Liberty Mutual Uneasy About Debt-Equity Regs' Impact on Insurers

We would like to thank you and your staff for meeting with us on June 23 to discuss issues facing U.S.-based global insurers relating to the proposed regulations (REG-108060-15) under section 385 of the Internal Revenue Code¹ ("Proposed Regulations")². We are concerned that the Proposed Regulations will result in unintended consequences as it relates to the insurance industry, which is uniquely impacted because it faces myriad regulatory requirements. As such, we respectfully request careful consideration of targeted changes to ensure that the insurance industry is not inadvertently placed at a competitive disadvantage.

Liberty Mutual Insurance ("Liberty Mutual") is a U.S.-headquartered, diversified, global insurer. We employ 50,000 employees across 800 offices and operate in 30 countries³. Worldwide revenue for 2015 was $37.6 billion. Like other property-casualty insurers, the Company's profitability is cyclical and highly affected by catastrophes (ranging from $2.7B in 2011, to $1.3B in 2014 and $1.8B in 2015. Liberty Mutual's insurance operations are subject to extensive regulatory oversight in the United States (by state), the EU, and the foreign countries where we operate, including with respect to our capital structure and the requirements of Solvency II⁴.

As you know, U.S.-based multinational enterprises efficiently redeploy cash through a variety of ordinary course internal cash management techniques, including intercompany loans. Like our foreign-based insurance counterparts, we typically issue third party debt from a U.S. holding company and loan or contribute cash to foreign insurance subsidiaries or holding companies. There is a strong business rationale in the insurance industry, where possible, for loaning money rather than contributing capital as this requires local management to effectively manage operations to meet repayment terms and allows the U.S. parent to manage a limited capital base that is subject to numerous different regulations. Local insurance regulators also influence capital management decisions by restricting or requiring approval for dividends and setting standards for admissible capital for local insurance companies.

Liberty Mutual broadly understands the intent of the Proposed Regulations as described in the preamble. However, the purpose of those regulations does not fit well in connection with ordinary course business transactions of US.-based insurance multinationals. As a U.S.-based multinational insurance organization that is taxed on its worldwide income, liberty Mutual believes there are unintended consequences that do not fall within the scope of transactions that the Proposed Regulations are intended to address. The following is a list of the key concerns for liberty Mutual as well as some related proposals to mitigate these unintended consequences:

1. Treatment of foreign tax credits attributable to payments that have been recharacterized from interest and principal to dividends.

• Issue: U.S.-based multinationals, particularly insurance companies that are "per se" corporations and ineligible for "check the box" elections, operate through foreign insurance subsidiaries that are almost all CFCs (as opposed to disregarded entities). Debt issued by a CFC that is recharacterized under proposed § 385 regulations will be treated as nonvoting equity. IRC §§ 902 and 960 provide for a foreign tax credit ("FTC") to certain U.S. shareholders of CFCs on payment or deemed payment of dividends. The FTC mechanism is designed to eliminate double taxation of foreign earnings. Eligibility for the FTC generally requires that a U.S. corporate shareholder own at least a 10% voting interest in a foreign entity (§ 902). Recharacterization of a CFCs related party debt as nonvoting equity will result in double taxation of payments as a result of the loss of FTCs related to the earnings that are recharacterized as a dividend on nonvoting stock. Loss of FTCs and the resulting double taxation would apply with respect to loans from a U.S. entity to a CFC, as well as from one CFC to another CFC.

• Proposal: There are a number of ways that this form of double taxation could be avoided. For instance, allow recharacterized debt to qualify for the credit (or deemed paid credit) to the extent an actual dividend would have qualified if paid to existing shareholders within the expanded group immediately prior to the recharacterization of debt. Alternatively, with respect to recharacterized interest and principal payments, apply the "one corporation" rule of § 1.385-1(e) to determine the E&P and FTC consequences of the payments (as long as the U.S. consolidated group includes U.S. shareholders, the treatment for U.S. shareholders, direct or indirect, would apply). (Note these alternatives would similarly need to preserve FTCs with respect to loans from one CFC to another CFC.) Both proposals allow for E&P and tax pools to be reduced by the recharacterized interest or principal payment and require that taxes remain with the related E&P⁵.

