FTC Regs Should Clarify Allocation of Insurance Reserves, Group Says

December 7, 2018

Honorable Charles P. Rettig
Commissioner of Internal Revenue
CC:PA:LPD:PR (REG-105600-18)
Courier's Desk
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20044

Re: REG-105600-18 — Proposed Foreign Tax Credit Regulations

Dear Commissioner Rettig:

In the preamble to the recently proposed foreign tax credit regulations, the Treasury and the IRS announced that they are reexamining existing approaches for allocating and apportioning expenses and requested comments with respect to specific revisions that should be made in connection with that review.

As you revise the foreign tax credit regulations, we ask that you include a provision to confirm that life insurance reserve expenses are allocated on a consolidated basis. In this regard, we note that in Notice 89-91, 1989-2 C.B. 408, the Internal Revenue Service announced that it intended to modify the section 1.861-14T regulations to explicitly provide that the expenses allocated under those regulations on a consolidated basis "include all expenses and deductions that are not definitely related to a particular class of income." Because Section 818(f)(1) of the Code provides that life insurance reserve expenses "cannot be definitely allocated to any item or class of gross income", such a modification of the section 1.861-14T regulations would confirm that life insurance reserve expenses should be allocated on a consolidated basis.

Attached is a detailed memorandum explaining why we believe life insurance reserve expenses are properly allocated on a consolidated basis. The memorandum also explains why, in the context of a life-nonlife group, these expenses are properly allocated on a full consolidated basis to all members of the group (and not solely the members of the life subgroup) if, were all members of the consolidated group treated as a single corporation, that corporation would constitute a life insurance company.

If you have any questions, please call me at (202) 637-5667.

Respectfully submitted,

H. Todd Miller
Hogan Lovells US LLP
Washington, DC

Enclosure

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

Douglas L. Poms
International Tax Counsel
Department of the Treasury

Lindsay Kitzinger
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

Marjorie A. Rollinson
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

Jeffery L. Parry
Attorney-Advisor, Office of Associate Chief Counsel (International)
Internal Revenue Service

Larry R. Pounders
Attorney-Advisor, Office of Associate Chief Counsel (International)
Internal Revenue Service

Suzanne M. Walsh
Attorney-Advisor, Office of Associate Chief Counsel (international)
Internal Revenue Service

Karen J. Cate
Attorney-Advisor, Office of Associate Chief Counsel (International)
Internal Revenue Service

Marie C. Milnes-Vasquez
Special Counsel — Special Projects
Internal Revenue Service

Kevin Jacobs
Senior Technician Reviewer, Office of Associate Chief Counsel (Corporate)
Internal Revenue Service

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

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 Allocation of Life Insurance Reserve Expenses for Purposes
of the Foreign Tax Credit Limitation

This memorandum considers the proper allocation of life insurance reserve expenses across a consolidated group that includes both life and nonlife members. It concludes that life insurance reserve expenses are properly allocated on a group basis and not on a separate corporation basis. It also concludes that, in the context of a life-nonlife consolidated group, these expenses are properly allocated on a full consolidated group basis to all members of the group (and not solely the members of the life subgroup) if, were all members of the consolidated group treated as a single corporation, that corporation would constitute a life insurance company. We respectfully request that the foreign tax credit expense allocation regulations include a provision confirming these points.

To assist in your review of these issues, this memorandum begins with an executive summary, which includes only a summary of the full analysis and largely omits citations. The discussion (which begins on page 3) contains our complete analysis, including relevant citations.

l. Executive Summary

A. Reserve Expenses Are Properly Allocated on a Group Basis and not on a Separate Corporation Basis

In determining whether life insurance reserve expenses are properly allocated on a group basis or a separate corporation basis, it is critical to consider Sections 818(f) and 864(e)(6), their legislative histories, and the regulations issued under Section 864(e)(6).

