AFLAC Suggests Methods for Allocating Life Insurance Company Expenses

February 14, 2020

Honorable Charles P. Rettig
Commissioner of Internal Revenue
CC:PA:LPD:PR (REG-105495-19)
Courier's Desk
Internal Revenue Service
1111 Constitution Avenue NW
Washington, DC 20224

Re: REG-105495-19 — Proposed Treas. Reg. § 1.861-14(h)

Dear Commissioner Rettig:

On December 2, 2019, the Treasury Department and IRS issued final and proposed regulations regarding foreign tax credits. These regulations include proposed amendments to Treas. Reg. § 1.861-14 which implements Code section 864(e)(6), as stated in Treas. Reg. § 1.861-14T(a). Despite the rule in section 864(e)(6) that expenses are to be allocated and apportioned on a group-wide basis, proposed Treas. Reg. § 1.861-14(h) would allocate and apportion life insurance company expenses specified in section 818(f) (primarily reserve expenses) on a separate entity basis, including with regard to members of a consolidated group.

Although the proposed regulation provides for the separate entity method of allocation, the preamble to the proposed regulation expresses concern that the separate entity method “may create opportunities for consolidated groups to use intercompany transactions to shift their 818(f) expenses and achieve a more desirable foreign tax credit result.” The preamble goes on to request comments on “whether an anti-abuse rule may be appropriate to address concerns with the separate entity method.”

In a June 2019 meeting with Treasury and the IRS, the American Council of Life Insurers (“ACLI”) argued that both the separate corporation method and the life subgroup method were appropriate for allocating section 818(f) deductions, and it proposed that taxpayers be provided an election (revocable only with the consent of the Secretary) to choose either method. If Treasury and the IRS were not to adopt the election approach in the final regulations, we, for the reasons stated below, would urge you to adopt the “life subgroup” method (applicable to all of the life insurance companies within the taxpayer's affiliated group), and not the separate entity method, as the appropriate method to allocate and apportion life insurance company expenses specified in section 818(f).

Executive Summary

A. Prop. Reg. § 1.861-14(h) is inconsistent with section 864(e)(6) which provides for allocation on a group basis.

Section 818(f) provides that reserve deductions cannot definitely be allocated to a class of gross income, and section 864(e)(6) provides that expenses that are not directly allocable or apportioned to any specific income producing activity are allocated and apportioned as if all members of the affiliated group are a single corporation. Accordingly, under the language of section 864(e)(6), section 818(f) deductions are to be allocated on a group basis. In allocating section 818(f) expenses using the separate entity method, rather than the life subgroup method, Prop. Reg. § 1.861-14(h) is inconsistent with section 864(e)(6).

In fact, the preamble does not even mention section 864(e)(6). Ironically, the preamble does express the concern that the separate entity method may create opportunities for taxpayers to use intercompany transactions to achieve a more desirable foreign tax credit position. Similarly, in enacting section 864(e)(6) in 1986, Congress was concerned that the then current rules that permitted allocations on a separate entity basis could be used to overstate foreign source income in some cases and in other cases could provide traps for the unwary.

B. The life subgroup method is consistent with section 864(e)(6) which provides for allocation on a group basis.

Under the life subgroup method, consistent with section 864(e)(6), section 818(f) deductions would be allocated on a group basis across all the life insurance companies in the group. Consequently, intra-group transactions would have no effect on the allocations and business considerations would solely drive decisions concerning intra-group transactions. In this regard, it is important to keep in mind that the members of major-multi-corporation life insurance groups engaged in the life insurance business inside and outside the United States are commonly managed with the goal of maximizing the overall profits of the common enterprise and often engage in intra-group transactions, including intra-group reinsurance.

The life subgroup method would also provide stability and predictability; allocations of section 818(f) expenses and the group's overall foreign tax credit would not be affected, for example, by a business decision to engage in a significant intra-group reinsurance transaction.

C. Under the life subgroup method there would be no opportunities for taxpayers to achieve a more desirable foreign tax credit result.

The concern expressed in the preamble that the separate entity method “may create opportunities for consolidated groups to use intercompany transactions to shift their 818(f) expenses and achieve a more desirable foreign tax credit result” would be eliminated under the life subgroup method. Under the life subgroup method, intra-group transactions simply do not affect the allocation of section 818(f) deductions.

In contrast, under the separate entity method, every intra-group transaction, including every intra-group reinsurance transaction, would affect the allocation of section 818(f) expenses, and hence cause the amount of the group's overall foreign tax credit to vary. With every transaction impacting foreign tax credits, it would be expected that life insurance groups would need to take into account tax consequences whenever they undertook intra-group transactions.

D. Under the life subgroup method there would be no need for an anti-abuse rule and the difficulties associated with such a rule could be avoided.

Under the life subgroup method, intercompany or intra-group transactions would not affect the allocation of section 818(f) deductions, Therefore, there would be no need for an anti-abuse rule if the life subgroup method were adopted.

