ACLI Recommends Modifications to Proposed FTC Regs

February 18, 2020

David J. Kautter
Assistant Secretary for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

L.G. “Chip” Harter
Deputy Assistant Secretary (International Tax)
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 2022

RE: ACLI Comments on Guidance Related to the Allocation and Apportionment of Deductions and Foreign Taxes, Financial Services Income, Foreign Tax Redeterminations, Foreign Tax Credit Disallowance Under Section 965(g), and Consolidated Groups (REG-105495-19) (“Proposed Regulations”)

Dear Messrs. Kautter and Harter:

On behalf of the American Council of Life Insurers (“ACLI”),¹ we are writing with recommendations for Guidance Related to the Allocation and Apportionment of Deductions and Foreign Taxes, Financial Services Income, Foreign Tax Redeterminations, Foreign Tax Credit Disallowance Under Section 965(g), and Consolidated Groups (REG-105495-19) (“Proposed Regulations”). Our recommendations offer reasons for why the Proposed Regulations should be modified to best address issues unique to our industry.

1. Treatment of section 818(f) Expenses for Consolidated Groups

a. History of Section 818(f)

Section 818(f) of the Internal Revenue Code (“IRC”) provides regulatory authority for rules for allocation of certain items for purposes of the foreign tax credit (“FTC”) of a life insurance company. Specifically, section 818(f)(1) provides that, under regulations, in applying IRC sections 861, 862, and 863 to a life insurance company, the deduction for policyholder dividends determined under section 808(c), reserve adjustments under section 807(a) and (b), and death benefits and other amounts described in section 805(a)(1) shall be treated as items which cannot definitely be allocated to an item or class of gross income. Accordingly, in applying the sources of income rules of sections 861-863, the items described in section 818(f) are subject to ratable allocation or apportionment to sources of income within and without the US.

Section 818(f) was added to the IRC by the Deficit Reduction Act of 1984 (P.L. 98-369, the “1984 Act”). The 1984 Act eliminated the three-phase system of life insurance company taxation that applied prior to 1984,² and provided that life insurance companies, like corporate taxpayers generally, would be subject to taxation on all of their income. As noted in the legislative history for section 818(f), elimination of the three-phase system presupposed that gross premium income and gross investment income contribute in similar ways to total income. The Congressional tax-writing committees believed that the deductions described in section 818(f) generally bear the same relationship to gross premium income that they bear to gross investment income, and generally bear the same relationship to gross US source income that they bear to gross foreign source income. Accordingly, Congress determined that those deductions should generally reduce US source gross income and foreign source gross income ratably in computing the FTC limitation.

However, Congress also recognized that in some cases this general rule of ratable allocation could be inequitable in its application to companies that can identify gross income to which these expenses relate. Therefore, section 818(f)(2) provided for a one-time election (revocable only with the consent of the Secretary) to be made on or before September 15, 1985 to treat the items described in section 818(f)(1) as properly apportioned or allocated among items of gross income. For example, the legislative history notes that a foreign country may require life insurance companies that sell policies there to maintain reserves there. In such a case, a taxpayer could show that some deductions for reserve increases, policyholder dividends, and claims should be treated as properly apportioned or allocated among items of gross income.

b. The Proposed Regulations Treatment of Section 818(f) Expenses

On December 17, 2019, the Federal Register published Proposed Regulations from the Department of Treasury and the Internal Revenue Service (“IRS”). These Proposed Regulations include guidance on the treatment of the items described in section 818(f)(1) (“section 818(f) expenses”) for consolidated groups that include a life insurance company. The Proposed Regulations provide (§1.861-14(h)) that section 818(f) expenses are allocated and apportioned on a separate entity basis, including with respect to members of a consolidated group, and not on a life-nonlife or a life subgroup basis.

