Senator Provides Treasury With Info on BEAT Provision

October 31, 2018

The Honorable Steven T. Mnuchin
Secretary of the Treasury
Department of the Treasury
1500 Pennsylvania Ave, NW
Washington, DC 20220

Dear Mr. Secretary:

I appreciated our recent conversation concerning the Department of the Treasury's ("Treasury") forthcoming guidance on §59A of the Tax Cuts and Jobs Act (the "TCJA"), commonly referred to as the BEAT provision, as it relates to reinsurance payments by domestic life insurers to foreign affiliated reinsurers. To inform your regulatory process, I write today to ensure that you and your staff have clarity as to what was intended by that statute and the nature of the specific reinsurance payment to which the language refers.

I. Modified Coinsurance ("Modco")

I trust that you are familiar with Modco given your successful negotiation of the U.S.-E.U. Covered Agreement, which enshrines Treasury's support for a robust and competitive foreign reinsurance market. Modco is a reinsurance structure wherein a U.S. life insurer or annuity provider reinsures risk with a foreign reinsurer but does not physically transfer ceded assets and reserves to the reinsurer because of U.S. insurance regulations designed to ensure there is sufficient collateral in the U.S. to meet and pay claims. Because reserves stay onshore, the foreign reinsurer is entitled to a percentage of premiums and investment income in consideration of its reinsuring the risk. The cedant, too, is entitled to a portion of the premium to maintain reserves, pay out policies, and finance underwriting and other business-related expenses.

For decades, as directed by and under the supervision of state insurance regulators, the various obligations between a U.S. life insurer and a foreign affiliated reinsurer have been accrued and paid quarterly with a single cash settlement payment from one party to the other.¹ Undertaking this kind of arrangement on anything other than a period settlement basis would be effectively impossible as a practical matter and impermissible from a regulatory perspective. Typically, the cash settlement amount flows from the U.S. insurer to the foreign affiliated reinsurer (but that is not necessarily always the case). Given how the rules of Subchapter L (life insurance taxation) work, these cash settlement outflows to the reinsurer have the effect of reducing the U.S. life insurer's taxable income. The TCJA, and specifically the BEAT provision, was designed to end the base erosion that resulted from these cash settlement amounts' being paid to the foreign reinsurance affiliate.

II. The Tax Cuts and Jobs Act

One of the bargains of the TCJA was a reduction in the generally applicable corporate income tax from 35 percent to 21 percent paired with an increase in the tax base to which that rate is applied. With respect to Modco, the BEAT fully accomplishes this purpose by ensuring that the cash settlement payments flowing to a foreign affiliated reinsurer are brought back into the U.S. tax base. Section 59A acts as an "alternative minimum tax" to the 21 percent rate by forcing the U.S. taxpayer to calculate its a modified taxable income" and then applying a rate of ten percent (five percent for 2018) to that number.

For a Modco transaction, a taxpayer's "modified taxable income" means taxable income computed "without regard to any base erosion tax benefit with respect to a base erosion payment."² The statute thus contemplates a two-step analysis: first, determine the applicable base erosion payment; and second, determine the base erosion tax benefit with respect to that payment.

A '"base erosion payment" is defined in §59A(d). Subsection (d)(1) provides that a base erosion tax payment is "any amount paid or accrued by the taxpayer to a [foreign related party] and with respect to which a deduction is allowable under this chapter." On its face, this subsection does not and cannot include the cash settlement amount or a gross ceded premium amount because neither amount entitles the U.S. life insurance company to a "deduction." Technically, both amounts reduce "life insurance gross income," which is computed under §803(a)(1). Subsection (d)(3) was therefore added when the bill was conferenced for the sole purpose of defining the cash settlement amount as a base erosion payment, as it should be.

Subsection (d)(3) states that notwithstanding subsection (d)(1), the term "base erosion payment also [includes] any premium or other consideration paid or accrued by the taxpayer to a [foreign related party] for any reinsurance payments which are taken into account under sections 803(a)(1)(B) or 832(b)(4)(A)."³ The inclusion of the word "also" here is important: without subsection (d)(3), the cash settlement amount would not be a base erosion payment. In construing the meaning of subsection (d)(3), diction and grammar are very important. First, Congress chose to use the phrase "any premium or other consideration," which is a phrase used elsewhere in Subchapter L that tax regulations construe to refer to a netted amount.⁴ Second, Congress's reference to section 803(a)(1)(B) in this statute begins with the word "which." A clause that begins with the word "which" is a subordinate dependent clause; it clarifies the meaning of the clause upon which it depends but does nothing to enlarge its scope. "Which" is not the same as "that"; if the word here had been "that," one would have to consider a "reinsurance payment" of the kind taken into account under §803(a)(1)(B) (which would be nonsensical). Perhaps a better arrangement of this definition — one that places the dependent clause next to the clause upon which it depends but that does not change its meaning-would have been: "base erosion payment [includes] any premium or other consideration paid or accrued by the taxpayer to a [foreign related party], which are taken into account under sections 803(a)(J)(B) or 832(b)(4)(A), for any reinsurance payments." The fact that premiums and other consideration are taken into account under §803(a)(1)(8) is merely tautological, not additive.

