Insurance Group Finds Room for Improvement in Proposed FTC Regs

Comments to 2020 Proposed Regulations Regarding the Definitions of Financial Services Group, Financial Services Entity and Financial Services Income as they Apply to Insurance Companies

February 9, 2021

Internal Revenue Service
CC:PA:LPD:PR (REG-101657-20)
Courier's Desk
1111 Constitution Avenue, N.W.
Washington, DC 20224

I. Introduction and Summary

On November 12, 2020, the United States Department of the Treasury (the “Treasury”) and the Internal Revenue Service (the “IRS”) published proposed foreign tax credit (“ FTC”) regulations, including new proposed regulations under section 904¹ relating to the definitions of financial services entity, financial services group and financial services income. As insurance companies taxed under part I of Subchapter L (life insurance companies) and under part II of Subchapter L (non-life insurance companies) with extensive operations in the United States and globally, we² appreciate the opportunity to submit these comments on the Proposed Regulations and we look forward to working with Treasury and the IRS to ensure that final regulations accurately and sufficiently define a financial services group to include insurance businesses, insurance companies, and income in a manner that is consistent with the statutory language and Congressional intent.

We are grateful for the responsiveness Treasury and the IRS have shown to comment letters submitted regarding 2019 proposed regulations that addressed the definition of a financial services entity for purposes of section 904 by issuing these new revised proposed regulations (REG-101657-20)³ (the “2020 Proposed Regulations”) that retain the general approach of the existing Treas. Reg. § 1.904-4(e) final regulations and the list of income that qualifies as active financing income. We believe the 2020 Proposed Regulations are more aligned with the original intent and purposes of the financial services basket as well as more closely reflect the present law interpretation of what it means to be a “person predominantly engaged in the active conduct of a banking, insurance, financing, or similar business.”

In response to Treasury's and the IRS's request in the preamble to the 2020 Proposed Regulations for comments addressing whether certain related party payments should be taken into account and treated as active financing income for purposes of Prop. Reg. §1.904-4(e)(2) and (3) as well as the new limitations on the amount of an insurance company's investment income that may be treated as active financing income, we are submitting the comments in this letter for consideration. Our comments generally center around Prop. Reg. §1.904-4(e)(2)'s definition of active financing income when determining whether an insurance company and its affiliates may constitute a financial services entity (“FSE”) or a financial services group (“FSG”) within the meaning of Prop. Reg. §1.904-4(e)(3). More particularly, however, this letter focuses on the general definition of gross income as applied to a life insurance company or a non-life insurance company and the following two significant limitations that will prevent certain income earned in an active insurance business from potentially qualifying as active financing income for purposes of the 2020 Proposed Regulations' 70-percent test (as defined below) —

• the narrow exception to the types of related party transactions that will give rise to active financing income for purposes of determining whether an entity is a financial services entity;⁴ and

• the proposed thresholds for when investment income earned by an insurance company will no longer be considered ordinary and necessary to the proper conduct of a company's active insurance business.⁵

II. Background

The following discussion and recommendations are submitted with an understanding regarding a common current day operational structure in which a global insurance business is conducted. To be competitive in today's marketplace, insurance companies must provide various insurance-related services to their customers, including insurance underwriter services, insurance brokerage or agency services, and loss adjuster and surveyor services. However, regulatory, or other legal, restrictions in the jurisdiction in which the company operates may prevent a corporation taxable under Subchapter L (or that would be taxable under Subchapter L if the corporation was treated as a domestic corporation for purposes of the Code) (each a “Subchapter L Corporation”) from providing all of such services directly through its own employees.⁶ In such situations, the required services generally are provided by persons related (within the meaning of either section 267(b) or section 707) to the customer facing corporation. Furthermore, global insurance groups regularly organize their insurance related operations along functional lines to efficiently manage their internal resources and expertise. For example, a group may organize its high-end underwriting and investment support functions in a particular company to increase global management of business and investment risks; while, at the same time, pooling the support service resources in a particular company/jurisdiction to mitigate local country tax and/or labor considerations and increase cost efficiencies on global scale. Importantly, the structuring of a global insurance business along these lines (“modern insurance business”) is driven by clear business, legal and regulatory factors and is not motivated by improper US tax considerations.

III. Gross Income for purposes of the 70-percent test

1. Prop. Reg. §1.904-4(e)(3)

The 2020 Proposed Regulations define the term “financial services entity” generally to include a domestic or foreign corporation that, either on a stand-alone basis or as a member of an affiliated group that constitutes a “financial services group,” “is predominantly engaged in the active conduct of a banking, insurance, financing, or similar business [(“active financing business”)] for any taxable year.”⁷ A corporation generally will be treated as predominantly engaged in the active financing business for any year if more than 70 percent (the “70-percent test”) of its gross income for that year is “active financing income” that is derived directly from transactions with persons that are not related (within the meaning of section 267(b) or section 707(b)(1)) unless expressly provided otherwise.⁸

As relevant for purposes of this letter, Prop. Reg. §1.904-4(e)(2)(i) defines “active financing income” to include:

• Regularly making personal, mortgage, industrial, or other loans to customers in the ordinary course of the corporation's trade or business;⁹

• Investments by an insurance company of its unearned premiums or reserves ordinary and necessary to the proper conduct of the insurance business (“Investment Income”);¹⁰

• Activities generating income of a kind that would be insurance income as defined in section 953(a)(1) (including related person insurance income as defined in section 953(c)(2) and without regard to the exception in section 953(a)(2) for income that is exempt insurance income under section 953(e) (“RPII”)), but with respect to investment income includible in section 953(a)(1) insurance income, only to the extent ordinary and necessary to the proper conduct of the insurance business (“Section 953(a)(1) Income”);¹¹

• Providing services as an insurance underwriter, insurance brokerage or agency services, or loss adjuster and surveyor services;¹² and

• Providing financial or investment advisory services, investment management services, fiduciary services, or custodial services to customers.¹³