The preamble to the Proposed Regulations notes that Treasury and IRS considered the following methods for allocating section 818(f) expenses if a life insurance company is a member of an affiliated group of corporations including both life and nonlife members that join in filing of a consolidated return:³

• Separate entity method — allocate solely among items of the life company with the section 818(f) expenses

• Limited single entity method — to the extent of intercompany reinsurance, allocate in a manner that achieves single entity treatment between the ceding member and the assuming member

• Life subgroup method — allocate among items of all life insurance company members

• Single entity method — allocate among all members of the consolidated group, including both life and nonlife members

• Facts and circumstances method — allocate based on a facts and circumstances analysis

The Proposed Regulations declined to adopt the single entity method on the basis that section 818(f) only applies to a life insurance company, and thus section 818(f) expenses should not be allocated to nonlife members of a consolidated group. ACLI agrees that the single entity method is not appropriate in the context of a life-nonlife consolidated return and that section 818(f) expenses should not be allocated to nonlife members of a consolidated group.⁴

The Proposed Regulations also reject the facts and circumstances method because it would introduce substantial uncertainty into the tax system and would be difficult to administer. Again, ACLI agrees with this conclusion.

The Proposed Regulations adopt the separate entity method for allocation of section 818(f) expenses as being generally consistent with section 818(f) and with the separate entity treatment of reserves under the intercompany transaction rules of §1.1502-13(e)(2). Nevertheless, comments were requested on whether a life subgroup approach would more accurately reflect the relationship between section 818(f) expenses and the income producing activities of the life subgroup as a whole and be less susceptible to abuse. Comments also were requested on whether an anti-abuse rule may be appropriate to address concerns with the separate entity method creating opportunities to achieve a more desirable foreign tax credit result.

In a letter to Treasury dated April 5, 2019, ACLI indicated disagreement with a methodology that would allocate section 818(f) expenses to nonlife insurance company members of a consolidated return group, and advocated that consolidated groups that include life companies could utilize either a separate entity or a life subgroup approach, depending on the factual relationship of the section 818(f) expenses to the sources of gross income.⁵ In this regard, we refer to the similar circumstances noted in the legislative history of section 818(f) which led Congress to provide for the section 818(f)(2) election. Accordingly, in a June 2019 meeting with Treasury and the IRS, ACLI proffered an approach whereby an election (revocable only with the consent of the Secretary) could be made to apply either a separate entity or a life subgroup approach. For the reasons discussed below, we continue to advocate for such an approach, which we recommend be available for the first taxable year ending after publication in the Federal Register of final regulations for which it is relevant for a consolidated group including life insurance companies.⁶

c. Life Subgroup Approach

IRC sections 1504(c)(2) and 1503(c) impose limitations on inclusion of life insurance companies in a life-nonlife consolidated return group and on the utilization of nonlife net operating losses against life insurance company taxable income. For this purpose, life-nonlife consolidated return regulations define a life subgroup as composed of those members that are life insurance companies.⁷ The statutory limitations on life-nonlife consolidation address the determination of consolidated taxable income, not consolidated tax liability after credits. Life-nonlife consolidated groups are subject to the same limitations on the utilization of credits as are consolidated groups generally.

As already discussed above, it is clearly inappropriate for life insurance company-specific items to be allocated to nonlife insurance companies on a fully consolidated single entity basis for purposes of determinations relating to the FTC. In the absence of a fully consolidated approach, a life subgroup approach would be consistent with general consolidated return principles depending on the income producing activities of the life insurance members of the group.⁸ A life subgroup approach would also take into account that investment assets for an affiliated group of life insurance companies often are managed on a line-of-business basis across the affiliated entities.

d. Separate Entity Approach

Just as Congress recognized in 1984 that the general ratable allocation rule of section 818(f)(1) could in some cases result in inequities in the allocation of section 818(f) expenses, so too should regulations recognize that a life subgroup approach could be inequitable in some circumstances.