Finally, Congress chose to use the phrase "reinsurance payments," which appears nowhere else in the Tax Code, to capture the concept of the cash settlement amount. After all, this was the amount leaving the U.S. tax base before the BEAT provision was enacted. There is no other term in the Tax Code that defines this cash settlement amount, so Congress created a new term. We believed the meaning of the new term "reinsurance payment" was evident given the context of the BEAT's purpose and the tax provisions applicable to insurance generally.

Based on our recent conversation, I understand that it may not be. As I understand, Treasury may be considering the use of a bright line "gross premiums" test (the total gross amount of ceded premiums) to define the scope of §59A(d)(3). This would be a mistake; there is evidence in. the statutory scheme to reject this construction. First, if Congress intended the base erosion payment in §59A(d)(3) to be tantamount to the amount calculated under §803(a)(1)(B) with respect to a foreign reinsurer, it would simply have said so — and said so in a far easier manner than interposing the "base erosion payment" analysis required by subsection (d). It would very simply have defined "base erosion tax benefit" (with respect to Modco reinsurance) to mean "any reduction under section 803(a)(1)(B)." Congress did not do that. Instead, it created a two-step process pursuant to which the first inquiry is whether and to what extent there is a "base erosion payment." To construe the Modco reinsurance "base erosion tax benefit" specified in §59A(c)(2)(a)(iii) as the same thing as "the reduction under section 803(a)(1)(B)" is to read subsection (d) entirely out of the BEAT statute.

To the contrary, subsection (d) — the calculation of the "base erosion payment" — is a critical step in determining the "base erosion tax benefit." As a very simple matter, the entire purpose of tying the tax benefit to a "base erosion payment" is to define the benefit in reference to amounts actually paid or accrued, not theoretical amounts that never have been and never will be paid from the U.S. life insurer to the foreign affiliated reinsurer.

Second, a bright line rule would yield an absurd result. If Treasury were to construe "reinsurance payments" as the amount of gross premium attributable to the reinsurance contract and ceded to the foreign reinsurer-an amount that in many cases is a multiple of 15-20 times the cash settlement amount — the U.S. life insurer would have an effective tax rate approaching or exceeding l 00 percent. This outcome would require Treasury to espouse that Congress intended to kill Modco reinsurance with an affiliate when it enacted the BEAT provision. I can tell you we did not; in fact, r entered commentary into the Congressional Record evidencing our true purpose, which was to level the playing field between U.S. and foreign affiliate reinsurance.⁵ Evidenced in other provisions of the TCJA — in fact, of the BEAT provision itself-Congress knows how to specify a gross amounts test when it so intends.⁶

III. Proposed Interpretation of §59A(d)(3)'s Term "Reinsurance Payments"

While Congress intended the BEAT to recapture only the foreign affiliated reinsurance cash settlement amount, I understand Treasury's concern that allowing non-insurance company taxpayers to use something other than a gross basis calculation could lead to those taxpayers' trying to "beat" the BEAT through netting. For example, a U.S. taxpayer previously making transfer payments to a foreign affiliate could drum up a services contract from the affiliate to the U.S. entity in approximately the same amount as the outbound contract and enter into a group master netting agreement to evade the BEAT. I support Treasury's efforts to promulgate regulations to ensure that kind of abuse does not take place.

But Treasury should recognize that there is a long history of treating reinsurance payments quite differently. Accruing and settling reinsurance obligations on a fixed periodic basis has been the rule of the road in the life insurance and annuity industry for decades. Since at least 1959, the Tax Code has specifically called for various reductions, deductions, and additions in the calculation of life insurance company income tax. Life insurers do not choose this; it is imposed on them and on no other kind of company by Subchapter L. Similarly, non-tax prudential regulation of life insurers, overseen by state insurance commissioners, dictates what a life insurer can and must do with premiums it receives. Even if a U.S.-based life insurance company and a foreign affiliated reinsurer wanted to game the system by, say, an "expense stuffing" scheme, they likely would soon run afoul of collateral, reserve, and other stringent requirements applicable to life insurers.

The absurdity of the result that would occur if a gross premiums test were applied strongly suggests what I know to be true: that cash settlement amount is the amount referred to in §59A(d)(3). This fact does not mean that Treasury lacks the authority to issue regulations to use a true gross basis test in (most) other circumstances to ensure BEAT fully captures outbound related-party transfers.

* * *

Thank you for your continued efforts toward implementing the Tax Cuts and Jobs Act in a manner consistent with Congressional intent and the language of the statute. I share your interest in preserving a competitive foreign reinsurance market, which the BEAT was designed to place on a level playing field with domestic reinsurers. The BEAT was not intended to subject U.S. companies who choose to reinsure with a foreign affiliate to an effective tax rate of over 100 percent. I look forward to working with you on this provision.

If you have any questions, please do not hesitate to contact me.

Sincerely,

Lindsey O. Graham
United States Senator