Income derived from related parties, other than RPII, generally is not taken into account as active financing income (for purposes of the numerator of the 70-percent test) but is taken into account as total gross income (for purposes of the denominator of the 70-percent test).¹⁴

A corporation that fails to qualify as a FSE under the entity-by-entity rule above (the “FSE test”) may still qualify as a FSE if such corporation is a member of a FSG. Under Prop. Reg. §1.904-4(e)(3)(ii), an affiliated group will be treated as a FSG if the group as a whole meets the 70-percent test with certain modifications (the “FSG test ”). More specifically, for purposes of determining the numerator and denominator of the 70-percent test fraction under the FSG test, only the income of group members that are domestic corporations or foreign corporations that are controlled foreign corporations (within the meaning of section 957 (each a “CFC”)) in which US members of the affiliated group own, directly or indirectly, at least 80 percent of the total voting power and value of the stock, is included.¹⁵ Additionally, the income of the group does not include any income from transactions with other members of the group for purposes of determining the numerator and denominator of the 70-percent test fraction under the FSG test.¹⁶

2. Recommendation — Clarify the Gross Income Definition

The “gross income” amount of a corporation taxable under Subchapter L is computationally different than the “gross income” amount that would otherwise normally be computed under the rules of Subchapter C. The 2020 Proposed Regulations, however, do not explicitly provide whether the Subchapter L definition of gross income (with or without modifications) should apply for purposes of applying the 70-percent test to a corporation (or group) taxable under Subchapter L (or that would be taxable under Subchapter L if the corporation was treated as a domestic corporation for purposes of the Code). A salient component of measuring a Subchapter L Corporation's gross income under the rules of Subchapter L is reducing the total premiums received by the company by the total premiums paid for reinsurance and return premiums.¹⁷ However, in the case of a non-life insurance company, the company's net premium amount is further reduced by certain payments for claims or losses incurred (“Section 832(b)(5) Adjustments”); whereas, in the case of a life insurance company, payments for claims or losses incurred are deductible pursuant to sections 805(a)(1).

The Section 832(b)(5) Adjustments consist of certain claims payments for losses incurred that are treated as reductions in gross income under section 832(b)(3), rather than deductions under section 832(c), and such amounts include certain liabilities that are not yet properly accruable — e.g., contested reported claims and claims arising during the taxable year but not yet reported.¹⁸ There does not appear to be any policy reason why claims payments of a non-life company should be treated differently from those of a life company for purposes of determining the gross income of a Subchapter L Corporation when applying the 70-percent test under the FSE test or the FSG test. If the Section 832(b)(5) Adjustments were eliminated in determining a non-life company's gross income for purposes of the FSE and FSG tests, the treatment of payments for claims and losses would be symmetrical for life and non-life insurance companies. Such treatment would be consistent with the approach taken in the recently finalized Base Erosion and Anti-Abuse Tax (“BEAT”) regulations under section 59A as well as the Subpart F regulations. The BEAT regulations embrace the concept that section 832(b)(5) adjustments economically are more akin to deductions from gross income rather than a reduction in the amount of gross income recognized by a non-life company.¹⁹ Similarly, under the Subpart F regulations, a non-life CFC's gross income is determined, in part, by adding back the Section 832(b)(5) Adjustments.²⁰ Thus, as a correlative and to be consistent with the BEAT and Subpart F regulations, we believe that, in the context of the FSE and FSG tests, it would be appropriate for the gross income (and, concomitantly, the active financing income) of a non-life company be determined without taking into account the Section 832(b)(5) Adjustments.

Accordingly, we urge Treasury and the IRS to consider modifying the FSE and FSG rules of Prop. Reg. §1.904-4(e)(3)(i) and (ii) to explicitly clarify that for purposes of the 70-percent test a Subchapter L Corporation's gross income amount should be determined in accordance with section 803 in the case of a life insurance company, and in the case of a non-life insurance company, in accordance with section 832(b) other than taking into account gross income reduction amounts under section 832(b)(5).

IV. Related Party Income Limitation

In the preamble to the 2020 Proposed Regulations, Treasury and the IRS asked taxpayers to submit comments “on the treatment of related party payments in the numerator and denominator of the 70-percent gross income test, and whether related party payments should in some cases constitute active financing income.” Our comments in this section are specifically in response to that request and give specific examples to help demonstrate why certain types of related party payments should be treated as active financing income and be taken into account in the numerator and denominator of the 70-percent test.

1. Section 953(a)(1) Income

Prop. Reg. §1.904-4(e)(2)(i)(W) re-proposes the current rule that income that is “of a kind that would be related person insurance income as defined by section 953(c)(2)” is active financing income for the purposes of the 70-percent test (the “Related Party Insurance Rule”).²¹ Related person insurance income is defined by section 953(c)(2) as any income attributable to a policy of insurance or reinsurance with respect to which “the person (directly or indirectly) insured is a United States shareholder in the foreign corporation or a related person to such a shareholder."²² A literal application of section 953(c)(2) under the Related Party Insurance Rule would result in income attributable to an insurance, reinsurance or annuity contract where the assuming corporation is not a CFC or the insured is not a US shareholder (or a person related thereto) with respect to the assuming foreign corporation not constituting active financing income for purposes of Prop. Reg. §1.904-4(e). Thus, we are requesting that Treasury and the IRS take this opportunity to clarify that the “of a kind” description in the Related Party Insurance Rule means income earned from persons that are related (within the meaning of section 267(b) or section 707) where such income is attributable to issuing (or reinsuring) an insurance or annuity contract and regardless of whether the related assuming corporation is domestic, foreign or a CFC and whether the related insured corporation is a US shareholder (or a person related thereto) with respect to a assuming corporation.

