ACLI Outlines Effect of Proposed Loss Limitation Regs on Insurers

November 11, 2019

Internal Revenue Service
CC:PA:LPD:PR (REG-125710-18)
Room 5203
P. O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Re: REG-125710-18 Proposed Regulations under Section 382(h) Related to Built-in Gain and Loss

Dear Sir or Madam:

On September 10, 2019, proposed regulations (REG-125710-18) were published in the Federal Register regarding the items of income and deduction which are included in the calculation of built-in gains and losses under section 382 of the Internal Revenue Code (“IRC”) that would affect corporations that experience an ownership change for purposes of section 382. On behalf of its member companies, the American Council of Life Insurers (“ACLI”)¹ is pleased to submit the following comments on matters relating to the proposed regulations that are of special interest to the life insurance industry.

Summary of Proposed Regulations

IRC section 382 imposes a limitation on the ability of a “loss corporation” to offset its taxable income in periods subsequent to an ownership change with losses attributable to periods prior to that ownership change. For this purpose, a loss corporation is a corporation with 1) certain carryovers (e.g., net operating loss (“NOL”), capital loss, or credit carryovers), 2) certain attributes (e.g., an NOL, net capital loss, or certain credits) for the taxable year of an ownership change, or 3) a net unrealized built-in loss (“NUBIL”) as of the ownership change. 

If the loss corporation has a NUBIL, the use of any recognized built-in loss (“RBIL”) recognized during the recognition period (i.e., the 5-year period beginning on the change date) is subject to the section 382 limitation. NUBIL is the amount by which the aggregate adjusted basis of the loss corporation's assets immediately before an ownership change exceeds the fair market value of such assets at that time. RBIL is any loss recognized during the recognition period on the disposition of any asset held by the loss corporation on the change date, not to exceed the asset's built-in loss on the change date. RBIL also includes any amount allowable as a deduction during the recognition period but which is attributable to periods before the change date, and NUBIL is adjusted for amounts of this type that would be treated as RBIL if allowable as a deduction during the recognition period.

On the other hand, if a loss corporation has a net unrealized built-in gain (“NUBIG”), the section 382 limitation for any taxable year ending during the recognition period is increased by the recognized built-in gain (“RBIG”) for the taxable year, with cumulative increases limited to the amount of NUBIG. NUBIG is the amount by which the fair market value of assets immediately before an ownership change exceeds the aggregate adjusted basis of such assets at such time. RBIG is any gain recognized during the recognition period on the disposition of any asset held by the loss corporation on the change date, not to exceed the asset's built-in gain on the change date. RBIG also includes any item of income properly taken into account during the recognition period but which is attributable to periods before the change date, and NUBIG is increased by income of this type that would be treated as RBIG if taken into account during the recognition period.

The proposed regulations would make revisions to Treas. Reg. § 1.382-7 to provide rules governing the determination of a loss corporation's NUBIG or NUBIL, as well as its RBIG and RBIL for purposes of section 382 and the section 382 regulations. In general, with regard to the computation of NUBIG and NUBIL and the identification of RBIG and RBIL, the proposed regulations adopt, with modifications, the approach provided in Notice 2003-65 based on the principles of IRC section 1374 (“the 1374 approach”). With regard to the computation of NUBIG or NUBIL, the 1374 approach analyzes a hypothetical sale or exchange of all assets of the loss corporation to a third party. The 1374 approach also identifies RBIG and RBIL at the time of the disposition of a loss corporation's assets during the recognition period. Generally, this approach relies on accrual method of accounting principles to identify built-in income and deduction items at the time of the ownership change.

The proposed regulations do not permit the “338 approach” set forth in Notice 2003-65. Under the 338 approach, depreciation deductions on certain built-in gain assets give rise to RBIG. The preamble to the proposed regulations notes that this would be the case even though no actual recognition of gain or income has occurred, and that the statute does not authorize RBIG treatment in the absence of actual gain or income recognized by the loss corporation. The preamble also notes that changes made by the Tax Cuts and Jobs Act (“TCJA”) have led the IRS and Treasury Department to the conclusion that hypothetical cost recovery deductions would fail to provide a reasonable estimate of the income or expense produced by a built-in gain or loss asset during the recognition period.