1. Section 818(f) and Its Legislative History — Allocation of Life Insurance Reserve Expenses Ratably Between U.S. Source Gross Income and Foreign Source Income

Section 818(f)(1) was enacted in 1984 and it provides that in applying Sections 861, 862, and 863 to a life insurance company, the deduction for life insurance reserves and certain other deductions "shall be treated as items which cannot definitely be allocated to an item or class of gross income." The legislative history of Section 818(f) reasons that these deductions "generally bear the same relationship to gross premium income that they bear to gross investment income" and that they "generally bear the same relationship to gross U.S. source income that they bear to gross foreign source income." The legislative history concludes that "[t]hese deductions should, therefore, generally reduce U.S. source gross income and foreign source gross income ratably in calculating the foreign tax credit limitation." The legislative history also provides that these deductions "will be allocated in this way regardless of the current residence of the decedents whose deaths caused the death benefit payments, the source of the premiums those decedents had paid the company in any year, the residence of the policyholders receiving or crediting dividends, or any other factor."

Section 818(f) does not specifically address the question of whether members of an affiliated group filing a consolidated Federal income tax return should allocate the deductions covered by Section 818(f) on a consolidated basis. However, in enacting Section 818(f), Congress intended to require that certain 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. Where members of an affiliated group that file a consolidated return conduct a life insurance business, allocating life reserve and other Section 818(f) expenses ratably across all income of the consolidated group would be most consistent with that intent. In contrast, making separate allocations of reserve and other Section 818(f) expenses for each member of the consolidated group could result in the expenses not being allocated ratably across all the gross income of the group.

2. Section 864(e)(6), Its Legislative History, and Treas. Reg. 1.861-14T — Expenses Not Directly Allocable to Particular Income Are Properly Allocated on a Group Basis

Section 864(e)(6) was enacted in 1986 and 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." Reserve 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 related to investment activities).

In enacting Section 864(e)(6), Congress was concerned that the existing rules, which permitted expenses that were not allocated or apportioned to any specific income producing activity 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." The legislative history further states that Congress did not believe that the approach of the then-current allocation rules "necessarily reflects economic reality" and 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."

Treas. Reg. § 1.861-14T implements the rules of Section 864(e)(6) and provides for the allocation of expenses on a group basis. Paragraph (a) of those regulations states that "[p]aragraph (h) of this section provides rules concerning the treatment of reserve expenses of a life insurance company," and paragraph (h) directs that reserve expenses be allocated under the § 1.861-14T regulations, i.e., on a group basis. Allocating the reserve expenses on a group basis is not only directed by Treas. Reg. § 1.861-14T(h), it is also consistent with the purposes of Sections 818(f) and 864(e)(6). Indeed, to allocate the remaining reserves on a separate corporation basis would frustrate the purposes of both sections. Allocating the reserve expenses on a group basis is also consistent with Notice 89-91 in which the Internal Revenue Service announced that it intended to modify the enumerated expenses in the § 1.861-14T regulations to include all expenses that are not definitely related to a particular source of income (and not just reserve expenses covered by § 1.861-14T(h)) in the list of expenses that are to be allocated on a group basis.

B. In a Life-Nonlife Consolidated Group, Life Insurance Reserve Expenses Are Properly Allocated to All Members of the Group if, Were All Members of the Group Treated as a Simile Corporation, that Corporation Would Constitute a Life Insurance Company

As described below, in the context of a life-nonlife consolidated group, life insurance reserves are properly allocated to all members of the group (and not solely members of the life subgroup) if, were all members of the consolidated group treated as a single corporation, that corporation would constitute a life insurance company. Treas. Reg. §1.861-14T(c)(1) provides the general rule that expenses are to be allocated as if all members of the affiliated group were a single corporation (except as provided in paragraph (c)(2)) and Treas. Reg. § 1.861-14T(d)(4) provides that, in the context on a life-nonlife consolidate group, a life insurance company is considered to be a member of the affiliated group.

Treas. Reg. § 1.861-14T(c)(2) provides that if an expense relates to the gross income of some but not all members of an affiliated group, that expense should be allocated only to those members of the affiliated group to which the expense relates. An expense is considered to be allocable to fewer than all members of the group if, were all members of the group treated as a single corporation, the expense would not be considered definitely related to gross income derived by all members of the group.