We note that our requested clarification would be consistent with the interpretation that Treasury and the IRS adopted in the recently proposed section 1297 regulations (which were finalized December 2020) with respect to section 1297(b)(1)'s definition of passive income as “any income which is of a kind which would be foreign personal holding company income as defined in section 954(c).”²³ In that case, the cross reference was referring to a list of types of income that are intended to be treated as passive income; and in this case, the cross-reference is to a list of transactions occurring between related parties that is intended to be treated as giving rise to active financing income. As such, we understand the Related Party Insurance Rule to be providing that all insurance premium income received by a Subchapter L Corporation (i.e., the income is attributable to writing insurance or reinsurance contract) is to be treated as active financing income for purposes of the 70-percent test.

It is also important to note that the determination of gross income under Subchapter L increases the significance of the requested clarification of the Related Party Insurance Rule due to the natural mechanical netting that takes place with respect to premiums earned and paid when determining gross income under section 803 or section 832. That is, because an insurance company's gross income is reduced by the amount of premiums it pays, that amount of income should not be taken into account in the numerator or denominator of the 70-percent test. Furthermore, if the reinsurer is a related domestic party and the Related Party Insurance Rule was narrowly interpreted, the premiums received from the related party reinsurance transaction would be taken into account for purposes of determining the reinsurer's gross income (the denominator of the 70-percent test fraction) but would not be treated as active financing income (the numerator of the 70-percent test fraction). This distortive effect on the 70-percent test fraction and resulting determinations of FSE or FSG (as discussed in more detail below) is highlighted in two simple mathematical examples in Appendix A attached hereto, which helps demonstrate this risk, i.e., converting true active financing income into non-active financing income whenever the corporation that writes the insurance (or reinsurance) contract or annuity contract in a transaction between persons that are related (within the meaning of section 267(b) or section 707) is a domestic corporation or a foreign corporation that is not a CFC.²⁴

Thus, we request that Treasury and the IRS clarify that the Related Party Insurance Rule will treat as active financing income for purposes of the FSE and FSG tests any income earned from persons that are related (within the meaning of section 267(b) or section 707)) where such income is attributable to issuing (or reinsuring) an insurance or annuity contract and regardless of whether the related assuming corporation is domestic, foreign or a CFC and whether the related insured corporation is a US shareholder (or a person related thereto) with respect to an assuming corporation. Furthermore, because the Related Party Insurance Rule effectively applies only in the context of the FSE test (as any income members realize from transactions with other members of an affiliated group is eliminated for purposes of the FSG test), we believe Prop. Reg. §1.904-4(e)(3)(ii) should be revised to allow the Related Party Insurance Rule to apply in the context of the FSG test.

Under the proposed FSG test, the numerator and denominator of the 70-percent test fraction for the affiliated group is computed only by taking into account the income of group members other than income members realize from transactions with other members of the group. As such, to prevent an income elimination problem from arising under the FSG test of Prop. Reg. §1.904-4(e)(3)(ii), the income of the group must include any related party insurance income that otherwise would be taken into account as active financing income under the Related Party Insurance Rule for purposes of determining both the numerator and denominator of the 70-percent test. Without such a rule, income that otherwise would constitute active financing income under the Related Party Insurance Rule is eliminated from the group's 70-percent test fraction because the premiums paid on the reinsurance transaction between members of an affiliated group are eliminated from the ceding company's gross income by application of section 803 or section 832 (as applicable) and is not included in the affiliated group's gross income in determining the numerator or denominator of the affiliated group's 70-percent test fraction. To illustrate this, please see example two in Appendix A. Thus, to effectuate the Related Party Insurance Rule consistently, we respectfully request that Treasury and the IRS modify Prop. Reg. §1.904-4(e)(3)(ii) to include any income that qualifies as active financing income under the Related Party Insurance Rule in the numerator and denominator of the FSG's 70-percent test fraction.

2. Related Party Insurance Services

Prop. Reg. §1.904-4(e)'s general prohibition on permitting any income (other than income within the Related Party Insurance Rule) as active financing income if such income is derived from transactions between related parties for purposes of applying the 70-percent test likely would prevent certain bona fide insurance companies from qualifying as a FSE either on a separate-entity basis or as a member of an affiliated group. This is because, as explained above, the modern insurance business model requires various insurance-related services (e.g., underwriter services, insurance brokerage or agency services, loss adjuster and surveyor services, etc.) that generally are provided by one or more related persons. For example, a corporation (X) may derive at least 30 percent of its gross income from providing various insurance related services (e.g., insurance brokerage, insurance agency, or loss adjustment insurance services as well as investment services) to persons that are related within the meaning of section 267(b) or section 707 and are not members of an affiliated group with X. In such a situation, X (the service provider) would fail to qualify as a FSE on a separate-entity basis even if the remaining income earned by X was of a type that would constitute active financing income. Similarly, if X was a member of an affiliated group, X's entire group could fail to qualify as a FSG if X's income from related party transactions with non-affiliated group members was significant enough to constitute at least 30 percent of the group's total gross income.²⁵

A common arrangement in the insurance market today is the “Lloyd's syndicate”. In this arrangement, taxpayers engage with Lloyd's of London (“Lloyd's”) to do business through a Lloyd's syndicate. Each syndicate is made up of one or more members, who may be individuals or corporations, and functions as an insurance company, assuming risks and paying claims. To participate in the syndicate, a member must abide by Lloyd's requirements and generally forms a corporate member and a managing agent. The corporate member is not permitted to have any employees, the managing agent must be a separate entity and the managing agent entity generally provides insurance-related services to the syndicate and corporate member. The coverholders, a company or partnership authorized by Lloyd's to enter into insurance contacts, in the Lloyd's structure also provide services to the underwriter. This operating structure is a requirement to be part of the Lloyd's marketplace. Under Lloyd's requirements, the only activities each participating member may conduct is that of an underwriter with no employees. As such, Lloyd's model requires insurance-related services to be provided by related parties separate from the underwriter insurance company. Excluding related party insurance services income in this context may penalize taxpayers for utilizing a Lloyd's structure that effectuates a genuine business purpose, resulting in a misalignment of tax policy, specifically the 70-percent test discussed herein, and business realities. Similarly, this issue arises in the context of premium financing companies where local regulations require elements of the integrated insurance business to be split into separate legal entities.