In contrast, because under the separate entity method every intra-group transaction (including intra-group reinsurance) would affect the allocation of section 818(f) deductions, the preamble asked whether an anti-abuse rule should be adopted. Any anti-abuse rule would inherently depend on facts and circumstances and cause uncertainty for both the IRS and taxpayers. This uncertainty could become quite significant because the very type of transactions which occur on a regular basis for valid business reasons — for example, reinsurance within the group — are the same type of transactions that affect the allocation of section 818(f) deductions and could, thereby, be used by taxpayers to increase the foreign tax credit limitation. Taxpayers have waited over 30 years for a clear final rule on the allocation of section 818(f) deductions and it would be most unfortunate if the rule continues to be subject to significant uncertainty.

E. The assertion in the preamble concerning section 818(f) expenses and the separate entity method is not persuasive.

The preamble asserts that the separate entity method “is consistent with the Code because section 818(f) expenses generally are computed on a separate company basis and relate to the liabilities of a specific insurance company.” However, as a general principle of tax law, all deductible expense items, including section 818(f) expenses, are computed on a separate company basis and relate to the liabilities of the specific taxpayer. Consequently, this assertion in the preamble about the nature of section 818(f) expenses reflects a broader truism that does not provide support for overriding the application of the specific mandate in section 864(e)(6) that expenses be allocated on a group basis. Otherwise, the result would be that section 864(e)(6) would be a nullity and no deductions could be allocated on a group basis under section 864(e)(6) because all deductions, by their very nature, must relate to the trade or business or assets or liabilities of the corporation claiming them.

F. The attempted analogy to the consolidated return regulations in the preamble is misplaced.

The preamble points by analogy to two situations under the consolidated return regulations in § 1.1502-13 that are limited to internal transactions within the group and it continues to ignore section 864(e)(6). Neither of these situations is apposite to the case at hand which involves the allocation of expenses for foreign tax credit purposes in sales of life insurance to third party customers. Simply stated, the question of how a consolidated group determines the treatment of insurance transactions between members of the group is a completely separate question from how section 818(f) deductions arising from transactions with customers are allocated and apportioned within the group for purposes of the foreign tax credit.

G. A one-time election would be appropriate if the life subgroup approach were not adopted in the final regulations.

If the Treasury Department and IRS were, nonetheless, to finalize regulations adopting the separate entity method, we request that the final regulations provide consolidated groups with an irrevocable, one-time election to allocate section 818(f) deductions using the life subgroup method. A life subgroup method would be a simplified method under which the group would not need to track every routine intra-group transaction to determine how that transfer of assets or liabilities or reinsurance within the group impacts the group's allowable foreign tax credit.

Discussion

A. Prop. Reg. § 1.861-14(h) is inconsistent with section 864(e)(6) which provides for allocation on a group basis.

The section 1.861-14 regulations, of which proposed Treas. Reg. § 1.864-14(h) would become part, are, as stated in Treas. Reg. § 1.861-14T(a), intended to implement section 864(e)(6). Section 864(e)(6) provides that expenses other than interest

which are not directly allocable or apportioned to any specific income producing activity shall be allocated or apportioned as if all members of the affiliated group were a single corporation.

Section 818(f) provides that reserve deductions cannot definitely be allocated to a class of gross income, and the legislative history of that section provides that reserve expenses are not related to either gross premium income (which is derived from underwriting activities) or investment income (which is derived from investment activities). Section 864(e)(6) provides that expenses that are not directly allocable or apportioned to any specific income producing activity are allocated and apportioned as if all members of the affiliated group are a single corporation. Accordingly, under the language of section 864(e)(6), section 818(f) deductions are to be allocated on a group basis. In allocating section 818(f) expenses using the separate entity method, rather than the life subgroup method, Prop. Reg. § 1.861-14(h) is inconsistent with section 864(e)(6).

In fact, the preamble does not even mention section 864(e)(6). Ironically, the preamble does express the concern that the separate entity method may create opportunities for taxpayers to use intercompany transactions to achieve a more desirable foreign tax credit position. Similarly, in enacting section 864(e)(6) in 1986, Congress was concerned that the then current rules that permitted allocations on a separate entity basis could be used to overstate foreign source income in some cases and in other cases could provide traps for the unwary.

We acknowledge that section 864(e)(7) authorizes the Secretary to issue regulations implementing section 864(e)(6). However, we believe that the exercise of such authority in a manner that imposes the separate entity method for allocating section 818(f) deductions is particularly inappropriate where that method is inconsistent with the language and legislative histories of sections 818(f) and 864(e)(6). In addition, it is simply not good policy for the allocation of section 818(f) expenses relating to life insurance provided to third parties to vary depending on the amount of intragroup transactions and whether the group's life insurance business is conducted through one corporation or multiple affiliated corporations. We further believe that the reasons given in the preamble for adopting the separate entity method (and thereby rejecting the life subgroup method) are not persuasive.