Section 818(f)(1) provides that life insurance reserve expenses "cannot be definitely related to an item or class of gross income" of a life insurance company and Treas. Reg. § 1.861-8(b)(5) provides that such expenses "shall ordinarily be treated as definitely related to all of the taxpayer's gross income." Consequently, if all members of the group are treated as a single corporation and that corporation qualifies as a life insurance company, the life insurance reserve expenses would be treated as definitely allocable to all of the gross income of that corporation and, under the § 1.861-14T regulations, would be allocated to all members of the life-nonlife consolidated group. On the other hand, if that deemed single corporation would not qualify as a life insurance company under Section 816, the life insurance reserve expenses, in accordance with Treas. Reg. § 1.861-14T(c)(2), should be allocated to all members of the affiliated group that individually qualify as a life insurance company within the meaning of Section 816.

* * *

We respectfully request that the foreign tax credit regulations include a provision confirming that (i) life insurance reserve expenses are properly allocated on a group basis and not on a separate corporation basis and (ii) in the context of a life-nonlife consolidated group, such expenses are properly allocated to all members of the group, if were all members of the group treated as a single corporation, that corporation would constitute a life insurance company.

II. Discussion

This discussion considers how life insurance reserve expenses should be allocated across a consolidated group that includes both life and nonlife members. Part A considers whether reserve expenses should be allocated on a group basis or a separate corporation basis. Part B then considers the question of how these expenses should be allocated on a full consolidated basis in the context of a life-nonlife consolidated group.

A. Reserve Expenses Are Properly Allocated on a Group Basis and Not on a Separate Corporation Basis

In determining whether life insurance reserve expenses should be allocated on a group basis or a separate corporation basis, it is critical to consider Sections 818(f) and 864(e)(6), their legislative histories, and the regulations issued under Section 864(e)(6).

1. Summary of Section 818(f) — Allocation of Life Insurance Reserve Expenses Ratably Between U.S. Source Gross Income and Foreign Source Income

• Section 818(f) requires that reserve expenses be treated as items that cannot definitely be allocated to an item or class of gross income.

• Enacted in 1984, Section 818(f)(1) provides that:

Under regulations¹, in applying sections 861, 862, and 863 to a life insurance company, the deduction for policyholder dividends (determined under section 808(c)), reserve adjustments under subsections (a) and (b) of section 807, 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. [Emphasis added.]

For purposes of this memorandum, the most important deduction covered by Section 818(f)(1) is the deduction for increases in reserves under Section 807(b).

2. Legislative History of Section 818(f)

• The legislative history of Section 818(f) shows that the purpose of Section 818(f) was to incentivize insurance companies to invest foreign reserves in U.S. securities. It did so by requiring that certain 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.

• What became Section 818(f)(1) was first proposed by Representatives Stark and Moore in 1983 and was described in a committee print as follows:

Under present law, different life insurance companies may have to calculate the foreign tax credit limitation on different bases. A company taxed on investment income may be able to credit otherwise creditable foreign income taxes imposed on underwriting income only if it generates sufficient foreign source investment income. This situation could encourage companies to invest abroad rather than in the United States.²

• Stated another way, foreign branches of U.S. insurance companies wanted to invest their foreign reserves in U.S. securities rather than foreign securities. However, U.S. securities produce U.S. source income. Without the foreign source income from investing their reserves in foreign securities, the foreign branches would have their foreign source income reduced and their foreign tax credits correspondingly limited. The income source rules could not be changed, but Section 818(f), by requiring that reserve expenses be allocated across all gross income, provided a proxy. It effectively permitted foreign reserve expenses to be allocated across U.S. and foreign source income, thereby preserving foreign source income and foreign tax credits for the foreign branches of U.S. insurance companies that invested in U.S. securities. In short, Section 818(f) encourages the investment of foreign reserves in U.S. securities.