Accordingly, consideration should be given to creating a special income inclusion rule for purposes of the FSE and FSG test that would treat all insurance related income received from a related person (other than income already subject to the Related Party Insurance Rule) as active financing income for purposes of the 70-percent test provided such income would constitute active financing income if the transaction was between unrelated parties that are not members of the same affiliated group. The recognition of related party insurance transactions as an integral part of the modern insurance business would be consistent with the treatment afforded to such services and activities under the Subpart F²⁶ and passive foreign investment company (“PFIC”)²⁷ rules and further advance the creation of a more uniform set of rules determining the characterization of income derived from the operation of a bona fide modern insurance business.

V. Investment Asset Limitation

In the preamble to the 2020 Proposed Regulations, Treasury and the IRS requested Subchapter L taxpayers to submit comments on the novel investment income limitation rule that would be applicable to Subchapter L corporations when determining whether such corporations qualify under the FSE or FSG tests. Our comments in this section are specifically in response to that request, including addressing whether modifications could result in a more reasonable “applicable percentages” being selected if this new limitation is promulgated.

1. Prop. Reg. §1.904-4(e)(2)(ii)

Prop. Reg. §1.904-4(e)(2)(ii) limits the amount of an insurance company's Investment Income and Section 953(a)(1) Income earned in a taxable year that may be treated as active financing income for purposes of applying the 70-percent test under both the FSE and FSG tests. This new limitation (the “investment asset limitation”) will prevent an insurance company from treating its Investment Income and Section 953(a)(1) Income as active financing income to the extent such income exceeds an amount determined by multiplying the insurance company's otherwise passive category income by a fraction, in which the numerator is calculated based on a fixed “applicable percentage” multiplied by the company's “total insurance liabilities” and the denominator is the value of the company's passive category assets for that taxable year.²⁸

For purpose of determining the numerator of the investment asset limitation fraction:

• The applicable “applicable percentage” is —

  (1) 200 percent for a domestic corporation taxable under part I of Subchapter L of the Code or a foreign corporation that would be taxable under part I of Subchapter L if it were a domestic corporation; or

  (2) 400 percent for a domestic corporation taxable under part II of Subchapter L or a foreign corporation that would be taxable under part II of Subchapter L if it were a domestic corporation.²⁹

• The total insurance liabilities, in the case of a corporation taxable under part I of Subchapter L (including a foreign corporation that is treated as a domestic corporation for purposes of the Code by reason of making an election under a section 953(d) (a “Section 953(d) Company”) ), means the sum of the total reserves (as defined in section 816(c)) plus (to the extent not included in total reserves) the items referred to in paragraphs (3), (4), (5) and (6) of section 807(c); and, in the case of a corporation taxable under part II of Subchapter L (including a Section 953(d) Company), it means the sum of unearned premiums (determined under Reg §1.832-4(a)(8)) and unpaid losses. Total insurance liabilities for a controlled foreign corporation that would be taxable under Subchapter L if it were a domestic corporation means the reserve determined in accordance with section 953(b)(3), which states that reserves for insurance or annuity contracts are the same as determined under section 954(i).

2. Clarifications Requested

a. Abuse Targeted

The Code generally recognizes that an insurance company must hold passive investment assets to support its insurance obligations, as an ordinary and necessary part of operating an insurance business. The new proposed thresholds, however, seek to establish a bright-line test for when the income earned from such passive assets will be treated as active financing income for purposes of section 904, and potentially, as general limitation income for all purposes of the US foreign tax credit provisions.³⁰ It is unclear to us what may have prompted Treasury and the IRS to propose these new limitations or the perceived abusive situation that is being targeted by this new limitation. In fact, we have been unable to find any suggestion in prior guidance or legislative history that there is any concern that would require imposing a bright-line limitation on the amount of insurance company's passive income that may be treated as active for purposes of section 904.³¹

Although the proposed PFIC regulations would impose a bright-line limitation on the amount of income and assets that may be treated as active based on the tested company's insurance liabilities,³² the aim of those rules, and the purpose for which they classify assets and income as passive, are separate and distinct from the aims and purpose of the FTC regime and the 2020 Proposed Regulations. The PFIC rules look at the overall, macro nature of an entity, based on its activities, assets, and income, in determining whether the entity is, in essence, an entity that passively generates income. Contrast this with the FTC regime, which takes a micro approach in analyzing the various types of income earned by an entity to determine the appropriate category of such income for purposes of taking foreign tax credits against US tax liabilities. This analysis requires a careful parsing of each income type and how it is earned in order to appropriately classify the income, and thus, we believe a bright-line test may not be appropriate here.

The preamble to the 2020 Proposed Regulations states that these limitations “are appropriate in cases where an insurance company holds substantially more investment assets and earns substantially more passive investment income than necessary to support its insurance business.”³³ However, insurance regulators generally impose strict rules regarding the type and amount of investments that an insurance company operating in their jurisdictions may hold. In fact, it would not be unusual for a Subchapter L Corporation to hold significant passive assets in order to meet its regulatory and core business obligations (e.g., regulatory or other legal requirements, life cycle of the insurance business or current marketplace conditions). Holding high amounts of reserves, whether to meet regulatory requirements, business needs, to seek future approval for additional underwriting capacity, or for other reasons, is generally not seen as advantageous or desirable by insurance companies and is normally done because it is required. Where more reserves are held, that means less assets are liquid, transferable, or otherwise available for other purposes of the company or its wider group. Although this can result in higher deductions for tax purposes, freezing assets in the form of reserves solely for a “less-than-dollar-for-dollar” tax benefit is not a beneficial business practice. Additionally, if the investment asset limitation is intended to mitigate against an inappropriate cross-crediting opportunity that Treasury and the IRS have identified, we note that Congress historically has taken the approach of using the “predominantly engaged” standard for purposes of applying the section 904 provisions in the context of an insurance business due to practical difficulty of determining whether an insurance company's investment income is ordinary and necessary to the proper conduct of the insurance business.³⁴