B. The life subgroup method accurately reflects the language and legislative histories of sections 818(f) and 864(e)(6) and is consistent with the mandate of section 864(e)(6).

1. The language and legislative history of section 818(f) support the application of the life subgroup method.

Sections 818(f) provides that certain deductions incurred by life insurance companies, including increases in reserves,

shall be treated as items which cannot definitely be allocated to an item of gross income.

In explaining why these deductions are to be allocated ratably across all gross income, the House Ways and Means Committee Report explains:

The committee believes that certain deductions generally bear the same relationship to gross premium income that they bear to gross investment income. Similarly, these deductions generally bear the same relationship to gross U.S. source income that they bear to gross foreign source income. These deductions should, therefore, generally reduce U.S. source gross income and foreign source gross income ratably in calculating the foreign tax credit limitation.¹

Section 818(f) does not specifically address the question of whether members of a life subgroup should allocate the deductions covered by Section 818(f) using the life subgroup method or the separate entity method. However, in enacting Section 818(f), Congress intended to require that section 818(f) deductions be allocated ratably across all gross income of the life insurance business regardless of whether the gross income is premium income or investment income or whether it is gross U.S. income or gross foreign income. Allocating increases in life insurance reserves and other section 818(f) deductions ratably across all income of the taxpayer's life insurance business conducted by the subgroup would be most consistent with that intent.

In contrast, allocating section 818(f) deductions on the separate entity method would likely result in the deductions not being allocated ratably across all the gross income of the life insurance business conducted by the subgroup and therefore frustrate Congressional intent in enacting section 818(f). For example, if Corporation A held foreign investment assets and Corporation B held domestic investment assets, and the separate entity method were used, the section 818(f) deductions of Corporation A would be allocated to foreign source income and the section 818(f) deductions of Corporation B would be allocated to domestic source income. And, as described at page 11, if the separate entity method were used, intra-group transactions could have the effect of reducing the allocation of section 818(f) deductions to foreign source income and likely increase the foreign tax credit limitation.

2. The language and legislative history of section 864(e)(6) further support the application of the life subgroup method.

It is important to remember that the purpose of Treas. Reg. § 1.861-14 of which proposed Treas. Reg. § 1.861-14(h) would become part is to implement Code section 864(e)(6). Section 864(e)(6) was enacted in 1986, two years after the enactment of section 818(f). It provides that expenses other than interest which are not directly allocable or apportioned to any specific income producing activity shall be allocated or apportioned as if all members of the affiliated group were a single corporation.

In enacting section 864(e)(6), Congress was concerned that the existing rules, which permitted deductions to be allocated on a separate corporation basis, “have been manipulated, in some cases, to overstate foreign income. In other cases, the rules provide traps for the unwary.”²

Congress did not believe that the approach of the then-current allocation rules “necessarily reflects economic reality” and it further believed that “consideration of the expenses of the entire group of taxpayers that files a consolidated return is more likely to yield an appropriate determination of what expenses generate U.S. and foreign source gross income than is the separate corporation approach.”³ As stated in the 1986 Conference Report: “Except to the extent provided in regulations, expenses other than interest that are not directly allocable or apportioned are to be allocated and apportioned as if all members of the affiliated group were one taxpayer.”⁴

Increases in life insurance reserves and other section 818(f) expenses are not directly related to any specific income producing activity, as the legislative history of Section 818(f) makes clear. For example, the legislative history provides that reserve expenses are not related to either gross premium income (which is derived from underwriting activities) or investment income (which is derived from investment activities). Consequently, under the authority of the applicable statutory provision in section 864(e)(6), reserve expenses should be allocated across the taxpayer's entire life insurance business using the life subgroup approach and not the separate entity approach.

3. Aflac and other major multi-corporation life insurance groups engaged in the life insurance business inside and outside the United States operate their businesses on a group basis.

For many years, Aflac primarily operated its life insurance business in the United States and Japan through a single U.S. life insurance company. Following discussions with the insurance regulators in which they expressed a preference that the Japan business be separately incorporated, Aflac reorganized its structure in 2018, and it now operates that same life insurance business primarily through two life insurance corporations which are U.S. taxpayers that are members of an affiliated group that files a consolidated federal income tax return.

Aflac continues to operate its life insurance business much as it did before its reorganization. The goal of all of its activities is to maximize the overall profits of the common enterprise. Even though there are now multiple life insurance corporations in the Aflac group, the corporations are commonly managed. The corporations have a common capital and risk management strategy and the Aflac group has a single chief investment officer.