Life insurance is a regulated business in the US and throughout the world. As regulated entities, life insurers are, in the jurisdictions in which they operate, subject to separate entity requirements with respect to reserves for policyholder obligations, investable assets, and asset-liability matching, as well as separate entity (and sometimes group) capital standards. In addition, policyholder dividends only take into account the income of the entity issuing the applicable policy. Business conducted in foreign jurisdictions also is subject to financial accounting requirements in those jurisdictions. On the other hand, for an affiliated group of life insurance companies, investment assets, asset-liability matching, and capital requirements may be managed for like products (e.g., whole life insurance contracts, or deferred annuities, or accident and health insurance) on a cross-entity, product-line basis, rather than on an entity-by-entity basis. As a result, a separate entity approach would be an appropriate allocation of section 818(f) expenses depending on the income producing activities of the life insurance members of the group.⁹ In addition, the separate entity approach would, as noted in the preamble, also be consistent with the separate entity treatment of reserves within the consolidated return regulations.

Accordingly, while the preamble to the Proposed Regulations requests comments on whether a life subgroup method “more accurately” reflects the relationship between section 818(f) expenses and the income producing activities of the life subgroup as a whole and is less susceptible to abuse, it can only be said that it varies by group depending on the income producing activities of the group. What is clear is that a single prescribed approach for all consolidated returns including life insurance companies would undoubtedly create inequities in some cases. This is precisely analogous to the factors that led Congress in 1984 to allow the section 818(f)(2) election, and those same factors should lead to a one-time irrevocable election approach (life subgroup or separate entity) in the regulations now under consideration.

e. Limited Single Entity Method and Whether an Anti-Abuse Rule is Appropriate

One of the five methods for allocating section 818(f) expenses described in the preamble to the proposed regulations is referred to as the limited single entity method, that would apply to the extent life insurance company members have engaged in intercompany reinsurance. ACLI is combining its comments on that method with comments on whether an anti-abuse rule may be appropriate because, in ACLI's view, the issues are related.

In the ordinary course of business, life insurers engage in reinsurance — with both related and unrelated parties — for a wide variety of non-tax business reasons, including:

• Capital relief

• Asset/liability duration mismatches

• Diversification to address concentration of risk, including geographical concentration

• Expanding market share while not exceeding risk limits

• Enabling a company to issue a policy on a single life in excess of its retention limit

• Economies of scale in policy administration cost

• Withdrawing from a line of business

Reinsurance is thus a real commercial transaction with real-world business, economic and regulatory consequences. Reinsurance is subject to regulatory approvals and the results of reinsurance are evaluated by insurance regulators, rating agencies, policyholders, and other stakeholders, even when conducted within an affiliated group. Any view that tax considerations routinely constitute primary drivers of reinsurance transactions is simply unrealistic.

The limited single entity method described in the preamble appears to contemplate that in all cases of intercompany reinsurance, the ceding member and the assuming member would allocate section 818(f) expenses in a manner that achieves single entity treatment to the extent of the reinsurance. Apart from the administrative difficulties of life company implementation and IRS examination of such an approach, the limited single entity method would require the exception to be the general rule and would undoubtedly result in significant distortions in many instances. It would also apparently require departure, solely for FTC computation purposes, of the treatment of reinsurance for other Federal income tax purposes. Given that this method receives no further explicit reference in the preamble, it may have been rejected by Treasury and the IRS as unworkable. Whether or not that is the case, ACLI believes it would be distortive and should not be adopted.

There are, however, overtones of this methodology in the preamble's requests for comments on “opportunities for consolidated groups to use intercompany transactions to shift their section 818(f) expenses and achieve a more desirable foreign tax credit result” and on “whether the life subgroup method is less susceptible to abuse because it might prevent a consolidated group from inflating its foreign tax credit limitation through intercompany transfers of assets, reinsurance transactions, or transfers of section 818(f) expenses.” For reasons already noted above, ACLI believes that opportunities for inflation of FTC benefits through intercompany reinsurance are limited. However, to the extent that Treasury and the IRS harbor such concerns, broad statutory authority for making adjustments already exists, and ACLI believes that there is no need for a specific regulatory rule in the context only of FTC computations for a consolidated return group including life insurance companies. Furthermore, ACLI believes that inclusion of an anti-abuse rule in the section of the FTC regulations dealing with allocation of section 818(f) expenses would lead to substantial uncertainty in the tax system and would be difficult to administer (i.e., would likely increase controversy) — the same reasons cited in the preamble for rejection of a facts and circumstances method.¹⁰