Accordingly, we would like to understand the specific concern or fact pattern that led to proposing the investment asset limitation provision, the thinking behind establishing the applicable percentage for a life company at 200 percent and 400 percent for a non-life company, and the legislative authority or support for imposing this bright-line limitation on the amount of passive income that is considered, at least for purposes of section 904, as ordinary and proper in the conduct of an insurance business and regardless of any particular facts and circumstances that the company may be under (e.g., regulatory requirements, life-cycle of the business, market place demands). We also would like to understand the data used and basis for these limits, as the foreign tax credit rules are equally applicable to US and non-US insurance companies. Specifically, it would be helpful to understand what considerations were taken into account for business needs and regulatory regimes in foreign jurisdictions. Finally, basing the amount of invested assets of an insurance company on its reserves as opposed to capital standards in the market perpetuates an older method for analyzing insurance companies. While such standards may exist in the Code, the more appropriate method for evaluating an insurance company is based on capital and not just reported reserves.

b. Applicable Percentage

The 2020 Proposed Regulations would set the applicable percentage of the investment asset limitation at 200 percent for a life company, and for a non-life company at 400 percent. It would be helpful for us to understand the origins of these percentages since an insurance company's needs generally are based on various factors apart from whether the corporation is taxable under part I or part II of Subchapter L.³⁵ For example, an insurance company's capital needs will change according to the different lines of insurance business being conducted and the products written, the life cycle stage of a particular line of insurance business, current marketplace conditions and the regulatory and legal requirements in the jurisdictions in which the corporation operates or is organized. Furthermore, there are certain unique businesses conducted within the insurance industry that are more capital-intensive than other lines of insurance business — e.g., warranty insurance, financial guarantee insurance, surety, and mortgage guarantee insurance. Such capital-intensive lines of insurance generally require capital and reserves far in excess of 200 or 400 percent of total liabilities, in fact such business lines may require up to 1000 percent to be commercially viable from a regulatory, rating or customer facing perspective.³⁶ When considering mortgage guarantee insurers specifically, these companies play a crucial role in the financial markets by providing credit relief, and it is not uncommon for even publicly traded companies in this line of business in the US to hold reserves of 5% or less of total assets (i.e., 2000 percent) for business, credit, regulatory, and marketability reasons. The current proposed regulations would cause such companies not to be treated as FSEs, and depending on the significance of that entity in its affiliated group, it could cause such group to fail to qualify as a FSG. Thus, we respectfully request that such lines of business, i.e., warranty, financial guarantee, surety, and mortgage guarantee, not be subject to a bright line threshold, but rather a facts and circumstances analysis, due to the nature of their businesses.

Further, we suggest that if a threshold is established to limit the amount of investment income earned by a Subchapter L Corporation that may be treated as active financing income for purposes of Prop. Reg. §1.904-4(e), such threshold should at a minimum be based on the type(s) of insurance business being conducted or written by the corporation and not based on whether the corporation is being taxed under part I or part II of Subchapter L. For example, if a corporation that is taxable under part I of Subchapter L has a portfolio of business that includes both life and non-life, that company should determine either a single threshold based on the overall capital needs of its business or separate thresholds based on the capital needs for each distinct line.

Thus, we respectfully request that the thresholds in the 2020 Proposed Regulations be reserved, and any future proposed thresholds be carefully tailored to accommodate the capital needs of the various distinct lines of business that may be conducted by an insurance corporation regardless of whether that corporation is taxable under part I or part II of Subchapter L (or would be if it were a domestic corporation). Furthermore, any use of a reserve-based limitation, even with a multiple of a reserve for surplus capital, could be difficult to manage if such reserve amounts are subject to discount or haircuts under the Code. Reserves subject to discounts and haircuts do not reflect the true amount of assets held for the active conduct of an insurance business and diminish any effect the surplus multiples would have in providing capital relief for commercial, insurance credit, business credit, or competitiveness purposes. As the methods for discounting and haircutting reserves under both part I and part II of Subchapter L, in both the foreign and domestic context, may be subject to legislative changes over time, and accordingly, may have the indirect effect of putting pressure on the amount of surplus to be taken into account by insurance companies under these thresholds, we would suggest that reserves for purposes of the investment asset limitation rule be calculated without discount or haircut.³⁷

We believe the thresholds, if re-proposed, should be based on the proper amount of capital that a company needs to operate and maintain in order to meet its future obligations as well as its insurance rating, credit rating and competitiveness in the market. Such a focus in tailoring the rule should allow enough flexibility for Subchapter L Corporations to operate as bona fide insurance companies and alleviate any conflict that may arise between the concerns that this rule is intended to address and substantial non-tax business reasons being satisfied by the insurance company holding such assets (e.g., regulatory, rating, market conditions, and local legal requirements).

c. Start-up and Run-off Periods

Prop. Reg. §1.904-4(e)(2)(ii) applies to all Subchapter L Corporations regardless of whether such corporations are in the process of starting-up or winding-down their overall business or a particular line of insurance business. During the beginning and ending life-cycle of most insurance businesses, a corporation may be required to maintain significant assets relative to liabilities by an insurance regulator, rating agency, or market conditions to be competitive.³⁸