In this regard, the Aflac group has a single investment committee and, according to the charter of the Aflac Global Investment Committee, it “acts as an executive body focused on providing comprehensive governance and oversight, and timely decisions relating to all aspects of the worldwide investment programs for Aflac Incorporated and its subsidiaries.” Public documents indicate that other major multi-corporation life insurance groups engaged in the life insurance business inside and outside the United States have similar committees. For example, the Investment Committee charter of one such group provides that the primary purpose of that committee is to “oversee and take actions with respect to the purchase, management, disposition, risk management and governance of the invested assets” of the parent corporation and its subsidiaries. Similarly, according to the 2019 proxy statement of another group, its Investment Committee, “in coordination with [its] Finance and Risk committee, oversees the management and mitigation of risks associated with . . . the consolidated . . . enterprise.”

Aflac also has a Global Risk Committee, which according to its charter, oversees “the processes for identifying, assessing, monitoring, controlling, and mitigating market, credit, liquidity, insurance, operational, reputational and strategic risks” associated with Aflac Incorporated and its subsidiaries. Similarly, according to the 2019 proxy statement of another major multi-corporation life insurance group engaged in the life insurance business inside and outside of the United States, that group has a Finance and Risk Committee that oversees the enterprise's risk management and financial policies and works closely with the Chief Risk Officer (who oversees and coordinates risk assessment and mitigation enterprise-wide). Still another major multi-corporation life insurance group has a Finance, Investment and Risk Committee which according to its charter provides oversight for enterprise risk management and investment strategies; and a fourth insurance group has a Risk Committee, which according to its charter, “is to oversee the governance of significant risks throughout the Company [defined to include the parent corporation together with its subsidiaries] and the establishment and ongoing monitoring of the Company's risk profile, risk capacity and risk appetite.”

In performing their functions, the Aflac global committees first assure that the regulatory requirements relating to each individual insurance company are satisfied. As in the case of other major multi-corporation life insurance groups engaged in the life insurance business inside and outside the United States, Aflac has assets substantially in excess of the regulatory minimums, and the Aflac committees focus on the investment of Aflac's surplus funds and intra-group transactions that assist in capital optimization and risk management.

With multiple life insurance corporations (instead of one corporation), Aflac, as noted above, now engages in intra-group transactions. For example, one Aflac life insurance corporation may pay a special dividend which is then used in the business of another group member. In addition, in the future Aflac may engage in intra-group reinsurance transactions. Such transactions are common industry practice⁵ and they are subject to regulation by the insurance regulators. In general, the regulators require that a request for approval of intra-group reinsurance transactions be submitted and such requests are routinely granted as evidenced by the fact that intra-group reinsurance transactions are common industry practice.

In an intra-group reinsurance transaction, Corporation A, which issued the policy to the consumer, transfers all or a portion of the risk under that policy to its sister corporation, Corporation B. Corporation A pays Corporation B a fee (generally all or a part of the premium it has collected from the consumer) to assume the liability and Corporation B establishes a reserve for the liability it has assumed. In essence, the reserve that otherwise would have been established by Corporation A is now at Corporation B.

Sometimes, reinsurance within the group is done because, for example, Corporation A may have the ability to sell a large amount of additional insurance but has limited capital (capital which is required to support the issuance of additional insurance to consumers); while Corporation B may have excess capital but a limited ability to sell additional insurance. In that case, Corporation A will sell the additional insurance and reinsure a large portion of that insurance with Corporation B. If 75% of the additional insurance is reinsured, Corporation B will establish a reserve for that portion of the liability and 75% of the reserve will effectively move to Corporation B. This use of reinsurance is sometimes referred to as capital optimization — optimizing the capital of the group.

Reinsurance is also used to spread risk within the group. For example, if Corporation C has a high concentration of insurance in X, the insurance regulator for Corporation C may request that that concentration be reduced. Corporation C would reinsure part of its X exposure with Corporation D, an affiliated corporation. This use of reinsurance is sometimes referred to as risk management.

As stated in the preamble to the proposed regulations, the separate entity method of allocation for section 818(f) expenses “may create opportunities for consolidated groups to use intercompany transactions [such as intra-group reinsurance] to shift their section 818(f) expenses and achieve a more desirable foreign tax credit result.”⁶ This could occur whether tax was a primary factor or just one of many business factors considered in determining whether to undertake any particular intra-group reinsurance transaction. Indeed, under the separate entity method, the allocation of section 818(f) expenses would be affected even if taxes were not considered in deciding to undertake the transaction.

In this regard, no two members of a life insurance group are identical — for example, each will have a different mix of foreign assets and domestic assets and different amounts of reserves and different amounts of foreign source and U.S. source gross income. Yet, under the separate entity method, each of these differences and other differences among members of the life insurance group will affect the allocation of section 818(f) expenses and, consequently, the amount of the group's foreign tax credit. Because intra-group reinsurance transactions would affect the amount of the group's foreign tax credit, Aflac and other life insurance groups would need to take into account tax consequences in deciding whether to undertake an intra-group reinsurance transaction or to undertake reinsurance transaction A as opposed to reinsurance transaction B. Application of a life subgroup method would make these considerations irrelevant.

4. The life subgroup method is consistent with the way that Aflac and other major multi-corporation life insurance groups engaged in the life insurance business inside and outside the United States conduct their businesses.