The proposed regulations' NUBIG/NUBIL computation first takes into account the aggregate amount that would be realized in a hypothetical disposition of all of the loss corporation's assets in two steps treated as taking place immediately before the ownership change in which the loss corporation is treated as:

The total amount in steps 1 and 2 is decreased by the sum of the loss corporation's liabilities (both fixed and contingent) and the loss corporation's basis in its assets. Lastly, the remaining total is increased or decreased as applicable by:

• The net amount of the total RBIG and RBIL income and deduction items that could be recognized during the recognition period (excluding COD income).

• The net amount of positive and negative section 481 adjustments that would be required to be included on the hypothetical disposal of all of the loss corporation's assets.

The proposed regulations would apply a methodology for identifying RBIG or RBIL that closely tracks the accrual based 1374 approach described in Notice 2003-65, with some modifications. For example, the proposed regulations would provide a new methodology for computing the amount of depreciation deductions treated as RBIL during the recognition period. The proposed regulations also would significantly modify Notice 2003-65's 1374 approach to include as RBIL the amount of any deductible contingent liabilities paid or accrued during the recognition period, to the extent of the estimated value of those liabilities on the change date.

The proposed regulations also address 1) the possible duplicative application of section 382 to certain disallowed business interest expense carryforwards (IRC section 163(j)(2)), and 2) the application of section 382(h) to certain excess business interest expense of a partnership.

The regulations are proposed to be effective for ownership changes occurring after the date the Treasury decision adopting them as final regulations is published in the Federal Register. However, taxpayers may apply the proposed regulations to any ownership change occurring during a taxable year with respect to which the period described in IRC section 6511(a) has not expired, so long as the proposed regulations are also consistently applied to all subsequent ownership changes that occur before the applicability date of final regulations.

Matters of Importance to the Life Insurance Industry

The comments below relate to matters of particular importance to the life insurance industry, including the following:

• The primary intangible asset in life insurance company acquisitions generally is the value of insurance-in-force (“VIF”) that arises from long-term contractual relationships with policyholders and that does not have value independent of the contractual obligations. Accordingly, the proposed regulations' hypothetical sale of assets to a buyer that assumes no liabilities is impossible to apply in the valuation of VIF.

• The valuation of VIF is dependent in part on the measurement of liabilities for policy reserves. Life insurance companies are allowed a tax deduction for life insurance reserves and should use those reserves in determining the value of VIF. Tax deductible reserves should not be treated as non-contingent or contingent liabilities in the computation of NUBIG/NUBIL, and post-ownership decreases/increases in such reserves should not give rise to RBIG/RBIL.

• The proposed regulations violate the “neutrality principle” underlying the statutory provisions of section 382 by denying, except in the case of a disposition, recognition of VIF as RBIG as it is earned during the recognition period.

• A binding contract exception should be included in the applicability dates provision of the regulations that recognizes the customary regulatory approval conditions applicable to life insurance company acquisitions.

Value of Insurance-in-Force

VIF (sometimes also referred to as value of business acquired (“VOBA”)) is generally the primary intangible asset involved in the acquisition of a life insurance business.² VIF is an actuarial determination of the discounted present value to shareholders of future earnings relating to existing contractual relationships with policyholders.³ Its value derives from assumption of the contractual liabilities⁴ under life insurance, annuity, and other long-term insurance contracts involving life, health, or accident contingencies. Those contractual liabilities are measured by reserves for future policy benefit obligations.⁵ Accordingly, the hypothetical sale of assets postulated by the proposed regulations, in which the third party purchaser is treated as having assumed no liabilities, is simply unworkable in the context of a life insurance company acquisition.

Nor can the cash flows attributable to in-force business merely be segregated into positive and negative amounts and valued independently of each other. First, the positive cash flows (e.g., premium income, interest and other income on invested assets, mortality and expense charges) are used to fund negative cash flows such as administrative expenses and policy expenses and benefits. Second, assumptions as to such items as mortality and morbidity, lapse rates, policyholder elections, etc. affect both positive and negative cash flows. All of the cash flows are interdependent with each other and with the reserve obligation and cannot be separated in a meaningful way.