We recommend consideration be given to providing grace periods during which the investment asset limitation will not apply to a corporation because such corporation's excess asset investment levels are temporary circumstances incident to the launching of, or winding down of, an insurance business.³⁹ Under such rules, the investment asset limitation would not apply to an insurance company that is predominantly engaged in the insurance business based on a general facts and circumstances test (e.g., the test could be based on the number and size of insured risks and employee time and company costs spent on investment activities versus underwriting activities) and the insurance business either is in (a) its first three years of operation (either by the taxpayer or any predecessor) or (b) run-off during which no new capital is being injected into the business (other than for solvency reasons), no new insurance business is being written and the remaining assets held by the business will be used solely to pay claims with respect to preexisting insurance risks remaining on the company's books.

d. Insurance Liabilities — Domestic Reserves

To the extent that reserves are used as a measure within the regulations, we respectfully request that the full amount of statutory insurance reserves, as reported on a company's National Association of Insurance Commissioners (“NAIC”) annual statement (“Statutory Reserves”), without any required haircut or discount for US federal income tax purposes (i.e., sections 807(d)(1)(A)(ii), 846 or 832(b)(4)), be applied in determining the total amount of insurance liabilities for purposes of the investment asset limitation rule. We request this approach as the Statutory Reserve amount reflects the full value of an insurance company's reserves required to conduct its insurance business, and thus, is the most accurate measure of insurance liabilities for purposes of the investment asset limitation rule.

In the life insurance context, section 807 warrants examination as to the applicability of its provisions. Section 807 was originally enacted as part of the Deficit Reduction Act of 1984,⁴⁰ which included a range of amendments to Subchapter L, part I. Section 807 addresses reserve computations for life insurance companies, which, similar to other insurance companies, are allowed a deduction for a net increase in reserves and must include in income any net reduction in reserves.⁴¹ Section 807(d)(1)(A) states that life insurance reserves for any contract, other than variable contracts, is the greater of the net surrender value of the contract, or 92.81% of the reserves determined under paragraph (2). As discussed further below and in Section V.2.e., we believe that the life insurance reserve amount, for purposes of calculating total insurance liabilities for the investment asset limitation rule, should be Statutory Reserves without reduction for the section 807(d)(1)(A)(ii) haircut. If applying the haircut in the context of the investment asset limitation rule, 7.19% of an insurance company's reserves will automatically be attributed to passive activity despite the fact that such reserves are attributable to, and held in connection with, the active conduct of an insurance business.

For property and casualty (“P&C”) and other non-life insurance companies, reserves are determined under sections 832(b)(5) and 846. Prior to 1987, the deduction allowed for losses incurred under section 832(b)(5) was generally equal to the amount claimed on the NAIC annual statement for losses incurred. As part of the Tax Reform Act of 1986 (the “TRA”), a discounting requirement was introduced for unpaid losses used in computing losses incurred under section 832(b)(5).⁴² The stated rationale for discounting was to reduce the losses incurred by the assumed investment earnings on unpaid losses and unpaid loss adjustment expenses between the end of the tax year and the time the loss is paid.⁴³ Section 846, also added by the TRA, defines discounted unpaid losses and prescribes the methods by which NAIC annual statement reserves are discounted for tax purposes. Reserves may be subject to further reduction for US federal income tax purposes where loss reserves are funded out of income that is tax-exempt.⁴⁴ The policy behind this reduction is that a deduction for an increase in reserves should not be allowed where such increase is funded by tax-exempt income.⁴⁵ For purposes of measuring reserves to determine total insurance liabilities under the investment asset limitation rule, we do not believe the section 846 discount for unpaid losses should apply. The reserves held to support a company's active insurance business are unchanged even though they are discounted for tax purposes under section 846. To use an amount of reserves less than that actually held by a company to determine whether its income is actively derived would distort the classification of the company's income for purposes of the investment asset limitation rule and potentially lead to an improper result.

Unearned premium reserves are determined separately under section 832(b)(4) and are generally discounted by a 20% haircut for US federal income tax purposes.⁴⁶ Note, however, that life insurance reserves under section 816(b) included in unearned premium reserves are not subject to the 20% haircut rule.⁴⁷ Unearned premiums for a P&C or other non-life contract generally represent the portion of gross premium written that is attributable to future insurance coverage during the effective period of the insurance contract. The 20% haircut for P&C unearned premium reserves represents the portion of expenses currently deductible under sections 832(b)(3) and 162, but that are allocable to generating premiums that have not yet been earned.⁴⁸ For purposes of measuring reserves and insurance liabilities for the investment asset limitation rule, we believe the unearned premium reserve 20% haircut should not apply. Similar to the life insurance context, the amount of Statutory Reserves for P&C and other non-life companies, without discount, represents the amount of reserves held in connection with the active conduct of an insurance business. A company should not be penalized by the unearned premium reserve haircut in this context because they received premium income in advance of it being earned; the entire unearned premium reserve amount is still held by the insurance company in its active conduct of an insurance business, and thus, should not be excluded for purposes of measuring insurance liabilities in the context of the investment asset limitation rule.

The purpose and policy of these reserve computations is to determine the appropriate measure of holding assets related to insurance liabilities, generally to calculate a deduction for an increase in reserves held or an income inclusion for a decrease in reserves held.⁴⁹ Contrast this with the purpose of the investment asset limitation rule, which is to identify companies and groups conducting active finance and insurance businesses. In this context, reserves are not meant to serve as a measuring stick for tax deductions and losses incurred to ensure they are properly aligned with an insurance business; rather, reserves are meant to measure the volume of insurance business conducted by an entity, i.e., to what extent is this asset (reserves) attributable to an active insurance business. Because Statutory Reserves are held to support an insurance business directly, as required by regulatory law, the entire amount of Statutory Reserves should be considered in determining insurance liabilities for purposes of the investment asset limitation rule. Thus, we respectfully request that the reserve haircuts and discounts provided under sections 807(d)(1)(A)(ii), 846, and 832(b)(4) not apply to Statutory Reserves in determining reserve amounts to be included as insurance liabilities under the investment asset limitation rule.