Under the life subgroup approach, common activities involving, for example, reinsurance within the group would have no effect on the allocation of section 818(f) deductions. In contrast, under the separate entity method, each intra-group transaction would affect the allocation of section 818(f) deductions and the amount of the foreign tax credit limitation. Accordingly, under the separate entity method, each intra-group transaction would have to be separately tracked by management on a real-time basis to consider its impact on the group's allowable foreign tax credit.

We believe that decisions concerning assets, liabilities and reinsurance within the life insurance subgroup should be made based on non-tax business considerations and not need to take into account how, for example, an intra-group reinsurance transaction might affect the allocation of life insurance reserve deductions for purposes of the foreign tax credit limitation.

The life subgroup method would also provide stability and predictability; allocations and the group's overall foreign tax credit would not be affected, for example, by a business decision to engage in an intra-group reinsurance transaction.

C. The life subgroup method would not create opportunities to achieve a more desirable foreign tax credit result, and therefore would address the concern expressed by Congress in enacting section 864(e)(6).

In enacting section 864(e)(6), Congress expressed concern that the then existing rules, which permitted deductions to be allocated on a separate corporation basis, “have been manipulated, in some cases, to overstate foreign source income.” This is similar to the concern expressed in the preamble to the proposed regulations, which states that the separate entity method “may create opportunities for consolidated groups to use intercompany transactions to shift their section 818(f) expenses and achieve a more desirable foreign tax credit result.”⁷

Under the separate entity method of allocating section 818(f) deductions, a life insurance group, on an annual basis, would be provided the opportunity to reduce the amount of reserve expenses allocated to foreign source income and thereby increase its usable foreign tax credits through reinsurance transactions within the group which have the effect of moving reserves from one life insurance corporation to another life insurance corporation. For example, under the separate entity approach, a life insurance group would have the opportunity to shift section 818(f) deductions from one life company affiliate with significant foreign source income to another life company affiliate with predominantly U.S. source income.

Thus, under the separate entity method, the allocation of section 818(f) deductions for purposes of the foreign tax credit — and hence the amount of allowable foreign tax credit itself for the group — would vary depending not upon the nature of the group's business, but whether that same business was conducted through one, two, three or four life insurance companies and the amount of intra-group transactions between and among the affiliated life insurance corporations. As previously discussed, this would be true whether the taxpayer was, in the words of the preamble, seeking to “shift [its] section 818(f) expenses and achieve a more desirable foreign tax credit result” or whether the taxpayer was simply undertaking routine intra-group activities which are part of the everyday operations of a life insurance group.

We see no reason why the allocation of section 818(f) deductions should be different solely because a life insurance business is operated through multiple corporations rather than one corporation. Furthermore, under the life subgroup method, the possibility of any tax planning use of reinsurance would be eliminated as the allocation of section 818(f) expenses would depend on the business of the life insurance subgroup as a whole and would not vary depending on the amount of transactions within the group or the number of corporations in the group.

D. The most effective anti-abuse rule is to adopt the life subgroup method. Any attempt to maintain the separate entity method backstopped by an anti-abuse rule would be difficult for taxpayers and the IRS to administer. An anti-abuse rule would cause uncertainty to taxpayers and the IRS alike because of the facts and circumstances nature of its application.

In the preamble to the recently proposed foreign tax credit regulations, the Treasury Department and the IRS announced that they were concerned that the separate entity method of allocating section 818(f) expenses for purposes of the foreign tax credit limitation

may create opportunities for consolidated groups to use intercompany transactions to shift section 818(f) expenses and achieve a more desirable foreign tax credit result.⁸

Accordingly, the Treasury Department and the IRS also requested comments on

whether an anti-abuse rule may be appropriate to address concerns with the separate entity approach. . . .⁹

1. The most effective anti-abuse rule would be to adopt the life subgroup method.

We acknowledge that it is inadequate to say that an anti-abuse rule is not needed because each life insurance corporation is subject to local regulation that limits its activities. The focus of local regulation is on whether the corporation satisfies minimum requirements. Life insurance companies that are part of a major multi-corporation life insurance group engaged in the life insurance business inside and outside of the United States generally have assets that are substantially in excess of the statutory minimums and these groups are readily able to engage in intra-group transactions without violating local regulatory provisions.

However, as previously discussed, under the life subgroup approach, neither reinsurance transactions within the life subgroup nor any other movement of assets and liabilities within the group would affect the allocation of section 818(f) deductions. Consequently, the life subgroup method assures that intercompany transactions could not shift section 818(f) expenses to increase the foreign tax credit limitation. In addition, as previously discussed, the life subgroup method is consistent with the language and legislative histories of sections 818(f) and 864(e)(6), and the § 1.861-14 regulations, of which proposed regulation § 1.861-14(h) would become part, are intended to implement section 864(e)(6).