• The Stark-Moore proposal was adopted by the Ways and Means Committee. The Ways and Means Committee Report describes the mechanics of computing the foreign tax credit limitation and the general rules relating to the allocation and apportionment of expenses under Treas. Reg. § 1.861-8.³ The Report then explains that:

Elimination of the present law three-phase system [of taxing life insurance companies] presupposes that gross premium income and gross investment income contribute in similar ways to total income. 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.

• The Report describes the general rule of Section 818(f) as follows:

Under its general rule, the bill provides that in calculating U.S. source income and foreign source income, three items will be treated under regulations as items which cannot definitely be allocated to an item or class of gross income.

• The Report then provides a detailed example involving the allocation of the three items (relating to policyholder dividend deductions, reserve deductions, and death benefit deductions) ratably across all gross income and further states:

Under the bill's general rule, these items will be allocated in this way regardless of the current residence of the decedents whose death caused the death benefit payments, the source of the premiums those decedents had paid the company in any year, the residence of the policyholders receiving or crediting dividends, or any other factor.

• The Report recognizes that the general rule of the bill was a bright line rule that produced winners and losers and it provides:

In some cases, the bill's general rule could be inequitable in its application to companies that can easily identify gross income to which these expenses relate. Therefore, taxpayers will be able to elect to treat the expenses that are the subject of the general rule of the bill as properly apportioned or allocated among items of gross income in a manner and to the extent prescribed in regulations.

• As enacted, the bill required that any such election be made by September 15, 1985. This memorandum does not discuss the allocation of Section 818(f) expenses for taxpayers who timely made that election.

• Section 818(f) does not specifically address the question of whether members of an affiliated group filing a consolidated Federal income tax return should allocate the deductions covered by Section 818(f) as if all members of the group were a single taxpayer or on a separate corporation basis. However, in enacting Section 818(f), Congress intended to require that certain 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. Where members of a consolidated group conduct a life insurance business, allocating life reserve and other Section 818(f) expenses ratably across all income of the consolidated group would be most consistent with that intent. In contrast, making separate allocations of reserve and other Section 818(f) expenses for each member of the consolidated group could result in the expenses not being allocated ratably across all the gross income of the group and therefore frustrate Congressional intent.

3. Summary of Section 864(e)(6) — Expenses Not Directly Allocable to Particular Income Are to be Allocated on a Group Basis

• Section 864(e)(6) was enacted in 1986 and 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."

• Section 864(e)(5) defines "affiliated group" to include a section 1504 affiliated group whether or not it elects to file a consolidated return. The section also includes a foreign corporation as a member of the affiliated group if (i) more than 50% of the foreign corporation's gross income is effectively connected with the conduct of a trade or business within the United States and (ii) at least 80% of either the vote or value of the outstanding stock of the corporation is owned by members of the affiliated group. This memorandum focuses on the proper allocation of life insurance reserve expenses in the context of a life-nonlife affiliated group which elects to file a consolidated return.⁴

• Section 864(e)(7) authorizes the Secretary to issue regulations as may be appropriate to carry out the purposes of Section 864(e).

4. Legislative History of 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."⁵ 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."⁶ 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."⁷

• Reserve 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, in the absence of regulations to the contrary, reserve expenses are required to be allocated as if all members of the affiliated group were a single corporation.

5. Regulations under Section 864(e)(6): Regulation § 1.861-14T

• In 1988, temporary regulations were issued under Section 864(e) providing the extent to which expenses, other than interest, are to be allocated as if the members of the affiliated group were a single corporation. See Treas. Reg. § 1.861-14T.

• Treas. Reg. § 1.861-14T(a) states:

Section 1.861-11T provides special rules for allocating and apportioning interest expense of an affiliated group of corporations. The rules of this § 1.861-14T also relate to affiliated groups of corporations and implement section 864(e)(6) which requires affiliated group allocation and apportionment of expenses other than interest which are not directly allocable and apportionable to any specific income producing activity or property.

