Peterson Institute Fellow Warns Against Raising Taxes on Foreign Reinsurers

© Peter G. Peterson Institute for International Economics. All rights reserved.

These are difficult times. Not only are 10 percent of Americans unemployed but the federal budget is out of whack thanks to the specter of rising entitlement outlays. A natural impulse in difficult times is to protect domestic products and domestic producers. The tone of political economy during the global recession of 2007-09 is no different from that in past recessions -- but louder because the economic damage is more severe. Emblematic of this spirit is a proposal to discriminate against foreign-owned insurance companies, using the tax code.

Under the broad canopy of trade and investment protection, opportunistic flowers are sometimes linked to worthy public policy objectives. So it is with the Neal bill (HR 3424), named after Congressman Richard Neal (D-MA).¹ This bill (first introduced in 1998) would tax foreign-owned insurance companies doing business in the United States more heavily than US-owned insurance companies doing exactly the same business in the United States. The worthy goal in this instance is to prevent tax abuse. However, the structure of the bill has provoked well-founded protests from Europe. If enacted the bill would likely be challenged in the World Trade Organization (WTO).

Besides breaking international obligations, what's the harm of tax discrimination against foreign-owned insurance companies? In the wake of 9/11, international insurance and reinsurance firms paid 64 percent of all US claims. In the wake of hurricanes Katrina, Wilma, and Rita, they paid 47 percent of all claims.² International insurance companies are major providers of earthquake insurance in California and windstorm insurance in Texas. Some 13 of the 19 reinsurance companies that report data to the Reinsurance Association of America are foreign owned. In addition to reinsurance, foreign-owned insurance companies operating in the United States are big players in the "surplus lines" category of insurance -- mainly large industrial or commercial risk policies. Catastrophic losses covered by reinsurance or surplus lines call on the deep pockets of the global insurance industry. When the next disaster strikes, the US economy would hardly benefit from the departure of foreign-owned insurance companies and their foreign affiliates. Yet the Neal bill will go some distance toward driving these companies away.

Equally important, it is a bad idea to deny US nonfinancial companies the benefit of competition between US-owned and foreign-owned firms in an industry that collects hundreds of billions of dollars of premiums annually.

INTERNATIONAL AGREEMENTS IN A NUTSHELL

In a moment I will delve into the details of the heavier tax burden and its potential impact on the US insurance market. But even without these details, tax discrimination is bad policy per se: It violates the national treatment provision of the WTO's General Agreement on Trade in Services (GATS) -- an agreement vigorously championed by the United States -- and the nondiscrimination provisions of US income tax treaties designed to prevent double taxation. If the Neal bill or something like it is enacted, European countries are almost certain to bring a case against the United States in the WTO and seek whatever redress they can under US income tax treaties. Some European countries might consider tit-for-tat retaliatory legislation that would hurt US-owned insurance companies. While legal and retaliatory battles are waged, some foreign-owned insurance companies might reconsider their presence in the US insurance market -- a role that has greatly benefited the US households and firms that suffered catastrophic losses in the wake of 9/11 and Hurricane Katrina.

The scenario just painted is quite unnecessary. Tax abuse in the insurance market, if it exists, can be addressed without discriminating against foreign-owned companies.

In 1995, the United States inscribed insurance under its schedule of GATS commitments. This locks in the obligations of Article XVII: National Treatment, which reads:

Following ratification in 1913 of the 16th Amendment to the US Constitution, which permitted the imposition of income taxes, the United States began to negotiate bilateral tax treaties with other countries to avoid double taxation of income. Today, the United States has more than 50 double-tax treaties in force. Nondiscrimination is a fundamental clause in these treaties. For example, Article 24: Non-Discrimination of the 1998 treaty with Switzerland provides:

THE NEAL BILL IN BRIEF

Current US tax law allows US insurance companies (whether US-owned or foreign-owned) to deduct reinsurance premiums paid to affiliated or unaffiliated insurance companies based abroad as well as in the United States. However, premiums paid to a foreign-based insurance company are subject to a federal excise tax (FET) at the rate of 1 percent of the gross premium -- unless the company is based in a country covered by a double-tax treaty with a waiver provision similar to the Swiss treaty quoted above or the premiums are "effectively connected" to the conduct of a US trade or business. Because the narrow-gauge US tax treaty with Bermuda does not waive the FET, reinsurance premiums paid to affiliates based in that country generally pay the 1 percent FET.³