2. Any attempt to maintain the separate entity method backstopped by an anti-abuse rule would be difficult for taxpayers and the IRS to administer. An anti-abuse rule would cause uncertainty to taxpayers and the IRS alike because of the facts and circumstances nature of its application.

We are concerned that if the separate entity method is adopted, an anti-abuse rule would necessarily involve the consideration of facts and circumstances and cause uncertainty to both taxpayers and the IRS. Adoption of a facts and circumstances test in an anti-abuse rule would be contrary to the statement in the preamble rejecting a facts and circumstances approach for the general rule because it would create substantial uncertainty and be difficult to administer.

Uncertainty is the enemy of both taxpayers and the IRS. In the preamble to the proposed regulations, the Treasury and the IRS state that they are aware of at least five potential methods for allocating section 818(f) deductions.¹⁰ We know that, in the past, life insurance companies have taken at least that many positions in allocating section 818(f) deductions. We are also aware of situations in which the IRS has taken inconsistent positions. In one situation, the IRS claimed that a taxpayer using the separate entity method must use the life subgroup method; but, in another situation, the IRS claimed that a taxpayer using the life subgroup method must use the separate entity method.

Section 818(f) was enacted in 1984 and section 864(e)(6) was enacted in 1986. Taxpayers have waited for a long time for a clear rule as to how to allocate section 818(f) for consolidated groups. It would be most unfortunate if, after all these years, the adopted rule itself created uncertainty because the general rule was dependent upon an anti-abuse provision. In such a case there may be no uncertainty as to the general rule to apply; but the application of the anti-abuse rule would inherently depend on facts and circumstances and cause uncertainty for both the IRS and taxpayers. This uncertainty could become quite significant because the very type of transactions which occur on a regular basis for valid business reasons — for example, reinsurance within the group — are the same type of transactions that affect the allocation of section 818(f) deductions and could, thereby, increase the foreign tax credit limitation.

In contrast, if the life subgroup method were adopted, these types of intercompany transactions would not affect the allocation of section 818(f) deductions and, after all of these years, the IRS and taxpayers would have a clear rule for the allocation of section 818(f) that could be readily applied.

E. The assertion in the preamble concerning section 818(f) expenses and the separate entity method is not persuasive.

As previously discussed, the life subgroup method is consistent with the language and legislative histories of sections 818(f) and 864(e)(6). In enacting Section 818(f), Congress intended to require that section 818(f) deductions be allocated ratably across all gross income regardless of whether the gross income is premium income or investment income or whether it is gross U.S. income or gross foreign income. Allocating life insurance reserve and other section 818(f) deductions ratably across all income of the subgroup would be most consistent with that intent. In contrast, as previously discussed, allocating section 818(f) deductions using the separate entity method would likely result in the deductions not being allocated ratably across all the gross income of the subgroup and thereby frustrate the Congressional intent in enacting section 818(f).

It has been stated that the separate entity method “is consistent with the Code because section 818(f) expenses generally are computed on a separate company basis and relate to the liabilities of a specific life insurance company.”¹¹ However, it is a fundamental principle of income tax law that a corporation can only deduct expenses related to its specific trade or business, and, in this regard, section 818(f) expenses are not different from other expenses. See, e.g., Columbian Rope Company v. Commissioner, 42 T.C. 200 (1964) (in which the taxpayer paid the salaries of its executives and the executives of its foreign subsidiary; it was held that only payments of the salaries for its executives were deductible because the executives of the subsidiary were employed by another entity and “where a taxpayer undertakes to pay the obligations of another taxpayer, such payments are not deductible as ordinary and necessary expenses incurred in the payor's trade or business.”).

The fact that a taxpayer can claim section 818(f) deductions only with respect to its liabilities and reserves is consistent with this well-established principle. But that does not mean that the general rule of section 864(e)(6), which requires that expenses be allocated on a group basis, cannot work in tandem with this principle. Otherwise, the result would be that section 864(e)(6) would be a nullity and no deductions could be allocated on a group basis under section 864(e)(6) because all deductions, by their very nature, must relate to the trade or business or assets or liabilities of the corporation claiming them. Yet, as previously discussed, in enacting section 864(e)(6), Congress was concerned that the old rules, which permitted deductions to be allocated on a separate corporation basis, allowed taxpayers, in some cases, “to overstate foreign income” and, at the same time, provided “traps for the unwary.”¹²

It is important to keep in mind that the liabilities associated with issuing life insurance policies and the corresponding reserve amounts are often effectively moved from the issuing company to other members of the life insurance group. As previously discussed, major multi-corporation life insurance groups engaged in the life insurance business inside and outside of the United States manage their capital and risks on a group basis and often engage in intra-group reinsurance transactions for valid business reasons which result in the reserves and liabilities associated with insurance policies being effectively shifted between members of the life insurance group. These transactions do not affect the obligations to policyholders and under the life subgroup method they also would not affect the allocation of section 818(f) expenses. However, every such transaction would affect the allocation of section 818(f) expenses under the separate entity method.