Accordingly, in an acquisition of a life insurance company, assumption of liabilities must be taken into account in determining the amount of VIF. And, as discussed further in the following section, the proper measure of such liabilities for purposes of determining VIF should be the tax reserves of the acquired company as of the date of the ownership change.

Policy Reserves

Insurance companies are allowed tax deductions for reserves for future policy benefit obligations.⁶ Specifically, life insurance companies are allowed deductions for life insurance reserves and other reserves set forth in IRC section 807(c). Life insurance reserves are defined in section 816(b) as amounts required by law that are computed or estimated on the basis of recognized mortality or morbidity tables and assumed rates of interest, and set aside to mature or liquidate future unaccrued claims arising from life insurance, annuity, and noncancellable accident and health insurance contracts involving, at the time with respect to which the reserve is computed, life, accident, or health contingencies. The required method of computing life insurance reserves for purposes of determining taxable income is set forth in section 807(d).

Because VIF represents the present value of future distributable earnings from in-force business, and because reserves are a component in determining income attributable to in-force business, the amount of VIF is dependent in part on the level of reserves at the valuation date. In general, a lower amount of reserves means a higher amount of income recognition to-date, and a lower amount of future income recognition (i.e., lower VIF).

Life insurance companies transfer in-force business by means of reinsurance transactions, by which the reinsurer (or assuming company) takes on the policy obligations of the reinsured (or ceding company) in exchange for a transfer of assets from the ceding company to the assuming company. The difference between the amount of the policy obligations (i.e., the reserves) with respect to the business assumed and the amount of the assets transferred is known as the ceding commission, and represents the VIF on the reinsured contracts. Because tax reserves determined under section 807(d) generally are less than, and never greater than, state insurance regulatory reserves, a tax basis ceding commission is lower than the state insurance regulatory ceding commission by a corresponding amount.

The tax basis ceding commission in a reinsurance transaction is generally immediately deductible.⁷ However, capitalization is required in actual and deemed assumption reinsurance transactions. This capitalization is treated as a section 197 asset to the extent it exceeds the capitalization required by section 848.⁸ Various existing Treasury Regulations provide that these capitalized amounts are measured by the tax reserves in the actual or deemed reinsurance transaction. See Reg. §§ 1.817-4(d), 1.338-11(c), 1.197-2(g)(5), 1.1060-1(c)(5). Similarly, for purposes of section 382(h), tax reserves should be the measure used in determining VIF.

Furthermore, because tax reserves are deductible by life insurers in the same manner as an accrued liability, and because the method of computing tax reserves is set forth is section 807(d), they should not be treated either as non-contingent liabilities or as contingent liabilities under §§ 1.382-7(c)(3)(i)(C) or (D) of the proposed regulations in the calculation of NUBIG/NUBIL at the time of the ownership change. By so excluding tax reserves on in-force contracts from those definitions, payments of policy benefits with respect to those contracts during the recognition period should likewise be properly excluded from treatment as RBIL pursuant to § 1.382-7(d)(3)(v) of the proposed regulations.

VIF Should Be Included in RBIG

As noted in the above Summary of the Proposed Regulations, the proposed regulations do not permit the 338 approach set forth in Notice 2003-65. Specifically, Proposed Reg. § 1.382-7(d)(2)(i) provides that cost recovery deductions on an appreciated asset claimed during the recognition period are not treated as generating RBIG. The reasons for this presented in the preamble to the proposed regulations include 1) the statute does not authorize RBIG treatment in the absence of actual gain or income recognized by the loss corporation, and 2) post-TCJA hypothetical cost recovery deductions will not provide a reasonable estimate of income produced by a built-in gain asset during the recognition period.

