EY Seeks Tax-Exempt Income Guidance for Insurers Under FTC Regs

February 4, 2019

Internal Revenue Service
Attn: CC:PA:LPD:PR (REG-105600-18)
Courier's Desk
1111 Constitution Avenue, N.W.
Washington, DC 20224

Re: REG-105600-18 (Proposed Regulations Related to Foreign Tax Credit)

Dear Sir or Madam:

The attached comment letter requests Treasury and the IRS modify reproposed Temp. Reg. § 1.861-8T(d)(2), in accordance with the grant of authority given under section 807(e)(7)(E), to provide the necessary and appropriate guidance addressing the adjustments that an insurance company should make in applying section 864(e)(3). In general, the letter requests that Treasury clarify that a certain portion of the tax exempt assets/income of an insurance company is not going to be excluded under section 864(e)(3) for expense apportionment purposes.

Section 864(e)(3) generally prevents any tax-exempt asset (and any income from such asset) from being taken into account for purposes of allocating and apportioning any deductible expense. Insurance companies, however, are subject to special rules under Subchapter L that effectively limit an insurance company's tax-exempt income/asset tax benefit. In general, the special rules under Subchapter L are subjecting an insurance company to US tax on a portion of its tax-exempt assets/income, by requiring it to reduce certain deductions by a portion of its tax-exempt assets (or income from such assets).

Accordingly, the attached comment letter requests guidance addressing the specific adjustments that an insurance company should make to take into account the portion of its tax-exempt asset/income that is subject to US tax due to the required reduction of certain deductions. Such adjustments are necessary and appropriate to carry out the purposes of section 864(e)(3) and are consistent with the proposals made by the Technical Corrections Act of 1987.

Respectfully submitted,

Chris Ocasal
Principal, Ernst & Young, LLP
Washington, DC

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February 4, 2019

Internal Revenue Service
Attn: CC:PA:LPD:PR (REG-105600-18)
Courier's Desk
1111 Constitution Avenue, N.W.
Washington, DC 20224

Mr. Steven T. Mnuchin
Secretary
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

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

Mr. L.G. “Chip” Harter
Deputy Assistant Secretary (International Tax)
Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Ms. Marjorie Rollinson
Associate Chief Counsel, International
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Mr. Jeffrey G. Mitchell
Associate Chief Counsel, International
Internal Revenue Service
1111 Constitution Avenue, N.W.
Washington, D.C. 20224

Re: REG-105600-18 (Proposed Regulations Related to Foreign Tax Credit)

Dear Sir or Madam:

We appreciate the opportunity to comment and respectfully submit this letter on behalf of HCC Insurance Holdings, Inc. and American International Group, Inc., each a common parent of an affiliated group of corporations filing a consolidated US corporate income tax return.

On November 28, 2018, the US Department of the Treasury (the Treasury) and the Internal Revenue Service (the IRS) issued proposed regulations (the Proposed Regulations) that provide guidance relating to the determination of the foreign tax credit under the Internal Revenue Code (the Code).¹ In the preamble to the Proposed Regulations (the Preamble), the Treasury and IRS request comments on all aspects of the proposed rules. Furthermore, the Preamble also states that “[w]ith respect to portions of the temporary regulations under sections 861 through 865 that are being reproposed under the proposed regulations, the Treasury Department and the IRS will remove the corresponding temporary regulations upon finalization of the proposed regulations”.

As the reproposed regulations will replace the temporary regulations currently issued under section 861 (the Temporary Regulations), we are requesting that Temp. Reg. § 1.861-8T(d)(2) be modified to provide guidance that address the adjustments that insurance companies should make to carry out the purposes of section 864(e)(3), generally that the tax-exempt income (or assets that generate such income) that an insurance company must take into account for expense apportionment purposes would not be the total amount of its tax-exempt income (or assets) but rather the net amount of such income (or assets) after taking into account the reductions to reserves and the denial of dividend received deductions under subchapter L. In particular, we request that when apportioning deductions that are definitely related either to a class of gross income consisting of multiple grouping of income (whether statutory or residual) or to all gross income, the amount of exempt income and exempt assets that are not taken into account would be reduced by

Background

Section 864(e) was enacted as part of the Tax Reform Act of 1986 (TRA of 1986), in part, as a reflection of Congressional belief that an appropriate determination of how expenses relate to US and foreign source gross income should reflect the economic reality that money is fungible. To this end, section 864(e), and the regulations implementing that section under section 861, generally treat interest expense as being properly attributable to all business activities and property of a taxpayer, regardless of any specific purpose for incurring a specific obligation on which interest is paid.

Section 864(e)(3) provides an exception to Section 864(e)'s general fungible approach. More specifically, section 864(e)(3) provides that, generally, any tax-exempt asset (and any income from such asset) is not taken into account for purposes of allocating and apportioning any deductible expense. Section 864(e)(3) also provides that a similar rule applies to the deduction received amount allowable under section 243 or 245(a) with respect to any dividend and the like portion of any stock the dividends on which would be so deductible. Broadly speaking, section 864(e)(3) prevents a taxpayer's expenses from being treated as incurred for the purposes of owning any tax-exempt asset or the portion of any stock corresponding to the deduction allowed for dividends on the stock.