F. The claimed consistency of the separate entity method with the treatment of certain reserves under § 1.1502-13(e)(2) is not a basis for narrowing the scope of section 864(e)(6).

1. What is the role of the § 1.1502-13 regulations?

The preamble to the proposed amendments to § 1.861-14 regarding allocation of expenses for foreign tax credit purposes in sales of life insurance to third party customers ignores section 864(e)(6) and instead points by analogy to regulations under § 1.1501-13 that are limited to internal transactions within the group. More specifically, the § 1.1502-13 regulations provide rules to take into account income, gain, and deductions from transactions between corporations that are members of the same consolidated group.¹³ Under these rules members are treated as separate entities for some purposes and as divisions of a single corporation for other purposes.¹⁴ The preamble to the proposed § 1.861-14 regulations points to two different situations under the § 1.1502-13 regulations as supporting separate entity treatment in the allocation of section 818(f) expenses for foreign tax credit purposes.

The first situation involves direct insurance transactions between members of the group and the regulations provide that in such cases the reserve deductions are calculated and the income from the transactions is determined on a separate entity basis.¹⁵ Although direct non-life insurance (e.g., property and casualty insurance) between members of the group is often significant in the context of captive non-life insurance companies, direct life insurance between members of the group is relatively insignificant. It is generally limited, for example, to cases in which the life insurance company member provides life insurance coverage for another member (generally a non-life insurance company) with respect to its employees.

The second situation is the case of intra-group reinsurance transactions. As the preamble notes, in such case the amount of the increase or decrease in the reserves of the two corporations are determined on a separate entity basis. However, while the amount of the reserve increase or decrease may be determined on a separate entity basis, the §1.1502-13 regulations go on to provide that income and deductions are taken into account as if the two members were divisions of a single corporation.¹⁶

What is important to keep in mind here is that the § 1.1502-13(e)(2) regulations simply establish the rules for determining the amount of reserve increases or decreases associated with intercompany insurance transactions. These intercompany transaction regulations do not shed any light on how reserve deductions with respect to life insurance contracts issued by life insurance company members of a life subgroup, especially contracts issued to customers, should be allocated for purposes of the foreign tax credit limitation.

2. What is the relevance of the treatment of certain reserves under § 1.1502-13(e)?

The question of how the amount of an expense is determined and the question of how that amount is allocated for purposes of the foreign tax credit limitation are two separate questions. Section 1.1502-13(e)(2) of the consolidated return intercompany transaction regulations provides that reserves and increases and decreases in reserves in intercompany transactions are determined on a separate corporation basis. When finalized, § 1.861-14(h) of the regulations will describe how those deductions and deductions resulting from third party insurance transactions are allocable for purposes of the foreign tax credit limitation. Each question — how the amount of the section 818(f) deduction is determined in the context of intercompany transactions and how that deduction is allocated for purposes of the foreign tax credit limitation — should be determined on its own merits.

The treatment of reserves and reserve increases and decreases on a separate corporation basis for purposes of the consolidated return intercompany transaction regulations was first proposed in 1994 (and finalized in 1995). The preamble to those proposed regulations explains the reasons for the rule as follows:

Reserve accounting is permitted only for special status members, and it is inappropriate to apply some aspects of reserve accounting on a single entity basis (e.g., where both parties to an intercompany transaction do not have the same special status). To the extent that reserve accounting should apply to intercompany transactions, the necessary adjustments to produce single entity results may be complex.¹⁷

The first sentence could, for example, apply to the direct life insurance situation or to the situation in which one member involved in a reinsurance transaction is a life insurance company for tax and regulatory purposes and the other member is not a life insurance company for tax purposes. This special status concern would not be an issue in allocating section 818(f) expenses among members of a life subgroup as all members would have the same status as life insurance companies for tax purposes.

Underlying the second sentence in the 1994 preamble is the fact that tax reserve accounts are generally based on book reserve accounts. If the tax reserve accounts were not adjusted on a separate entity basis as a result of reinsurance transactions within the group, there could be significant differences between tax and book reserves because for regulatory purposes the changes in reserves resulting from reinsurance transactions would be reported on a separate entity basis. These differences could lead to unnecessary additional complexities and difficulties in computing tax reserves which are based on book reserves.

Subsequently, in 2007, the IRS and Treasury further noted that, in adopting the separate entity approach for tax reserves in 1995 for purposes of the consolidated return intercompany transaction regulations, it was believed that such a rule “would not have substantial effect on consolidated taxable income.”¹⁸ Taking into account the concerns of the IRS and the Treasury relating to (i) transactions involving life insurance and non-life insurance companies and (ii) the complexities of computing reserves on a single entity basis in intercompany transactions, as well as the fact that in 1995 the Treasury and the IRS believed that computing reserves on a separate corporation basis would not have a substantial effect on consolidated taxable income, it is understandable why the Treasury and the IRS decided that reserves should be determined on a separate corporation basis for purposes of the consolidated group intercompany transaction rules.

