premiums received. See §4371(3); 26 CFR §46.4371-3(b). That treatment is particularly relevant since the excise tax is intended to otherwise apply on a gross basis — that is, independent of business deductions. The IRS has issued at least one private letter ruling confirming that premiums should be netted when calculating the excise tax under section 4371(3). See IRS Private Ltr. Ruling 9302011. The ruling found that under a Modco treaty, amounts returned under experience refunds, initial and annual policy expense allowances, and reserve adjustments, and in connection with terminations, constitute return premiums that are subtracted from premiums when calculating the excise tax. This ruling is supported by situation 2 described in Revenue Ruling 66-197, where after an insurance policy was cancelled, the refund that the foreign reinsurer paid to the cedant was reduced from the amounts subject to the excise tax.

Second, as noted earlier, section 848, which requires capitalization of specified policy acquisition costs, also supports the conclusion that any reinsurance payment should be the cash settlement payment. Section 848(d) defines “net premiums” as the excess (if any) of (A) the gross amount of premiums and other consideration on such contracts, over (B) return premiums on such contracts and premiums and other consideration incurred for reinsurance of such contract. It also provides that the rules of section 803(b) apply for purposes of determining those premiums.

Application of section 848's principles to determine section 59A's reinsurance payments results in calculating base erosion payments based on the cash settlement payments to the reinsurer. Treasury Regulation §1.848-2(f)(9), example (4), provides the methodology for this computation. In the example, net positive consideration was determined by crediting the initial reinsurance premium, new premiums, and investment income, and deducting the reserve requirements, death benefits, and increase in reserves.

Finally, treating the cash settlement payment to a reinsurer as the base erosion tax benefit is consistent with the meaning of “tax benefit” in the context of the analogous tax benefit rule under section 111. The exclusionary part of the tax benefit rule applies to the recovery of any amount deducted in a prior tax year. Part and parcel of the concept of a tax benefit is the idea that one does not add to gross income what had previously been deducted “to the extent such amount did not reduce the amount of tax imposed by this chapter.” §111 (a). The tax benefit Congress has attempted to capture in enacting section 59A is similar: By adding the cash settlement payments to the modified taxable income for purposes of the BEAT, Congress aimed to add back into the tax base the portion of net income on which the cedant would have otherwise been able to avoid paying taxes by entering into the reinsurance transaction. Only a cash settlement payment approach to calculating the base erosion payment is therefore consistent with the treatment of tax benefits in other contexts.

(d) Legislative History

The legislative history of the TCJA serves to confirm the cash settlement payments construction of section 59A. During the legislative process, the Senate Finance Committee explained that the BEAT was “aim[ed] to level the playing field between U.S. and foreign-owned multinational corporations.” U.S. Senate Finance Cmte., Explanation on the Tax Cuts and Jobs Act to the Senate Budget Committee, available at https://www.budget.senate.gov/imo/media/doc/SFC%20Explanation%20of%20the%20Bill.pdf. Further, “[t]o the extent that corporations . . . are able to utilize deductible related party payments to foreign affiliates to reduce their U.S. corporate tax liability below 10-percent, the Committee intends that the base erosion and anti-abuse tax function as a minimum tax to preclude such companies from significantly reducing their corporate tax liability by virtue of these payments.” Id.

Because the provisions in section 59A that relate specifically to reinsurance payments were first added in the Conference Committee, there is limited legislative history regarding what constitutes a base erosion payment and tax benefit. A statement filed by Senator Graham after the Conference Committee produced its version of the bill is the only legislative history directly addressing the determination of the base erosion payment related to reinsurance. The Senator states:

My understanding of the conference report is that it is intended to limit the base erosion payment to the net amount paid to the foreign reinsurer, taking into account the amounts owed by the reinsurer to the U.S. party. . . . In determining the amount of base erosion payment, the amount of premium paid to the reinsurer must be offset by any return premium, ceding commission, reinsurance recovered or other amount received [by] the reinsurance company with respect to the reinsurance for which such premium is paid to the reinsurer. Moreover, this treatment is consistent with the regulatory accounting regime imposed by the National Association of Insurance Commissioners.

163 Cong. Rec. S8107 (daily ed. Dec. 19, 2017) (statement of Sen. Graham). The existence of this floor statement, without any contrary suggestion in the legislative record, lends support to the cash settlement payment construction of section 59A.

(e) Extreme Consequences of Alternative Approach

Applying the BEAT to gross reinsurance premiums would have a devastating effect that would go far beyond levelling the playing field between domestic and international reinsurance agreements. If the BEAT were applied on a gross basis to reinsurance premiums, then it could make it economically impractical for a foreign reinsurer to reinsure a related U.S. insurance and annuity company. Application of the BEAT on a gross basis could result in effective tax rates of at or above 100 percent of net income, which would make foreign related-party reinsurance virtually untenable. Had Congress intended to risk dismantling foreign related-party reinsurance, then the provisions in the Code would have more clearly expressed this intent (as was the case for payments to inverted companies). In the absence of such expression, the fairer reading of section 59A is the one most consistent with the statutory language and purpose that cash settlement payments from the cedant to the reinsurer are the relevant base erosion payments on which the BEAT should be calculated.

3.The Treasury Department has both specific and general regulatory authority to promulgate regulations to define a “base erosion payment” and “base erosion tax benefit.”

The Treasury Department has both specific and general regulatory authority to promulgate regulations that make clear that only the cash settlement payments made pursuant to a reinsurance agreement qualify as “base erosion payments” producing “base erosion tax benefits.” Specifically, section 59A(i) of the Code provides that “[t]he Secretary shall prescribe such regulations or other guidance as may be necessary or appropriate to carry out the provisions of this section.” Specific authority regulations have the force and effect of law and are controlling unless they are issued improperly or are clearly contrary to the will of Congress. See McKnight v. Commissioner, 99 T.C. 180, 183 (1992), aff'd, 7 F.3d 447 (5th Cir. 1993). That specific authority is supplemented by section 7805(a), which gives the Secretary of the Treasury general authority to promulgate regulations that “prescribe all needful rules and regulations for enforcement” of the Code.

Treasury therefore has multiple options for issuing regulations clarifying the calculation of the BEAT in this context. The Department can use its specific and general authority to issue regulations under section 59A to define the terms “reinsurance payment” and the phrase “premiums and other consideration arising out of indemnity insurance” for purposes of section 59A as reflecting the cash settlement payments from a cedant to a reinsurer. Alternatively, it can use its general authority under section 7805(a) to issue regulations clarifying that the phrase “premiums and other consideration arising out of indemnity reinsurance” in section 803(a)(1)(B) refers to the cash settlement payments from a cedant to a reinsurer.

In either event, because calculating the base erosion tax benefit based on cash settlement payments is the best construction of the statutory language, particularly in light of the statutory purpose, analogous provisions, and legislative history, a rule adopting such a construction would be valid under any conceivable level of deference, whether Chevron, Skidmore, or any other framework.

* * *

For these reasons, the Treasury Department should promulgate regulations to make clear that, for purposes of calculating the BEAT, the base erosion payment is the cash settlement payment from the cedant to the reinsurer.