The Neal bill would limit the tax deductibility of reinsurance premiums paid by a foreign-owned insurance company based in the United States to its foreign affiliates, but the same limit would not apply to a US-owned insurance company. Specifically, the bill creates a benchmark, called the "industry fraction," which represents the US industry average level of nonaffiliated reinsurance by line of business. When a foreign-owned company pays premiums both to its nonaffiliated and affiliated reinsurers that exceed the "industry fraction," the excess is disallowed as a deduction, to the extent of premiums paid to affiliated reinsurers.⁴

The Neal bill does contain an election that the affiliated foreign-based reinsurance firm can execute, and elect to be taxed as a US firm, thereby relieving the US-based (but foreign-owned) insurance firm from the tax penalty. But the election is meaningless, since it only offers the foreign-owned group a choice to jump from the frying pan into the fire: If it made the election, the foreign-owned group would face an overall tax burden that discriminates to an even greater extent. Many US-owned insurance companies control reinsurance affiliates based abroad, which are subject to total tax burdens at less than the US statutory rate. However, the election in the Neal bill would subject foreign-owned insurance companies with reinsurance affiliates based abroad not only to the US statutory rate but also to the branch profits tax of 30 percent on top of that.

The Joint Committee on Taxation (JCT) has scored the Obama administration proposal, which is similar to the Neal bill, as raising $2.3 billion over ten years. That makes it an attractive "pay for" in the context of specific legislative proposals that are working their way through Congress. The Obama administration's own score for its proposal has it raising $520 million over ten years -- a far more realistic estimate. However, it is the JCT score that counts for "pay for" purposes.

One might ask why the Neal bill (and the related administration proposal) does not raise still more money by applying its limits on deductibility to all US insurance companies, whether US-owned or foreign-owned. The snappy answer is straightforward: Several US-owned insurance companies support the Neal bill as written, but the coalition is not enthusiastic about increasing its own tax burden. The deeper answer is that the United States will severely undermine its competitiveness in the global economy by embarking on a course of higher corporate tax rates.

CAN THE NEAL BILL BE SAVED BY CALLING THE MEASURE A DIRECT TAX?

The short answer is "no." If by some torture of language, the Neal bill is said to impose a direct tax, and thus escapes the national treatment requirement of GATS Article XVII -- by way of GATS Article XIV(d) -- the quick reply should be "not so fast."

Article XIV(d) requires that any difference in direct taxes between US-owned and foreign-owned firms should not "constitute a means of arbitrary or unjustifiable discrimination...or a disguised restriction on trade in services." The fact that the Neal bill has been championed by US-owned insurance firms speaks to the possibility that it constitutes a "disguised restriction on trade." This possibility is reinforced by the technical explanation of the bill, which argues that current law operates as a "competitive disadvantage for U.S. insurers and reinsurers." Moreover, the Neal bill surely imposes "arbitrary or unjustifiable discrimination" since, by a simple drafting change, the same deduction disallowance could be applied to all US insurance companies, whether US-owned or foreign-owned.

Returning to common sense, supported by internationally agreed definitions of indirect taxes in the WTO Agreement on Subsidies and Countervailing Measures, it requires a linguistic contortionist to characterize the Neal bill as a direct tax rather than an indirect tax. An expense deduction normally claimed by insurance companies -- namely payment of reinsurance premiums to another firm -- would be denied for purposes of computing net income. Yet losses paid by the reinsurance affiliate would be included in the gross income of the foreign-owned US-based insurance company. Put these facts together and you have a tax on revenue, not a tax on net income.

If the Neal tax is magically characterized as an income tax, what about the nondiscrimination obligations of the US-Swiss double-tax treaty and multiple other double-tax treaties? Do those obligations get tossed out the window?

