ACLI Addresses Life Insurance Issues Under Proposed FTC Regs

February 10, 2021

Mr. Jeffrey L. Parry
Senior Counsel
IRS Associate Chief Counsel, International,
Branch 3
1111 Constitution Ave. NW
Washington, DC 20224

Re: Comments Regarding Foreign Tax Credit Proposed Regulations (REG-101657-20)

Dear Mr. Parry:

On behalf of the American Council of Life Insurers (“ACLI”), we are writing with recommendations for the Proposed Rules on Guidance Related to the Foreign Tax Credit (REG-101657-20) (the “Proposed Regulations”). Our recommendations offer reasons for why the Proposed Regulations should be modified to best address issues unique to our industry. We believe these recommendations will assist you to issue guidance effectively and efficiently to implement the FTC for the life insurance industry.

On November 12, 2020, Treasury and the IRS published the Proposed Regulations in the Federal Register, providing administrative guidance for the foreign tax credit (“FTC”) regime, which was updated in the 2017 Tax Reform Act.¹ Among other things, the Proposed Regulations provide guidance on the definition of financial services income and the application of section 818(f) of the Internal Revenue Code of 1986, as amended (the “Code”).²

We thank you for the continued solicitation of feedback. On behalf of the ACLI we thank you for the lowering of the threshold of the numerical test for a financial service entity from 80 percent to 70 percent, and providing guidance on the application of section 818(f) both of which are largely consistent with ACLI's letter to you dated February 18, 2020.

1. Definition of financial services income

a. The threshold of the numerical test for financial entity

As discussed in the preamble to the 2020 FTC final regulations, in response to comments made to the 2019 FTC proposed regulations, the Treasury and the IRS determined that the provisions of the 2019 FTC proposed regulations should be revised and reproposed to provide an additional opportunity for comment.³ The 2020 Proposed Regulations retain the general approach of existing Treas. Reg. § 1.904-4(e) by providing a numerical test whereby an entity is a financial services entity if more than a threshold percentage of its gross income is derived directly from active financing income, and the regulations continue to contain a list of income that qualifies as active financing income.⁴ However, the proposed regulations lower the threshold from 80 percent to 70 percent⁵ and further provide that active financing income must generally be earned from customers or other counterparties that are not related parties. Although in general the determination of whether an entity is a financial services entity is done on an entity-by-entity basis, a corporation that is a member of a financial services group is deemed to be a financial services entity regardless of whether it is a financial services entity if more than 70 percent of the affiliated group's gross income is active financing income. ACLI thanks the IRS and Treasury for adopting its recommendation of using the 70 percent threshold generally as set forth in its letter dated February 21, 2020.

b. The definition of active financing income

The 2020 Proposed Regulations provide that Income derived in the active conduct of a banking, insurance, financing, or similar business (active financing income) must generally be earned from customers or other counterparties that are not related parties.⁶ Prop. Reg. § 1.904-4(e)(3)(i)(A) specifically provides that a corporation is predominantly engaged in the active financing business for any year if for that year more than 70 percent of its gross income is derived directly from active financing income with customers, or counterparties, that are not related to such individual or corporation under section 267(b) or 707, except related party insurance income. The Preamble to the 2020 Proposed Regulations provides: “These changes will promote simplification and greater consistency between Code provisions that have complementary policy objectives, while still taking into account the differences between sections 954 and 904.”⁷ Prop. Reg. § 1.904-4(e)(2)(i)(W) provides that active financing income includes income from activities generating income of a kind that would be insurance income as defined in section 953(a)(1) including related party insurance income (“RPII”) as defined in section 953(c)(2) but without taking into account the exception for exempt insurance income under section 953(e).⁸ We appreciate the exception provided for related party insurance from the general related party rule in Prop. Reg. § 1.904-4(e)(3)(i)(A). However, the proposed definition of related party reinsurance references the section 953(c)(2) definition of RPII which provides that the income is earned by a foreign insurance corporation from a policy with respect to which the insured is a United States shareholder in the foreign corporation or a related person to such a shareholder. As a result, under a strict reading of this definition, insurance income that is earned by a domestic insurance company derived from insuring or reinsuring persons related to the corporation under section 267(b) or 707 will not be treated as active financing income, whereas such income earned by a foreign insurance corporation would be treated as active financing income if it meets the RPII definition. Similarly, if the insured is not a United States shareholder of the assuming corporation or a related person to such a shareholder, insurance income would not be treated as active financing income. To provide a rule that works uniformly to treat all insurance income of domestic and foreign insurance companies as active financing income (that is without limitation as to whether the insured or reinsured is a related party), ACLI recommends the following changes:

First, the last sentence of the definition of financial services entities in Prop. Reg. § 1.904-4(e)(3)(i)(A) should be modified to say:

“An individual or corporation is predominantly engaged in the active financing business for any year if for that year more than 70 percent of its gross income is derived directly from active financing income under paragraph (e)(2) of this section with customers, or counterparties, that are not related to such individual or corporation under section 267(b) or 707 (except in the case of paragraph (e)(2)(i)(W), which has no such limitation).”