• Issue: U.S.-based multinational insurers who loan money to a foreign subsidiary as part of normal capital management practices would fall under the Proposed Regulations. If a loan is made directly to a foreign subsidiary (holding company or foreign insurer), interest income is subject to tax in the U.S. (included in the U.S.-consolidated return), and interest expense is deductible (subject to local tax rules) in the local country. If a loan is made from a foreign subsidiary (holding company or insurer) to another foreign subsidiary, neither the interest income or interest expense is subject to current tax in the U.S. (ultimately tax will be due on repatriation of profits, but there is limited ability to strip earnings from the U.S.). There are also situations where a U.S.-consolidated group would loan funds to a non-consolidated U.S. entity that is an expanded group member but not a consolidated group member. In this instance, both the interest income and interest expense are subject to tax in the U.S., although in separate tax returns. In all examples, the issuance of debt as well as overall debt and capital levels are strictly regulated for insurers and regulation under Solvency II is typically at a holding company level and applies to all insurance and non-insurance subsidiaries. Application of Proposed Regulations under § 385 in these instances results in significant administrative complexity, while the U.S. tax consequences arising from the indebtedness are not in conflict with any of the material policy goals of the regulations.

• Proposals:

• • Amend definition of EGI in § 1.385-2(a)(4)(ii) and (iii) to specify that, if the holder of an EGI is a member of the consolidated group (§ 1.385-1(e)), and the issuer is a foreign person, then both are considered members of the consolidated group for determining whether the instrument is an EGI.

  • Exempt foreign to foreign loans from application of § 1.385. Exemption would need to apply to bifurcation rules, documentation rules, and the funding rules. Either a broad exemption or an ordinary course exemption in both § 1.385-2 and § 1.385-3.

  • Exempt loans between regulated entities from application of § 1.385. Exemption would need to apply to bifurcation rules, documentation rules, and the funding rules. Either a broad exemption or an ordinary course exemption in both § 1.385-2 and § 1.385-3. The definition of regulated entities should include all entities (whether insurance or non-insurance) subject to regulation).

  • The insurance industry is submitting comments that explain unique issues to life-nonlife consolidated returns with a proposed solution that Liberty Mutual supports.

• Issue: Liberty Mutual believes that comments will be submitted identifying issues related to the use of current-year earnings and profits. There are numerous issues across industry lines that are raised by the Proposed Regulations. For property-casualty insurers, however, there are two key issues:

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  1. Earnings are volatile due to covered catastrophe and other losses. Indebtedness could be issued early in the year with full expectation that the issuer will have sufficient earnings and profits to meet the § 1.3 85-3(c) exception, but prior to a large catastrophe that drastically reduces or eliminates the expected current earnings and profits for that year. It is also likely that short-term indebtedness will be put in place as a result of a catastrophe to enable an issuer to pay claims. In the first instance, current-year earnings and profits is nearly impossible to accurately predict. In the second instance, a loan is required for short-term cash funding to meet current (and unexpected) policyholder obligations. Cumulative earnings viewed over a series of years would be a more accurate measure of profitability.

  2. Payment of dividends is subject to local law limitations and often requires regulatory approval to ensure that adequate capital is maintained. As a result, it is highly unusual for foreign insurers to distribute earnings on an annual basis. Rather, earnings are often required to be re-invested as regulatory capital. Excess earnings, if any, are built up over time and distributed every few years. An assumption that insurers are able to distribute current profits annually is not accurate.

• Proposal: Allow the exception in § 1.385-3(c) to be for an amount equal to the sum (cumulative) of such member's most recent five (5) years of net undistributed earnings and profits. (Note that using average earnings does not take into account insurer annual dividend restrictions.)

• Issue: Proposed regulation § 1.385-3(b)(iv)(B)(2) provides an exception to the "per se" funding rule (debt instrument is issued with a principal purpose of funding a distribution or acquisition) for debt instruments that arise in the ordinary course of the issuer's trade or business. The proposed regulations further define ordinary course obligations as those that would be deductible under § 162 or included in cost of goods sold or inventory. Insurers do not have cost of goods sold or inventory and many ordinary course obligations (i.e., losses incurred) are defined under § 832 for property-casualty insurers and §§ 803-805 for life insurers. The field should be leveled for insurance and non-insurance companies.

• Proposals:

• • Clarify the ordinary course business exception to include obligations arising in the ordinary course of trade or business activity for the insurance industry included in Subchapter L.

  • § 1.385-2 (a)(4)(i)(B) reserves on the application of the bifurcation and documentation rules to an interest that is not, in form, a debt instrument. Any future guidance should take into account similar ordinary course trade or business activity.

• Issue: Both U.S. and foreign insurance companies are subject to regulation in their home jurisdictions (U.S. state or foreign country). Insurer regulation ensures that capital meets minimum adequacy levels and that asset quality meets certain specifications. Dividend capacity (ability to pay dividends), overall debt levels, and the issuance of debt instruments are all highly regulated. Some insurer debt instruments include regulatory provisions that restrict, in certain circumstances, an insurer's ability to make interest and/or principal payments (as dividends are also restricted in certain circumstances). These insurer debt instruments (surplus notes in the U.S. or Solvency II debt in the EU) result in regulators providing some limited "capital credit" to the insurers for what is treated in applicable financial statements (U.S. GAAP) and for all other purposes, as debt. Third parties would typically take these regulatory restraints into consideration when investing in an insurance company, whether it is through equity or debt markets.