e. Insurance Liabilities — Foreign Reserves

Similar to the recommendation above, we respectfully request the use of section 954(i) reserves, without haircut, and including deficiency and like reserves, as the reserve amount to be used in calculating insurance liabilities for purposes of the investment asset limitation rule. To adopt this approach, more detailed guidance is requested regarding how a CFC that would be taxable under Subchapter L if it were a domestic corporation should determine its total insurance liabilities for purposes of the investment asset limitation rule. Prop. Reg. §1.904-4(e)(2)(ii)(C) cross-references section 953(b)(3) for purposes of defining the term total insurance liabilities in this context. Section 953(b)(3) states that “[r]eserves for any insurance or annuity contract shall be determined in the same manner as under section 954(i).” As Treasury and the IRS have been studying the determination of reserves under section 954(i) since 2016, we would urge clarification and guidance in this area as section 954(i) reserves are crucial for a variety of determinations, which now include the investment asset limitation rule.⁵⁰ We believe that the use of section 954(i) reserves, without haircut, and including deficiency and like reserves, is a sound approach that also fits harmoniously with the aim of measuring reserves for calculating insurance liabilities under the investment asset limitation rule.

Section 954(i)(4)(B) provides a general rule and a specific rule for determining a CFC's reserve amount.⁵¹ For life insurance reserves in the section 954(i) context, we believe the section 807(d)(1)(A)(ii) reserve haircut should not apply. For section 954(i)'s Subpart F purposes, the tax policy should be to use, in the case of life insurance or annuity contracts, section 954(i) reserves plus at least 10 percent (as provided in section 954(i)(2)(B)(ii)) to afford an exemption for assets supporting reasonable surplus measures for an insurance company. If the section 954(i) reserves would be subject to the section 807(d)(1)(A)(ii) haircut (of 7.19 percent) then assets in excess of 102.09 percent (as opposed to 110 percent) of the foreign company's life insurance reserves would give rise to (passive) Subpart F income even if such assets support a bona fide life insurance business, a result that is inappropriate. Further, Section 954(i) does not include a specific reference to any haircut required to be applied on the amount of the reserve computed therein.⁵² In interpreting the Code and the policy behind section 954(i), there should also be no implied reference to an equivalent of the section 807(d)(1)(A)(ii) haircut in Subpart F because section 954(i)(5) corresponds to section 807(d)(2) and not section 807(d)(1). Thus, we believe section 954(i) reserves, without haircut, should be used for calculating insurance liabilities for purposes of the investment asset limitation rule.

Separately, in the context of reserves for CFC non-life companies, we also recommend the use of section 954(i) reserves without discount or haircut. This is an approach taken in the section 842(b) context where total insurance liabilities for non-life companies are defined as the sum of unearned premiums and unpaid losses.⁵³ We believe this is the appropriate approach as it reflects the full amount of reserves actually held by an insurance company in the active conduct of its insurance business, and thus, provides the best measure of insurance liabilities for purposes of the investment asset limitation rule. Further, and consistent with maintaining parity between the foreign and domestic contexts, we request that the 20% unearned premium reserve haircut not apply in determining section 954(i) reserves for purposes of the investment asset limitation rule. For the reasons previously stated, i.e., that the full amount of section 954(i) reserves, without haircut, represent the true amount of reserves held in connection with the active conduct of an insurance business, the unearned premium reserve haircut should not apply. The full amount of reserves held by a company with respect to unearned premiums represents assets held in the active conduct of an insurance business, and thus, should not be discounted when measuring insurance liabilities for purposes of the investment asset limitation rule.

Section 954(i) does not take into account catastrophe, deficiency, and equalization or similar reserves. Modern capitalization rules, however, focus on the proper amount of capital that a company needs to operate and maintain to meet its future obligations as well as its insurance rating, credit rating and competitiveness in the market, an aim similar to that of the investment asset limitation rule. In other words, the amount of capital required to conduct an insurance business, and the amount that should be used to determine insurance liabilities for purposes of the investment asset limitation rule, is different than the reserve amount calculated under section 954(i). Additionally, Congress and the IRS have acknowledged that deficiency and similar reserves should be included in determining the statutory reserve cap under section 807.⁵⁴ However, a similar rule has not been adopted for foreign companies, denying parity when determining reserves in the foreign context.

For these reasons, we respectfully request that you consider permitting the use of section 954(i) reserves, without haircut, and with inclusion of deficiency and similar reserves, as the method for determining reserves that are included as insurance liabilities in the investment asset limitation rule. While the ratios stated in the 2020 Proposed Regulations (i.e., 200% and 400%) may be designed to take into account the haircuts and discounts under the Code, we believe that the discounts, haircuts, and ratios accounting for such do not aid taxpayers or the government in determining the true amount of insurance liabilities held in the active conduct of an insurance business, i.e., assets actually held for insurance reserves, not those determined for tax purposes. Further, discount rates and haircut amounts in the Code are subject to change over time, and such changes may not be commensurate with business practices, statutory approaches, or the purpose of the investment asset limitation rule. Such changes make the application of this facet of the investment asset limitation rule unpredictable in the long run, and thus, we would recommend that the rule align itself to the business practices of insurance companies; this will serve as the best measure of insurance liabilities held for the active conduct of an insurance business. We believe that only by turning off these haircuts and section 954(i) exclusions (i.e., deficiency and like reserves) in determining a reserve amount will a reserve be an appropriate measure for determining the total liabilities of a CFC insurance company and whether the investment assets held by that insurance company are necessary for the proper conduct of a bona fide insurance business.⁵⁵

VI. Summary

We appreciate Treasury and the IRS requesting taxpayers provide comments on the topics discussed in this letter as well as the opportunity to provide the above comments and recommendations on the 2020 Proposed Regulations. We respectfully request that you consider adopting our recommendations in the final regulations to modify and clarify the general definitions of gross income and active financing income in the context of applying the FSE and FSG tests in the context of a Subchapter L Corporation.