Between the enactment of section 864(e) and the passage of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), Temp. Reg. § 1.861-8T(d)(2) was promulgated.² Notably the rules of that regulation differ from the express language in the statute by generally requiring exempt income be taken into account when allocating deductions that are definitely related to one or more classes of gross income but preventing such exempt income, and the assets generating such exempt income, from being taken into account when apportioning deductions.³

Following the issuance of Temp. Reg. § 1.861-8T(d)(2), TAMRA was passed and current section 864(e)(7)(E) was enacted. Current section 864(e)(7)(E) authorizes the Secretary to prescribed regulations making the necessary and appropriate adjustments in the case of an insurance company to carry out the purposes of section 864(e)(3). Under TAMRA, section 864(e)(7)(E) was made effective as if the provision was included in the Tax Reform Act of 1986 (i.e., before the promulgation of Treas. Reg. § 1.861-8T(d)(2)).

The revisions to the Code made by TAMRA were intended to generally adopt proposals made by the Technical Corrections Act of 1987 (TCA of 1987).⁴ While the TCA of 1987 was not passed as part of the Omnibus Reconciliation Act of 1987, the removal of the technical corrections from that reconciliation package was made with the understanding that “. . . efforts [would] be made to provide retroactive protection for those [taxpayers] who are relying on the original Technical Corrections Act of 1987 . . . [and] the Treasury Department [was urged] to provide guidelines for those taxpayers who file their 1987 returns in reliance on those technical corrections.”

Importantly, the TCA of 1987 proposed amending section 864(e)(7) by adding, as a new subparagraph (E), the following:

(E) that, in the case of an insurance company —

(a) the first sentence of paragraph (3) shall not apply to the policyholders' share of (or, in the case of an insurance company taxable under section 831 [a non-life insurance company], 15 percent of) any tax-exempt asset (or income from such an asset), and

(b) a similar rule shall apply to any stock (or dividend thereon) which would otherwise be subject to the second sentence of paragraph (3).

Despite the understanding the types of the adjustments that were intended to be made when applying section 864(e)(3) to insurance companies and the authority provided to the Secretary by section 864(e)(7)(E), as enacted by TAMRA, to date Temp. Reg. § 1.861-8T(d)(2) has not been modified, nor has any other guidance been issued, that addresses what adjustments should be made by insurance companies when applying section 864(e)(3).

Reduction of Tax-Exempt Benefit for Insurance Companies

As a general matter, insurance companies invest part of the assets that support their reserves in assets that generate (i) interest that is exempt from gross income under section 103 (tax-exempt interest) or (ii) dividends that may qualify for a dividend received deduction (DRD) under section 243 or 245. However, since the enactment of the Deficit Reduction Act of 1984 (the 1984 Act), insurance companies have been subject to special rules that effectively limit the amount of the tax benefit an insurance company may realize from earning tax-exempt income, or owning assets that generate tax-exempt income, for US tax purposes. This is because the 1984 Tax Act substantially revised the rules necessary to determine an insurance company's taxable income.

Under pre-1984 law, a life insurance company was taxed on the lesser of its taxable investment income or its gain from operations (under a three-phase system). In computing gains from operations a deduction was allowed for the company's allocable share of tax-exempt income and the amount of any dividends received by the company that were deductible under provisions generally applicable to all corporations. The initial inclusion of tax-exempt income, followed by the later deduction of the company's share, had the effect of allocating a portion of tax-exempt income to the policyholders' share which was not includible in the company's taxable income in any event. Thus, tax-exempt income was not as attractive to life insurance companies as to other taxpayers as a means of reducing their effective tax rate.⁵ Further, all items of investment yield (i.e., gross investment income, including tax-exempt interest and dividends received, less certain investment expenses) were allocated between the policyholders and the company. Amounts allocated to policyholders were not included in taxable investment income or gain from operations. Generally, this allocation was accomplished by means of a proration formula which, in general, compared amounts credited to policyholders to investment yield. The practical effect of the proration formula was to treat additions to reserves as funded in part out of tax-exempt income thus limiting the tax benefit a company can enjoy by receipt of tax-exempt income. ⁶

The 1984 Tax Act repealed the three-phase system and replaced it with a single phase tax, imposing income tax on the life insurance company taxable income (generally, the company's gross income less deductions). Among the allowable deductions, the 1984 Tax Act granted life insurance companies the ability to deduct (i) net increases in reserves, and (ii) dividends received by the company.⁷ Because reserve increases might be viewed as being funded proportionately out of taxable and tax-exempt income, the net increase in reserves are computed by reducing the ending balance of the reserve items by the policyholders' share of tax-exempt interest.⁸ Similarly, a life insurance company is allowed a DRD for intercorporate dividends from non-affiliates only in proportion to the company's share of such dividends (i.e., disallowing such deduction for the policyholders' share of such dividends). 100 percent deductible dividends from affiliates are excluded from application of the proration formula, if such dividends are not themselves distributions from tax-exempt interest or from dividend income that would not be 100 percent deductible if received directly by the company.⁹

In Congress's view, these changes prevented an insurance company from economically receiving a double tax benefit for tax-exempt income (or the assets that generate such income).