As for breaking international obligations, two can play that game. If the United States ignores its commitments, and imposes discriminatory taxes on foreign-owned companies, it is only a matter of time before European nations impose payback taxes on US-owned companies. In the meantime, a legal case in the WTO seems all but certain.

Is this the right way for the world's most powerful country to write its tax laws?

tax notes

Neal Bill and Foreign-Owned U.S. Insurance Companies: Hufbauer Responds to Rosenbloom

To the Editor:

On May 10, 2010 (at p. 703), Tax Notes published a letter from an old colleague, H. David Rosenbloom, responding to my Policy Brief which criticized H.R. 3424 (the Neal bill). For the text of Rosenbloom's letter, see Doc 2010-10037 or 2010 TNT 89-31 ; for the text of my Policy Brief, see Doc 2010-10059 or 2010 TNT 87-38 . The purpose of this letter is to set the record straight and explain in more detail why the Neal bill would discriminate against foreign-owned US insurance companies.

In classical fashion, this letter is divided into three parts. First it responds to Rosenbloom's description of the Neal bill; second it addresses his analysis of the bill from a tax treaty perspective; and third it turns to implications under the rules of the World Trade Organization (WTO).

Description of the Neal Bill

We both agree that that tax discrimination is bad policy. However, Rosenbloom asserts "not true," when I say that the Neal bill would limit deductions "paid by a foreign-owned insurance company based in the United States to its foreign affiliates, but the same limit would not apply to a U.S.-owned insurance company." That is exactly what the bill does; it limits deductions paid by a foreign-owned insurance company based in the United States to its foreign affiliates. To be sure, nowhere does the bill contain a title headed "Discrimination against foreign-owned insurance companies." But the terms of the bill clearly apply to foreign-owned insurance companies, not their U.S.-owned competitors.

The Neal bill's limitation on tax deductions applies only to payments (above the formula) made to foreign-owned, foreign-based reinsurers, and not to payments made to U.S.-owned or U.S.-based reinsurers. It accomplishes this by defining the term "affiliated non-taxed reinsurance premium" as any reinsurance premium paid directly or indirectly to an affiliated corporation if that premium is neither subpart F income (i.e., U.S.-owned) or not subject to U.S. tax (i.e., U.S. based). Rosenbloom is thus incorrect when he states that the "bill does not distinguish among insurance companies based on for-eign or domestic ownership." Indeed, he acknowledges that "the primary effect of the . . . bill would doubtless be on foreign-owned insurance companies . . ." It is no accident that many U.S.-owned insurance companies have championed the Neal bill but few if any foreign-owned insurance companies have done so.

Rosenbloom states that the bill "denies deductions only to the extent a U.S. insurance company pays reinsurance premiums in excess of industry averages. . . ."

This obfuscates the true nature of the formula used to determine the denial of the deduction. The limit is based on the average industry use of unaffiliated reinsurance. The industry average for unaffiliated reinsurance payments over a period of years is believed to fall somewhere between 10 percent and 15 percent. However, nearly half of U.S. insurers reinsure more than 50 percent of their business to affiliates. Accordingly, the limitation is designed to prevent foreign-owned U.S. insurers from conducting their business in the same manner as their U.S.-owned counterparts. If the Neal bill was intended not to discriminate, the benchmark norm for denying deductions would be the industry's average use of affiliated reinsurance.

Rosenbloom argues that the election provisions in the bill allow a foreign reinsurer to be treated "exactly the same" as a U.S.-owned reinsurer. To be sure, the bill allows a foreign-owned reinsurer to elect to treat any reinsurance income received from related U.S. insurance companies as effectively connected with a U.S. business and therefore subject to U.S. income tax. However, if the foreign-owned reinsurer made this election, it would face a swarm of tax bites: (i) it would be subject to U.S. income taxes plus branch profits taxes, resulting in an effective U.S. tax rate up to 55 percent; (ii) it would be subject to double taxation by the United States and its home country; (iii) it would be required to waive all U.S. tax treaty benefits; (iv) it would not be permitted to join in a consolidated tax return with its U.S. affiliates; and consequently (v) unlike U.S. companies in a U.S.-owned group, it would not be able to offset its own losses against the income earned by the related U.S. insurance company. A U.S.-owned insurance company that cedes payments to an affiliated foreign reinsurance affiliate faces none of these tax bites, and even under subpart F its maximum income tax rate is 35 percent. No wonder Rosenbloom's claim of equality by virtue of the election provision rings hollow to foreign-owned U.S. insurance companies.