More specifically, for the reasons discussed in this letter, we ask that the Treasury and IRS:

• modify Prop. Reg. §1.904-4(e)(3)(i) and (ii) to explicitly provide that for purposes of the 70-percent test a Subchapter L Corporation's gross income amount should be determined in accordance with section 803 in the case of a life insurance company, and in the case of a property and casualty insurance company in accordance with section 832(b) other than taking into account gross income reduction amounts under section 832(b)(5);

• clarify that the “of a kind” description in the Related Party Insurance Rule means income earned from persons that are related (within the meaning of section 267(b) or section 707) where such income is attributable to issuing (or reinsuring) an insurance or annuity contract and regardless of whether the related assuming corporation is domestic, foreign or a CFC and whether the related insured corporation is a US shareholder (or a person related thereto) with respect to an assuming corporation;

• clarify that the Related Party Insurance Rule applies for purposes of both the FSE test and FSG test by modifying Prop. Reg. §1.904-4(e)(3)(ii) to include related insurance income derived from transactions between member of the same affiliated group in both the numerator and denominator of the 70-percent test;

• modify the definition of active financing income in the context of a Subchapter L Corporation to treat service income derived from related parties as active financing income for purposes of the 70-percent test where such income would constitute active financing income if the transaction were between unrelated parties, which would align with the treatment of this type of income under the Subpart F and PFIC rules;

• re-consider imposing the investment asset limitation overall as well as establishing fixed applicable percentage amounts determined solely by reference to whether the Subchapter L Corporation is (or would be) taxable under part I or part II of Subchapter L – in this regard, if the investment asset limitation is adopted in the final regulations, we urge the Treasury and IRS to establish thresholds that are tailored to the business being written (rather than whether the company is taxable under part I or part II of Subchapter L), create start-up and run-off grace periods during which the limitation will not apply and clarify the mechanical rules for determining an insurance company's liabilities for purposes of this limitation.

• determine reserves for purposes of the insurance liability amount under the investment asset limitation rule: without the section 807(d)(1)(A)(ii) haircut for life insurance reserves, the section 846 discount for unpaid losses, or the section 832(b)(4) haircut for unearned premium reserves; and by including deficiency and like reserves otherwise excluded under section 954(i).

We appreciate your consideration of our comments and recommendations discussed in this letter with respect to the qualifications of a modern insurance company or group as a FSE or FSG under the tests described in the Proposed Regulations. If you would like to discuss this letter further, please contact Chris Ocasal at chris.ocasal@ey.com or (202) 327-6868.

Respectfully submitted,

American International Group, Inc.

Pan-American Life Insurance Group

Assurant

Prudential Financial, Inc.

Chubb

Reinsurance Group of America, Incorporated

Liberty Mutual Insurance

Tokio Marine HCC

Copies to:

Jeffrey Van Hove
Acting Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, DC 20224

Mark Mazur
Deputy Assistant Secretary
(Tax Policy)
Department of the Treasury

William M. Paul
Acting Chief Counsel
Internal Revenue Service

Karen J. Cate
Internal Revenue Service
Office of Associate Chief Counsel (International)

Josephine Firehock
Internal Revenue Service
Office of Associate Chief Counsel (International)

Angela J. Walitt
Attorney-Advisor
Department of the Treasury

Wade Sutton
Attorney-Advisor
Department of the Treasury

Jason Yen
Attorney-Advisor
Department of the Treasury

Barbara A. Felker
Internal Revenue Service
Office of Associate Chief Counsel (International)

Jeffrey P. Cowan
Internal Revenue Service
Office of Associate Chief Counsel (International)

Jeffrey L. Parry
Internal Revenue Service
Office of Associate Chief Counsel (International)

Suzanne M. Walsh
Internal Revenue Service
Office of Associate Chief Counsel (International)

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Appendix A

1. The following simple example illustrates how true active financing income may be inadvertently converted to non-active financing income under the 2020 Proposed Regulations. Consider a nonlife reinsurance arrangement involving two related domestic corporations that are not members of the same affiliated group where the insured corporation (IC) deducts the premiums paid to the corporation providing the reinsurance when determining its gross income under section 832 and the premiums paid by IC are included in the gross income of the related reinsurer corporation (RC).⁵⁶ Assume IC earns premium income of $100 and investment income of $2 and IC pays premiums of $80 to RC; whereas, RC earns $80 of premium income from IC and investment income of $8. In this instance, RC would fail to qualify as a FSE under Prop. Reg. §1.904-4(e)(3)(i) even though its primary activity from which it derives the majority of its income is providing insurance. This occurs because none of the $80 of premium income RC earned would be taken into account as active financing income under the Related Party Insurance Rule if a literal application of section 953(c)(2) is applied in interpreting the Related Party Insurance Rule. Thus, IC would have gross income of $22 (the $80 of reinsurance premiums is eliminated on the front-end under section 832(b)) of which all may be active financing income (depending on the application of the investment asset limitation discussed below); while RC would have gross income of $88 of which only $8 may be treated as active financing income (the $80 of reinsurance premiums would not qualify as active financing income since RC is a domestic corporation). As such, final regulations should clarify that active financing income includes insurance (or reinsurance) income derived from a transaction between persons that are related (within the meaning of section 267(b) or section 707) including if the income is received by a domestic corporation or a foreign corporation that is not a CFC.

2. Assume that IC and RC from the above example are members of an affiliated group. Under the FSG test (as currently proposed), IC's gross income would be $22 ($100 premium income from third parties less the $80 of reinsurance premium paid to RC plus the $2 of investment income) and RC's income would be $8 of investment income (the $80 of related insurance income would be eliminated as it is income derived from a transaction with a member of RC's affiliated group). Thus, the group as a whole has $30 of gross income even though the group as a whole earned $110 of income. Accordingly, in order to avoid distortion in the FSG test, final regulations should be revised to provide that any income that qualifies as active financing income under the Related Party Insurance Rule is included in the numerator and denominator of the FSG's 70-percent test fraction.