Second, we suggest that Prop. Reg. § 1.904-4(e)(2)(i)(W) be modified to provide:

“Activities generating income of a kind that would be insurance income as defined in section 953(a)(1) (without regard to whether the insured or reinsured is related to the corporation under section 267(b) or 707, or the exception in section 953(a)(2) for income that is exempt insurance income under section 953(e)), 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 (as defined in paragraph (e)(2)(ii) of this section);”

c. The limitation of active financing income

In the case of an insurance company's income from investments, the preamble states that the Treasury Department and the IRS recognize that an insurance company must hold passive investment assets to support its insurance obligations, including capital and surplus in addition to insurance reserves, to ensure the company's ability to satisfy insurance liabilities if claims are greater than anticipated or investment returns are less than anticipated. However, the Treasury Department and the IRS have determined that limits on the amount of an insurance company's investment income that may be treated as active financing income 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.

Under Prop. Reg. § 1.904-4(e)(2)(i)(W) active financing income generally includes income from investments by an insurance company of its unearned premiums or reserves ordinary and necessary to the proper conduct of the insurance business which is further defined in Prop. Reg. § 1.904-4(e)(2)(ii).⁹ Similarly, investment income includible in section 953(a)(1) insurance income, is treated as active financing income only to the extent ordinary and necessary to the proper conduct of the insurance business.¹⁰

Prop. Reg. § 1.904-4(e)(2)(ii) imposes a cap on the amount of an insurance company's income from investments that are considered ordinary and necessary to the proper conduct of the insurance business and therefore that may be treated as active financing income.¹¹ The cap is determined based on an applicable percentage of the insurance company's total insurance liabilities. If investment income exceeds the insurance company's investment income limitation, investment income in excess of the limitation is not considered ordinary and necessary to the proper conduct of the company's insurance business and will not qualify as active financing income.¹²

The regulations essentially set forth that 200 percent of total insurance liabilities for life companies and 400 percent of total insurance liabilities for nonlife companies is the appropriate measure of their investment assets.¹³ How these percentages were arrived at has not been explained, including the differences in insurance liabilities for life and nonlife insurance companies. It is also not clear if the basis used to determine these limitations take into account the differing reserve and capital rules of US and non-US companies. Thus, these limits appear to be arbitrary. The approach of capping investment income based on insurance liabilities is a departure from how subchapter L applies to domestic insurance companies. In general, the term "insurance company" means any company more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies under section 816(a). If more than half its activities were deemed to be investment activity that is unrelated to its insurance business, the company fails to be an insurance company.¹⁴ The proposed regulations only allow insurance liabilities to be considered for the percentage tests if the corporation is, as a domestic corporation, subject to tax under subchapter L or in the case of a controlled foreign corporation, it would be taxable under subchapter L if it were a domestic corporation. Therefore, in either case, only a corporation that would meet the definition of an insurance company can apply the cap. As a company can be an insurance company only if it meets the section 816(a) definition of an insurance company, ACLI believes that to the extent a company meets that test, its investment income should not be subject to further limitation. It may be noted that subchapter L generally treats what is reported on the annual statement as investment income, which forms part of the insurance company's gross income, without any limitation.

Furthermore, the proposed definition is problematic for insurance companies that have significant assets relative to their liabilities in a start-up or run-off mode. In such situations, the proposed percentage test may treat a portion of the investment income of such companies as not qualifying as active financing income, even though they may be treated as insurance companies under section 816(a).

The proposed tests would also add significant compliance burdens on insurance companies, as they would have to develop systems to test each company within the group every year.

If a company fails to meet the insurance company test, (e.g. if it had a non-insurance business that was larger than the insurance business), then a percentage test that acts as a limiter on the investment income that may be regarded as active financing income may be warranted.

2. Allocation and apportionment of expenses under section 818(f)

ACLI thanks the Treasury and the IRS for modifying and re-proposing provisions of the 2019 Proposed Regulations addressing section 818(f) generally in line with ACLI's request in letter dated February 18, 2020. Specifically, we welcome the rule that provides for the allocation and apportionment of expenses defined under section 818(f) among all life insurance company members in the consolidated group as if they were a single corporation (“life subgroup method”). Additionally, ACLI thanks the IRS and Treasury for providing a rule under which a consolidated group may choose not to apply the life subgroup method and may instead allocate and apportion section 818(f)(1) items solely among items of the life insurance company that generated the section 818(f)(1) items (“separate entity method”) with a one-time election. Given that these rules are still proposed, it is our understanding that these rules will be effective for the first tax year following the year in which the proposed regulations are issued as final, and it is on the tax return for that year when a consolidated group should make this one-time election.

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

Sincerely,

Regina Rose
Senior Vice President, Taxes & Retirement Security
(202) 624-2154 t/reginarose@acli.com

MandanaParsazad
Vice President, Taxes & Retirement Security
(202) 624-2152 t/mandanaparsazad@acli.com

ACLI
Washington, DC

cc:
Ms. Angela Walitt
Ms. Je Y. Baik
Ms. Josephine Firehock
Mr. Steven D. Jensen