• Treas. Reg. § 1.861-14T(a) further provides:

Paragraph (b) of this section describes the scope of the application of the rule for the allocation and apportionment of such expenses of affiliated groups of corporations. Such rule is then set forth in paragraph (c) of this section. . . . Paragraph (e) of this section describes the expenses subject to allocation and apportionment under this section.

• Treas. Reg. § 1.861-14T(a) also provides:

Paragraph (h) of this section provides rules concerning the treatment of the reserve expenses of life insurance companies.

• Section 1.861-14T(h) of the regulations, in turn, provides:

Special rule for the allocation of reserve expenses of a life insurance company. — An amount of reserve expenses of a life insurance company equal to the dividends received deduction that is disallowed because it is attributable to the policyholders share of dividends received shall be treated as definitely related to such dividends. The remaining reserve expenses of such company shall be allocated and apportioned under § 1.861-8 and this section.

• The first sentence of Treas. Reg. § 1.861-14T(h) provides a special rule related to reserve expenses and the denial of the dividends received deduction attributable to the policyholders' share of dividends received. It is an example of the type of exception to allocating expenses on a group basis that was contemplated by the 1986 Conference Report when it stated: "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."

• Under the second sentence of Treas. Reg. § 1.861-14T(h), the remaining reserve expenses are allocated under the rules of Treas. Reg. §1.861-8 and Treas. Reg. § 1.861-14T.⁸ These remaining reserves are what this memorandum is referring to when it discusses the allocation of life insurance reserves.

• Treas. Reg. § 1.861-8(b)(1) sets forth the general rules concerning the allocation of deductions:

For purposes of this section, the gross income to which a specific deduction is definitely related is referred to as a "class of gross income" and may consist of one or more items of gross income. The rules emphasize the factual relationship between the deduction and the class of gross income. . . . Although most deductions will be definitely related to some class of a taxpayer's total gross income, some deductions are related to all gross income. In addition, some deductions are treated as not definitely related to any gross income and are ratably apportioned to all gross income. [Emphasis added.]

If a deduction does not bear a definite relationship to a class of gross of income constituting less than all of the gross income, it shall ordinarily be treated as definitely related to all of the taxpayer's gross income . . .⁹

• Thus, under Treas. Reg. § 1.861-8(b)(1) "deductions that are treated as not definitely related to any income," including the remaining reserve expenses which, by statute, "cannot be allocated to an item or class of gross income," are "ratably apportioned to all gross income." Treas. Reg. § 1.861-14T(h) provides not only that the remaining reserve expenses shall be allocated under the 1.861-8 regulations, but also that they shall be allocated under Treas. Reg. § 1.861-14T. In essence, the § 1.861-14T(h) regulation directs that reserve expenses be allocated under the § 1.861-14T regulations just as the expenses specifically enumerated in Treas. Reg. § 1.861-14T(e)(1) are allocated — on a group basis.

• In this regard, we note that the expenses specifically enumerated in § 1.861-14T(e)(1) include "expenses related to certain supportive functions, research and experimental expenses, stewardship expenses and legal and accounting expenses."¹⁰ Just as Treas. Reg. § 1.861-8(b)(5) provides that expenses such as life insurance reserve expenses "generally are not related to any gross income and are ratably apportioned to all gross income," Treas. Reg. § 1.861-8(b)(3) provides that supportive expenses are generally allocated to all gross income.

• Following the issuance of the § 1.861-14T regulations, the Service issued Notice 89-91, 1989-2 C.B. 408, "to provide taxpayers with information concerning the Service's intention to change, clarify and correct various provisions" of the temporary regulations. Paragraph 11 of that Notice states:

Section 1.861-14T(e) enumerates the expenses that are to be allocated and apportioned under the rules of 1.861-14T. The Service intends to modify 1.861-14T(e) to include all expenses and deductions that are not definitely related to a particular class of income.

• As previously discussed, the remaining reserve expenses "cannot definitely be allocated to an item or class of gross income,"¹¹ and, pursuant to the directive in the § 1.861-14T(h) regulations, these expenses are allocated on a group basis. Notice 89-91 announced the Service's intention to modify the enumerated expenses in the § 1.861-14T(e) regulations to include all expenses that are not definitely related to a particular source of income (and not just reserve expenses covered by § 1.861-14T(h)) in the list of expenses that are to be allocated on a group basis.