With respect to a non-life insurance companies, pre-1984 tax law provided that a non-life insurance company was taxable on its underwriting income and certain investment income. In calculating its taxable underwriting income, however, a non-life insurance company was allowed to deduct reserve losses paid/incurred during the year; and, in calculating its investment income, a non-life insurance company was allowed to deduct its tax-exempt interest and take a DRD without being required to reduce the amount of its loss reserve deduction by the amount of the DRD. Post-1984 law requires a non-life insurance company to reduce its losses incurred by an amount equal the applicable percentage¹⁰ of the sum of (i) the tax-exempt interest received or accrued during such taxable year¹¹ and (ii) the aggregate amount of deductions for dividends (other than 100 percent dividends) received during the taxable year, and 100 percent dividends received during the taxable year to the extent attributable (directly or indirectly) to prorated amounts.¹² These changes were intended to reflect the economic reality while at the same time providing a more accurate matching between the recognition of income and deduction for expenses.

Required Section 864(e)(3) Adjustments for Insurance Companies

As noted above, section 864(e) generally was adopted with the intent that allocation and apportionment of expenses should reflect economic reality and that money is fungible. To this end, section 864(e)(3) excludes assets which do not produce taxable income because generally such assets do not contribute to the denominator of the section 904 foreign tax credit limitation (section 904 fraction).¹³ Life and non-life insurance companies generally receive only a portion of the intended benefit (e.g., tax exemption for interest) from tax-exempt assets. This is because a life insurance company (i) must reduce its ending tax reserves by the policyholders' share of tax-exempt interest in accordance with section 807(b)(1) to determine its deduction for increase in reserves, and (ii) is not permitted to deduct the policyholders' share of the DRD pursuant to section 805(a)(4)(A)(ii).¹⁴ Similarly, in the case of a non-life insurance company, it must reduce the amount of the losses incurred (which reduces gross income) under section 832(b)(5)(B) by the applicable percentage (e.g., 25 percent for tax years beginning after December 31, 2017) of the sum of (i) the tax-exempt interest and (ii) the dividends received amount and 100 percent dividends received attributable (directly or indirectly) to the prorated amounts. The amounts disallowed as deductions are thus not exempt for tax and such assets (or income), in essence, contribute to the denominator of the section 904 fraction (entire taxable income).

Section 807(e)(7)(E) grants the Secretary the authority to prescribe regulations making the necessary and appropriate adjustments in case of an insurance company to carry out the purposes of section 864(e)(3). This specific grant was clearly intended to address the changes proposed by the TCA of 1987 that were intended to prevent insurance companies from being double penalized by first reducing the amount of their deductions by a portion of their tax-exempt assets (or income from such assets), and then again, not taking into account the entire amount of the tax-exempt assets (or any income from such assets) for purposes of allocating and apportioning any deductible expenses. Thus, similar to the relief granted for other items of partially exempt income, and the assets giving rise to that income, that were identified by Congress, the Secretary should provide insurance companies relief from the application of section 864(e)(3) for the portion of any tax-exempt asset/income that is subject to US tax due to the reduction of the insurance companies' deductions prescribed by sections 807(b)(1), 805(a)(4)(A)(ii) and 832(b)(5)(B).

Conclusion

We respectfully request that, in connection with amending the section 861 regulations to take into account changes made by H.R. 1 (more commonly referred to as the “Tax Cuts and Jobs Act of 2017”),¹⁵ the Secretary would also modify the language found in Temp. Reg. § 1.861-8T(d)(2) to provide guidance that address the adjustments that insurance companies should make to carry out the purposes of section 864(e)(3), generally that the tax-exempt income (or assets that generate such income) that an insurance company must take into account for expense apportionment purposes would not be the total amount of its tax-exempt income (or assets) but rather the net amount of such income (or assets) after taking into account the reductions to reserves and the denial of dividend received deductions under subchapter L.

In particular, we respectfully request that when apportioning deductions that are definitely related either to a class of gross income consisting of multiple grouping of income (whether statutory or residual) or to all gross income, the amount of exempt income and exempt assets that are not taken into account would be reduced by:

We appreciate the opportunity to provide comments on the Proposed Regulations. If you would like to discuss this letter further, please contact Chris Ocasal at chris.ocasal@ey.com, (202) 327-6868 or Revital Gallen at revital.gallen@ey.com, (949) 437-0302.

Respectfully submitted,

Chris Ocasal
Principal, Ernst & Young, LLP
Washington, DC

Copies to:
Mr. Douglas Poms
International Tax Counsel
Department of Treasury

Ms. Melinda Harvey
Attorney-advisor
Internal Revenue Service

Ms. Angela J. Walitt
Attorney-Advisor
Department of Treasury

Mr. Michael A. Kaercher
Attorney-advisor
Internal Revenue Service

Mr. Brett York
Attorney-Advisor
Department of Treasury