Tax Treaty Perspective

Turning to the question of U.S. tax treaty obligations, the U.S. Treasury's technical explanation to the current Model Tax Treaty explains that the non-discrimination provision "ensures that nationals...and residents of a Contracting State...will not subject, directly or indirectly to discriminatory taxation in the other Contracting State." [Emphasis added] However, the Neal bill treats two similarly situated U.S. insurance companies differently, depending upon the residence of the parent firm. The bill only applies if the parent of the U.S. insurer is foreign. The bill flat out discriminates against the foreign parent's U.S. subsidiary, which is specifically prohibited under many U.S. income tax treaties (see e.g., U.S.-Germany Income Tax Treaty Art. 24, Par. 4; U.S.-Switzerland Income Treaty Art. 24, Par. 4; and U.S.-Ireland Income Tax Treaty Art. 25 Par. 3). Rosenbloom attempts to argue that this is not the case by claiming that "ownership is not part of the equation." This is a remarkable claim. By its terms, the bill does not disallow reinsurance premiums paid to a reinsurer if that premium is either subpart F income or subject to U.S. income taxation. What does that leave? Foreign reinsurers with foreign parents.

I agree with Rosenbloom that the United States has a legitimate claim to protect its domestic tax base. But the United States should not penalize foreign firms to protect domestic firms -- even when the two sets of firms are subject to different corporate tax systems. Imagine the tax havoc if the United States attempted to impose its worldwide corporate tax system on SAP (a multinational enterprise headquartered in Germany) using the argument that SAP competes with Oracle in the high-end U.S. software market. If the United States wants to ensure equivalent tax treatment for all firms selling goods and services in the U.S. market, it should sharply reduce the corporate tax rate and instead raise revenue through a value added tax.

Rules of the World Trade Organization

Playing games with the corporate tax system is not a sensible way to protect the domestic tax base, and beyond that it would violate U.S. legal obligations under the WTO's General Agreement on Trade in Services (GATS). The Neal bill would clearly constitute "a means of arbitrary or unjustifiable discrimination between countries where like conditions prevail, or a disguised restriction on trade in services," and these acts are expressly prohibited by GATS Article XIV, unless a very specific exception can be cited. The character of the denied deduction does not meet any of the specific exceptions enumerated in Article XIV. As already explained, the structure of the Neal bill is geared toward penalizing foreign competition. This is manifested threefold: (i) the apples to oranges comparison of measuring use of unaffiliated reinsurance to determine what is "excess" foreign affiliated reinsurance use; (ii) the failure to allow the foreign-owned U.S. insurer to deduct losses that result from the specific reinsurance premiums, which means the tax operates upon gross premiums, not profits; and (iii) the double taxation of income, because it ignores any income tax paid by the foreign reinsurer to its own tax authorities.

² See the European insurance and reinsurance federation (CEA), "CEA Response to US Senate Finance Discussion Draft to disallow the deduction of reinsurance premiums with respect to United States risks paid to affiliates," CEA letter dated February 27, 2009, available at www.cea.eu. Also see "CEA Comment on US proposal disallowing tax deduction of certain affiliated reinsurance premiums," April 9, 2010, available at www.cea.eu.

³ Many reinsurance firms have affiliates based in Bermuda, both because the legal regime is stable and because taxes are low. If the Bermuda reinsurance premium income is "effectively connected" to a US trade or business, and therefore subject to US tax, the FET does not apply. Note that Bermuda is not a member of the WTO.

⁴ This brief discussion omits mention of "ceding commissions" -- i.e., commissions paid by the reinsurance firm back to the originating insurance firm -- but such commissions play little or no role in the discrimination between foreign-owned and US-owned firms.