6. Conclusion

• Allocating the remaining reserve expenses on a group basis as provided for by Treas. Reg. § 1.861-14T(h) is consistent with the purposes of Sections 818(f) and 864(e)(6). Indeed, to allocate the remaining reserves on a separate corporation basis would frustrate the purposes of both Sections.

• As described in detail above, the purpose of Section 818(f) is to require that certain 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. Before the enactment of Section 818(f), the expenses of a foreign branch of a U.S. insurance company were allocated between investment and underwriting activities. Investment expenses generally were allocated to the source of investment income and claim adjustment expenses and contract issuance and maintenance expenses were allocated to the source of premium income. For the three items covered in Section 818(f) (including reserve expenses), there were problems because they were funded by both investment and premium income.

• Although expenses are typically allocated to sources of income, the IRS had argued, for example, that these expenses needed to be allocated to foreign insurance activities because the claims were paid to foreign policyholders. This created distortion where the source of investment income and premium income was different. Section 818(f) was designed to solve these problems and to preclude any argument that, for example, reserve deductions related to specific activities. As stated by the Ways and Means Committee, in describing the general rule of Section 818(f): "Under the bill's general rule, these items will be allocated in this way regardless of the current residence of the decedents whose death caused the death benefit payments, the source of the premiums those decedents had paid the company in any year, the residence of the policyholders receiving or crediting dividends, or any other factor."¹²

• The purpose of Section 818(f) could be frustrated (and the bright line test of Section 818(f) avoided) if the reserve expenses were allocated on a separate corporation basis and taxpayers could establish separate corporations and, for example, invest in foreign securities in one corporation and invest in domestic securities in another corporation.

• Similarly, in enacting Section 864(e)(6), Congress expressed a clear preference for allocating expenses on a group basis. As discussed earlier, 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."¹³ In addition, Congress did not believe that the approach of those 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."¹⁴

• As stated in the 1986 Conference Report relating to Section 864(e)(6):

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.¹⁵

• For all the reasons discussed, we strongly believe that the remaining life insurance reserve expenses should be allocated on a group basis and not on a separate corporation basis.

B. In a Life-Nonlife Consolidated Group, Life Insurance Reserve Expenses Are Properly Allocated to All Members of the Group if, Were All Members of the Group Treated as a Single Corporation, that Corporation Would Constitute a Life Insurance Company

• For the reasons explained below, life insurance reserve expenses, in the context of a life-nonlife consolidated group, are properly allocated on a full consolidated group basis to all members of the group (and not only life members of the group) if, were all members of the consolidated group treated as a single corporation, that corporation would constitute a life insurance company. Treas. Reg. §1.861-14T(c)(1) provides the general rule that expenses are to be allocated as if all members of the group were a single corporation except as provided in paragraph (c)(2). Under paragraph (c)(2), if an expense relates to the gross income of some but not all members of an affiliated group within the meaning of Treas. Reg. § 1.861-14T(e)(1)(ii), that expense should be allocated only to those members of the affiliated group.

• Under Treas. Reg. § 1.861-14T(e)(1)(ii), an expense is considered to be allocable to fewer than all members of the group

if, were all members of the affiliated group treated as a single corporation, the expense would not be considered definitely related within the meaning of § 1.861-8T(b)(2) to gross income derived by all members of the group. In such a case, the expense shall be considered allocable, for purposes of paragraph (c)(2) of this section, to gross income of those members of the group that generated (or could reasonably be expected to generate) the gross income to which the expense would be definitely related if the group were treated as a single corporation.

Paragraph 17 of Notice 89-91 provides that the reference to "§ 1.861-8T(b)(2)" should be changed to "§ 1.861-8(b)(2)."