In doing so, however, the proposed regulations violate the “neutrality principle” underlying section 382 with respect to a life insurance company's built-in gain asset for VIF. Under the neutrality principle, the built-in gains and losses of a loss corporation that are recognized after an ownership change generally are to be treated in the same manner as if they had been recognized before the ownership change. In the absence of an ownership change, the earnings of a life insurance company's insurance-in-force would clearly be available to absorb NOL carryovers and other loss attributes, and the neutrality principle should lead to the same result for income from insurance-in-force that emerges during the post-change recognition period without requiring a disposition of the VIF asset. By providing rules so as to not permit RBIG treatment in the absence of actual gain or income recognized in a disposition by the loss corporation, the proposed regulations have gone to the other extreme of not permitting RBIG treatment when income from a built-in gain is recognized by the loss corporation without a disposition of the asset.⁹

Under Notice 2003-65's cost recovery approach, the cost recovery deductions served as a proxy for income measurement of RBIG generated by the built-in gain asset. The fact that cost recovery deductions may overstate the recognition period RBIG does not mean that no RBIG should be recognized except upon disposition. Admittedly, it would be quite difficult to track how built-in gain on a VIF asset at the change date is actually recognized during the recognition period, but a reasonable proxy that does not overstate the recognition period income should be ascertainable. For example, the aforementioned Reg. § 1.817-4(d) provides for amortization of a reinsurance ceding commission over the “reasonably estimated life” of the contracts.¹⁰ Alternatively, the 180-month straight-line amortization period under sections 197 and 848 might provide a reasonable approximation.

Binding Contract Exception

The regulations are proposed to generally be applicable to any ownership change occurring after the date of publication of the proposed regulations as final regulations in the Federal Register. The ACLI supports the general rule that any final regulations should be prospectively effective. However, we believe the effective date rule should be modified to exclude ownership changes occurring pursuant to a binding written agreement executed before the date of final regulations, but closed after the regulations are issued.

Similar binding contract exceptions have been incorporated into effective/applicability dates provisions in other regulations under IRC Subchapter C. For example, with respect to corporate reorganizations, Reg. § 1.368-2(d)(4)(iii) provides that:

This paragraph (d)(4) applies to transactions occurring after December 31, 1999, unless the transaction occurs pursuant to a written agreement that is (subject to customary conditions) binding on that date and at all times thereafter.

Similar language is used in other regulations under Subchapter C. See, for example, Reg. §§ 1.337(d)-4(e), 1.355-6(g), 1.367(a)-8(r), and 1.368-1(e)(9).

This, of course, is not a matter unique only to acquisitions of life insurance companies. However, life insurance company acquisitions are subject to approvals that do not apply to non-insurance companies. Insurance companies are regulated entities in the U.S. and in other countries throughout the world. In the U.S., acquisitions involving insurance companies are subject to approvals by the insurance regulators of the domiciliary states of the acquired insurers and, if the acquired group owns insurance companies, by their lead state insurance regulator as well. Acquisitions of or by foreign insurance companies or groups require additional regulatory approvals. Accordingly, it is customary (indeed it is required) that insurance company/group sale and purchase agreements condition closing on having received the necessary regulatory approvals. It is not unusual for a significant amount of time to pass before such approvals are received, particularly in cases of cross-border acquisitions.

For acquisitions of distressed companies, further complications may arise because state insurance law provides regulators with authority over such companies, ranging from requiring a plan for corrective actions by company management to placing a company under regulatory control, depending on the company's level of risk-based capital. (See the National Association of Insurance Commissioners Risk-Based Capital (RBC) for Insurers Model Act, which sets forth a hierarchy of Company Action Level Events, Regulatory Action Level Events, Authorized Control Level Events, and Mandatory Control Level Events to which insurance companies are subject). The further complications of making an acquisition of an insurer in such circumstances are readily apparent

Accordingly, we request that a binding written agreement exception be included in the effective date provisions of final regulations — including customary conditions language sufficient to accommodate the unique regulatory approvals to which insurance company acquisitions are subject.

* * *

Thank you for your consideration of these comments.

Very truly yours,

Regina Rose
Senior Vice President, Taxes & Retirement Security

Mandana Parsazad
Vice President, Taxes & Retirement Security

American Council of Life Insurers
Washington, DC