IRC section 845 provides allocation and adjustment authority to the IRS in case of certain reinsurance agreements. With respect to reinsurance between related parties, section 845(a) provides that the IRS may (1) allocate income, deductions, assets, reserves, credits, and other items related to such agreement, (2) recharacterize any such items, or (3) make any other adjustment, if it is determined that such allocation, recharacterization, or adjustment is necessary to reflect the proper amount, source, or character of the taxable income (or any item described in (1) relating to the taxable income of each such party). In addition, section 845(b) provides that If the IRS determines that any reinsurance contract has a significant tax avoidance effect on any party to such contract, it may make proper adjustments with respect to such party to eliminate such tax avoidance effect, including treating such contract with respect to such party as terminated on December 31 of each year and reinstated on January 1 of the next year.

Thus, while ACLI believes that an anti-abuse rule would have limited potential for application in the context of allocation of section 818(f) expenses, it also believes that the allocation and adjustment authority provided in section 845 precludes the need for a specific regulatory anti-abuse rule in the FTC context.

For the reasons set forth above, ACLI continues to advocate an elective approach whereby either the life subgroup approach or a separate entity approach would be the general rule, with a one-time election (revocable only with the consent of the Secretary) to use the other approach. This election should be made available to existing consolidated return groups including life insurance companies, and to consolidated return groups that make either a life-life election under IRC section 1504(c)(1) or a life-nonlife election under IRC section 1504(c)(2) subsequent to the effective date of the final regulations.

2. Foreign Tax Credit Limitation Under Section 904

Any amendments to the regulations under 1.904-4(e) should define a financial services entity and a financial services group to include legitimate insurance companies and insurance company groups.

The Preamble to the Proposed Regulations states that “[t]he Treasury Department and IRS have determined that interpretive guidance should be simplified and made consistent where possible and appropriate,” and offers revisions to the regulations under 1.904-4(e) governing financial services income “to promote simplification and greater consistency with other Code provisions that have complementary policy objectives.” However, the Proposed Regulations as currently drafted do not promote simplification when looked at through the lens of efficient tax administration, as the revisions make significant changes to the definition of financial services income which has existed in substantially unchanged form since its promulgation in 1988.¹¹ The current definitions of financial service income and financial services entity and the special rule for affiliated groups which are predominantly engaged in an active financing business are well understood by applicable taxpayers (including life insurance companies) and have operated as intended to distinguish financial services income from passive category income for foreign tax credit limitation purposes. Accordingly, the ACLI does not believe that changes to the regulations under 1.904-4(e) are necessary.

However, if Treasury and the IRS determine that amendments to the definition of financial services income and financial services entity are desirable, the ACLI respectfully requests that any final regulations incorporate certain provisions to ensure that the rules operate such that bona fide life insurance companies and their affiliates within a substantial and genuinely active financial services group should be included in the definition of financial service entities. This request is in line with the statement in the Preamble that “[t]he Treasury Department and IRS agree that a substantial and genuinely active financial services group should be included in the definition of an FSE.”

a. Definition of Financial Services Entity

Prop. Reg. 1.904-4(e)(2)(i) provides that for an insurance company to qualify as a financial services entity, thus qualifying its income as financial services income, the company must either: (A) meet the requirements of section 953(e)(3)(A) and (C), provided that the company's foreign personal holding company income does not exceed the amount that would be treated as derived in the active conduct of an insurance business under section 954(i) if all of the insurance and annuity contracts issued or reinsured by the company had qualified as exempt contracts under section 953(e)(2) (“the 953(e) test”);

(B) meet the definition of a qualifying insurance corporation as defined in section 1297(f) that is engaged in the active conduct of an insurance business under section 1297(b)(2)(B) (but without regard to whether the corporation is a foreign corporation) (the “PFIC test”); or (C) be a domestic corporation, or a corporation that has elected to be treated as a domestic corporation under section 953(d), that is subject to Federal income tax under subchapter L on its net income and is subject to regulation as an insurance (or reinsurance) company in its jurisdiction of organization (the “subchapter L test”).