• Treas. Reg. § 1.861-8(b)(2) provides that:

A deduction shall be considered definitely related to a class of gross income and therefore allocable to such class if it is incurred as a result of, or incident to, an activity or in connection with property from which such class of income is derived.

• If treating all members of the affiliated group as a single corporation under Treas. Reg. § 1.861-14T(e)(1)(ii) results in a single corporation that qualifies as a life insurance company, Treas. Reg. § 1.861-8(b)(2) cannot serve as a basis for concluding that life insurance reserve expenses are not allocable on a full consolidated group basis and are, instead, allocable to fewer than all of the members of the group.

• Treas. Reg. § 1.861-8(b)(1) provides that deductions are generally definitely related to a class of gross income and Treas. Reg. § 1.861-8(b)(2) provides an activity or property test for determining the specific class of gross income to which such deductions are related.

• Treas. Reg. § 1.861-8(b)(1) further provides that "some deductions are treated as not definitely related to any gross income" and Treas. Reg. § 1.861-8(b)(5) generally provides that such deductions are "definitely related and allocable to all of the taxpayers gross income." Treas. Reg. § 1.861-8(b)(2) is inapplicable to these deductions because they are not definitely related to a class of the taxpayers gross income and there is no need to apply the test for determining the specific class of income to which the deduction relates.

• Life insurance reserve deductions are not related to any class of gross income and are the type of deduction to which Treas. Reg. § 1.861-8(b)(2) simply does not apply. In this regard, Section 818(f)(1) provides that life insurance reserve expenses "cannot be definitely related to an item or class of gross income." Similarly, the legislative history of that section, after stating the rule that life insurance reserves "cannot be allocated to an item or class of gross income", states:

Under the bill's general rule, these items will be allocated in this way regardless of the current residence of the decedents whose death caused the death benefit payments, the source of the premiums those decedents had paid the company in any year, the residence of the policyholders receiving or crediting dividends, or any other factor.¹⁷

• Simply stated, Treas. Reg. § 1.861-8(b)(2) cannot treat the life insurance reserves of a life insurance company as being definitely related to a class of gross income and overrule the statutory mandate that life insurance reserves of a life insurance company "cannot be definitely related to any item or class of gross income" and must be allocated across all of the gross income of the life insurance company.

• In summary, to determine whether life reserve expenses relate to all members of the group, Treas. Reg. § 1.861-14T(e)(1)(ii) requires that all members of the group be treated as a single corporation. If that single corporation would qualify as a life insurance company under Section 816, Section 818(f) and the rules of Treas. Reg. § 1.861-8 provide that the expenses are definitely related to all of the taxpayers gross income. Because the reserve expenses would relate to all of the taxpayers gross income, the expenses would not relate to fewer than all members and they are allocable on a full consolidated group basis to all members of the group.

• On the other hand, if that deemed single corporation would not qualify as a life insurance company under Section 816, the life insurance reserve expenses, in accordance with Treas. Reg. § 1.861-14T(c)(2), should be allocated to all members of the affiliated group that individually qualify as a life insurance company within the meaning of Section 816.¹⁸

• For sake of completeness, it should be noted that Treas. Reg. § 1.1502-47, entitled "Consolidated returns by life-nonlife members", does not discuss the allocation of expenses for the purposes of the foreign tax credit limitation and has no application to our question. When the § 1.1502-47 regulations do not address an issue, the rules otherwise applicable to other consolidated groups are to be applied. See Treas. Reg. § 1.1502-47(r); State Farm Mut. Auto. Ins. Co. v. Commissioner, 130 T.C. 263, 270-271 (2008). As previously discussed, under Treas. Reg. § 1.861-14T, which is generally applicable to affiliated groups, life insurance reserve expenses are generally allocated to all members of the group as if all members of the group were a single corporation.

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• We would, of course, be happy to discuss any points covered in this memorandum with you at your convenience.

H. Todd Miller
Partner
Hogan Lovells US LLP
Columbia Square
555 Thirteenth Street, NW
Washington, DC 20004
T 202 637 5667
F 202 617 5910
todd.miller@hoganlovells.com