• Proposal: For purposes of evaluating whether a debt instrument should be respected as bona fide indebtedness under U.S. federal income tax principles under either § 1.385-1 or § 1.385-2, regulatory restrictions imposed on insurers should not be per se disqualifying and should be evaluated in the same manner that third-party lenders or investors would evaluate such instruments and the issuing insurer. Specifically, the rules should provide that the requirements that an issuer have an "unconditional obligation to pay" and that an instrument holder must have "creditor's rights" should be interpreted in light of the unique regulatory environment that insurers operate in, and the presence of these limitations or conditions should not automatically result in bifurcation or disqualification of a debt instrument. This proposal should specifically apply to related party surplus notes issued by a U.S. insurer as well as Solvency II debt issued by a foreign insurer.

• Issues: The Proposed Regulations substantially change how insurers manage internal cash by requiring new U.S. tax analysis: (i) the decision to fund foreign subsidiaries with debt or capital, often made in conjunction with regulators, will now require specific contemporaneous, third-party equivalent, "audit ready," U.S. tax documentation; (ii) the ability to bifurcate instruments that were historically treated as either 100% debt or equity adds a level of uncertainty that tax departments will need to address, manage, support, and potentially disclose; and (iii) new systems will need to be put in place to track the various funding transactions under § 1.385-3.

• Proposals:

• • Documentation: § 1.385-2(b) will recast EGI as stock if documentation and maintenance requirements are not met, subject to a very limited "reasonable cause" exception. We believe these requirements are overly burdensome for most U.S.-based multinationals. However, even if not reduced appropriately, a transition rule would be appropriate to allow companies to work with tax departments and potentially unrelated third-party lenders to develop the required due diligence analysis and documentation. An example for a transition period is found in the recent FATCA legislation where, in Notice 2014-33, a two-year transition period where taxpayers who made "good faith efforts" to comply were provided with relief if requirements were not met. Relief would take the form of no recast of EGI. Notice 2014-33 states that this "transition period for compliance is similar to other transition periods that the IRS has provided when it has introduced at significantly revised due diligence, reporting, and withholding rules."

  • Bifurcation: Provide transition relief on bifurcation of debt to eliminate the significant uncertainty of how debt will be treated or evaluated on audit Absent guidance (e.g., LB&I audit procedures and what circumstances bifurcation would be appropriate or inappropriate), safe harbors, or an ability for taxpayers to obtain fast-track resolution and/or use profiling procedures, there will be significant uncertainty in how to evaluate an instrument subject to bifurcation and present/disclose the consequences in financial statements. A transition period should be allowed to further discuss and communicate the intended application of, or procedures/safe harbors taxpayers can pursue where debt would not be subject to bifurcation.

  • Funding Rules: Proposed regulations under § 1.385-3 may be adjusted to reflect comments submitted and to clarify numerous uncertainties. In order to allow companies to establish the systems to track applicable debt instruments, distributions, stock acquisitions and property acquisitions by legal entity, (i) the § 1.385-3(h)(1) effective date should be for debt issued after final regulations are published; and (ii) the rules should only be applied to distributions or acquisitions occurring after final regulations are published (§ 1.385-3(h)(2)).

² On April 4, 2016, the IRS and Treasury issued Proposed Regulations ("the Proposed Regulations") under authority granted in section 385 of the Internal Revenue Code ("Code") that, among other changes to existing U.S. tax rules, would, in certain circumstances, treat related-party debt as equity for U.S. tax purposes.

³ In terms of size, liberty Mutual ranks 73^rd among Fortune 500 Companies. We also are the 5^th largest property and casualty insurance writer in the U.S. and the 6^th largest global property and casualty insurer,

⁴ A European Union Directive that harmonizes European Union insurance regulation.

⁵ For example, assume CFC is owned 10% by US1, 80% by US2 (all within the same expanded group ("EG")), and 10% by unrelated FC. CFC has $500 of cumulative untaxed E&P and $100 in its section 902 tax pool. Assume US3 (also within the same EG) receives Note1 in Year 1 from CFC for $200 and this note is thereafter recharacterized as equity (due to the operation of the 51.385-3 rules). In year 2, CFC repays the note (this example ignores interest). If CFC had paid a $200 dividend to shareholders within the EG, the dividend would have resulted in a $40 FTC to US1 and US2. Under this proposal, the repayment of Note1 in Year 2 to US3 will result in the same $40 FTC allowable to US3. CFC E&P after principal repayment will be $300 with a tax pool of $60. (In the event other distributions are made, US1 voting control should remain at 10%, and should not be further diluted.)