With respect to qualification as a financial services entity under the 953(e) test, it is not apparent why the Proposed Regulations depart from the current rules under section 904 and require an insurance company to satisfy the requirements of section 953(e)(3)(A), which provide, among other prerequisites, that a company must be licensed to sell insurance, reinsurance, or annuity contracts to persons other than related persons in the company's home country. There is no rationale expressed in the Preamble why an insurance company which is only licensed to reinsure risk of related insurance companies, or an insurance company which is only licensed to sell products to non-home country persons — either of which would not satisfy the requirements of section 953(e)(3)(A) — should not meet the definition of a financial services entity and accordingly have its income allocated to the passive category for foreign tax credit purposes. There is likewise no support in the statutory text of section 904 for any such limitation. We understand that there could be a rationale to exclude a captive insurance company that insures related party non-insurance risk from an entity that does not meet the financial service entity definition, as distinguished from a licensed reinsurance company that reinsures risk of related insurance companies that emanates from unrelated party insurance risk (which is a germane fact pattern for many of our member companies).

In addition, Treasury and the IRS do not offer a reason why an insurance company qualifying as a financial services entity must meet the income requirement under the 953(e) test, which provides that the company's foreign personal holding company income cannot exceed the amount that would be treated as derived in the active conduct of an insurance business under section 954(i). This income requirement creates a cliff effect pursuant to which a single dollar of income can disqualify an insurance company from the definition of a financial services entity.¹² It seems arbitrary for a small amount of income not qualifying as derived in the active conduct of an insurance business within the meaning of section 954(i) to result in an otherwise active insurance company having all of its income allocated to the passive category for foreign tax credit purposes.

With respect to qualification under the PFIC test, regulations under section 1297 are in proposed form and remain subject to change, and accordingly it is not possible to fully evaluate the implications of including a reference to those definitions in these proposed rules.

Regarding the subchapter L test, we note that it is not necessary to refer to a corporation that has elected to be treated as a domestic corporation under section 953(d), as such a company is incorporated in the plain reference to a domestic corporation that is subject to Federal income tax under subchapter L.¹³

The long-standing rules for determining whether an entity is a financial services entity for foreign tax credit limitation purposes are appropriately designed to ensure that an entity that is predominantly engaged in the conduct of an active financial business has none of its income allocated to the passive basket and accordingly does not need to allocate resources to track whether a particular item of its income is active or passive in nature. This outcome is strongly in the interest of taxpayers and tax administrators, and it is not clear why changes are being considered at this point. It is worth noting in this regard that the policy objectives of the section 904 financial services income rules and the subpart F rules under sections 953 and 954 are fundamentally different. The subpart F rules are designed to ensure that income of a financial nature is subject to tax in the United States if such income is mobile in nature, as well as to exclude from subpart F income investment income earned in the conduct of an insurance business. Section 904(d)(2)(D) and the existing regulations thereunder, on the other hand, are designed such that income of companies predominantly engaged in financial service activities is not assigned to the passive category for foreign tax credit limitation purposes.

If Treasury and the IRS nonetheless believe that the current rules defining financial services entities are deficient in some respect, the ACLI would be happy to consider modifications to the current rules, so long as any such modifications do not affect the classification of income derived by a substantial (and genuinely active) financial services group.

b. Definition of Financial Services Group.

Prop. Reg. 1.904-4(e)(2)(ii) defines a financial services group, and provides that a corporation that is a member of a financial services group is deemed to be a financial services entity regardless of whether it is a financial services entity under paragraph (e)(2)(i) of the Proposed Regulations. Section 904(d)(2)(C)(ii) defines financial services group to explicitly include an affiliated group predominantly engaged in the insurance business. However, the Proposed Regulations provide that an affiliated group qualifies as a financial services group only if the affiliated group as a whole meets the requirements of section 954(h)(2)(B)(i). Section 954(h)(2)(B)(i) specifically only mentions being predominantly engaged in “a banking, financing, or similar business,” and does not include any reference to the insurance business.