In contrast, the consideration of these factors in the case of selecting the rule for the allocation of section 818(f) deductions leads to the opposite conclusion. Under the life subgroup method for allocating section 818(f) deductions, only life insurance companies are involved. Moreover, allocating section 818(f) deductions using a life subgroup method would be no more complex than using the separate entity method. Indeed, using a separate entity method which includes an anti-abuse rule could become substantially more complicated than using the life subgroup method which does not require an anti-abuse rule. In addition, whereas in 1995 the Treasury and the IRS believed that treating reserves on a separate corporation basis in the context of the § 1.1502-13 intercompany transaction regulations would not have a substantial income tax effect, the use of the separate entity method for allocating section 818(f) deductions could have significant tax effects, as evidenced by the concern of the Treasury and the IRS that the method “may create opportunities for consolidated groups to use intercompany transactions to shift their section 818(f) expenses and achieve a more desirable foreign tax credit result.”¹⁹

Moreover, there are additional factors in selecting the method for the allocation of section 818(f) deductions and those additional significant factors further support the selection of the life subgroup method. The life subgroup method does not present opportunities to achieve a more desirable foreign tax credit result and it accurately reflects (i) the relationship between section 818(f) expenses and the income producing activities of the life subgroup as a whole and (ii) the language and legislative histories of sections 818(f) and 864(e)(6). In fact, in enacting section 864(e)(6), Congress was concerned that the old rules which permitted deductions to be allocated on a separate corporation basis allowed taxpayers to overstate foreign source income; the same concern that the Treasury and the IRS expresses in the preamble concerning the adoption of the separate entity method for allocating section 818(f) deductions. There is simply no reason to reject the general rule of section 864(e)(6) in allocating section 818(f) expenses.

Finally, it is important to re-emphasize that the question of how § 1.1502-13(e)(2) treats reserves and increases and decreases in reserves for purposes of the consolidated return intercompany transaction regulations and the question of how section 818(f) expenses are allocated under section 864(e)(6) for purposes of the foreign tax credit limitation are separate questions. Each question should be determined on its own merits and, for the reasons discussed in this letter, the allocation of section 818(f) expenses for purposes of the foreign tax credit limitation should be made using the life subgroup method.

G. A one-time simplification election should be available if the separate entity method is adopted in the final regulations.

If the Treasury Department and IRS were, nonetheless, to finalize regulations adopting the separate entity method, we request that the final regulations provide consolidated groups with an irrevocable, one-time election to allocate section 818(f) deductions using the life subgroup method. A life subgroup method would be a simplified method under which the group would not need to track every routine intra-group transaction to determine how that transfer of assets or liabilities or reinsurance within the group impacts the group's allowable foreign tax credit.

If you have any questions or would like to discuss these comments further, please contact me at (706) 763-2677 or DTrsic@aflac.com.

Respectfully submitted,

Dan Trsic
Vice President-Director of Tax
Aflac Incorporated
Columbia, GA

Cc:
David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury

Lafayette “Chip” G. Harter III
Deputy Assistant Secretary (International Tax Affairs)
Department of the Treasury

Wade Sutton
Deputy International Tax Counsel
Department of the Treasury

Jason Yen
Attorney-Advisor, Office of International Tax Counsel
Department of the Treasury

Brett York
Attorney-Advisor, Office of Tax Legislative Counsel
Department of the Treasury

Angela Walitt
Attorney-Advisor, Office of Tax Policy
Department of the Treasury

Colin Campbell
Attorney-Advisor, Office of Tax Policy
Department of the Treasury

Michael J. Desmond
Chief Counsel
Internal Revenue Service

Peter H. Blessing
Associate Chief Counsel (International)
Internal Revenue Service

Barbara Felker
Branch Chief, Office of Associate Chief Counsel (International)
Internal Revenue Service

Jeffrey P. Cowan
Attorney-Advisor, Office of Associate Chief Counsel (International)
Internal Revenue Service

Je Y. Baik
Senior Technician Reviewer, Office of Associate Chief Counsel (International)
Internal Revenue Service

Steven Jensen
Senior Counsel, Office of Associate Chief Counsel (International)
Internal Revenue Service

Josephine H. Firehock
Attorney-Advisor, Office of Associate Chief Counsel (International)
Internal Revenue Service

Alexis MacIvor
Branch Chief, Office of Associate Chief Counsel (Financial Institutions & Products)
Internal Revenue Service

John Glover
Senior Counsel, Office of Associate Chief Counsel (Financial Institutions & Products)
Internal Revenue Service

Austin Diamond-Jones
Assistant to Branch Chief, Office of Associate Chief Counsel (Corporate)
Internal Revenue Service

Marie C. Milnes Vasquez
Special Counsel-Special Projects, Office of Associate Chief Counsel (Corporate)
Internal Revenue Service