Section 904(d)(2)(C)(ii) does not reference the rules of section 954(h), and the reference to those rules in the Proposed Regulations would mean that an affiliated group predominantly engaged in the insurance business would not be eligible to qualify as a financial services group. The ACLI respectfully requests that, if revisions to the definition of a financial services group are finalized, the rules are drafted to provide that a financial services group includes an affiliated group which derives more than 70% of its gross income¹⁴ from financial services business (including insurance businesses, as required by the statutory text of section 904(d)(2)(C)(ii)).

c. Definition of Financial Services Income

As stated above, the ACLI does not believe that any amendments to the existing rules in subdivisions (A) through (Y) in 1.904-4(e)(2), which define active financing income, are necessary. However, to the extent Treasury and the IRS choose to amend those rules, the ACLI suggests that any final regulations consider expanding the proposed definition of financial services income to include income currently described in 1.904-4(e)(2)(i)(B) and not included in the Proposed Regulations as currently drafted. This would include income from providing services as an insurance underwriter and income from insurance brokerage or agency services.

3. Fiscal-Year CFCs

In response to the proposed regulations on Guidance Related to the Foreign Tax Credit released on December 7, 2018 (REG-105600-18)(2018 Proposed Foreign Tax Credit Regulations)¹⁵, and the proposed regulations Pertaining To The Global Intangible Low-Taxed Income Provisions Regarding Gross Income That Is Subject To A High Rate Of Foreign Tax released on June 21, 2019 (REG-101828-19) (GILTI High Tax Guidance),¹⁶ the ACLI requested that the rules be modified to allow US shareholders of controlled foreign corporations (“CFCs”) with fiscal years to attribute directly their foreign tax credits to the income to which such credits relate. We continue to believe that this is more consistent with the statutory language and legislative history of Section 960(a), which reference foreign income taxes “properly attributable” to income. Our comments have consistently provided reasons for why the rules should address circumstances when CFCs are required to have fiscal years by local authorities.

We reiterate our recommendation that future guidance revise the definition of current year taxes in the Regulations section 1.960-1(b)(4)¹⁷ so that the definition of current year taxes is modified to better reflect the matching of income and income tax expense. Treating income taxes of the foreign company as being paid or accrued in the calendar year in which the fiscal year ends causes a mismatch between the CFC's earnings and profits or GILTI income and the foreign income tax imposed on those items. Consider, for example, a Japanese CFC that has a US calendar year end and is required to have a March 31 Japan fiscal year. The CFC earns $50 of net income for each month in calendar year 1 and $100 of net income each month in calendar year two. Assuming a 30% local tax rate, the fiscal year net income would be $750, and the foreign tax accrued in year 2 would be $225 (tax as of 3/31/year2). For US tax purposes, however, the net income for year 2 would be $1,200, which results in a tax rate of less than 19%.

Even if the rule of Regulations section 1.960-1(b)(4) is not revised for deemed paid foreign tax credit purposes as requested above, the ACLI requests that, solely for purposes of the determination of the effective tax rate for the GILTI High Tax Exception, final regulations under section 951A should be drafted consistently with our recommendation to ensure that the GILTI tax does not apply to high taxed foreign income. Calculating the effective tax rate on GILTI by reference to “current year taxes” can lead to mismatches if a taxpayer has different U.S. and foreign tax years, as in such cases current year taxes are disconnected from the income with respect to which such taxes are due if the income is earned in the calendar year and foreign income tax is not accrued until the close of the foreign tax year (i.e., after the close of that calendar year), as illustrated in the above paragraph. However, the ACLI believes that a direct attribution rule can be applied only for purposes of the GILTI High Tax Exception and is particularly appropriate in such a framework in light of the manifest legislative history indicating that income subject to high rates of foreign tax is not supposed to be subject to the GILTI tax regime, which Treasury and the IRS acknowledged as the driving motivation behind the proposed GILTI High Tax Exception.¹⁸

We thank you for considering our comments to the Proposed Regulations and welcome the opportunity to discuss our recommendations.

Sincerely,

Regina Rose

Mandana Parsazad

American Council of Life Insurers
Washington, DC

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