SERVICE RELIES ON NAIC STATEMENTS IN FOREIGN INSURANCE COMPANY SOURCE RULE GUIDANCE.

Notice 89-96

This Notice provides interim guidance, until regulations or other guidance are published, for applying section 842 of the Internal Revenue Code as amended by the Omnibus Budget Reconciliation Act of 1987, Pub. L. No. 100-203, section 10242(a), 101 Stat. 1330 (the 1987 Act), and the Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647, section 2004(q)(3), 102 Stat. 3342 (the 1988 Act).

I. BACKGROUND.

Section 842(a) of the Code provides that if a foreign company carrying on an insurance business within the United States would qualify under part I or II of subchapter L for the taxable year if (without regard to income that is not effectively connected with the conduct of any trade or business within the United States) it were a domestic corporation, such company will be taxable under part I or II of subchapter L, whichever is applicable, on its income effectively connected with the conduct of any trade or business within the United States. The remainder of the foreign insurance company's income that is from sources within the United States is taxable as provided in section 881.

II. COMPUTATION OF MINIMUM EFFECTIVELY CONNECTED NET INVESTMENT INCOME UNDER SECTION 842(b).

Section 842(b)(1) of the Code provides that for any taxable year beginning after December 31, 1987, the net investment income of a foreign insurance company that is effectively connected with the conduct of an insurance business within the United States shall be not less than the amount of its "minimum effectively connected net investment income," as determined under section 842(b). Therefore, if a foreign insurance company's minimum effectively connected net investment income exceeds its net investment income, as determined under section 842(b)(5), that is actually effectively connected with the conduct of its trade or business within the United States, the company must increase its effectively connected income under section 842(a) by the excess.

Section 842(b) provides that the "minimum effectively connected net investment income" is the product of the "required U.S. assets" of the foreign insurance company and the "domestic investment yield" applicable to the foreign insurance company for the taxable year. However, if a company elects, it may use its "worldwide current investment yield," as defined in section 842(b)(4)(B), in lieu of the "domestic investment yield." Section 842(b)(4).

A. REQUIRED U.S. ASSETS. The required U.S. assets of a foreign insurance company for any taxable year equals the product of the mean of its "total insurance liabilities on United States business" and the "domestic asset/liability percentage" applicable to the company for the taxable year. Section 842(b)(2) of the Code.

(1) MEAN OF TOTAL INSURANCE LIABILITIES ON UNITED STATES BUSINESS. For taxable years of a foreign insurance company beginning after December 31, 1987, the mean of the company's total insurance liabilities on United States business is one-half of the sum of the "total insurance liabilities on United States business" on the last day of the current taxable year and on the last day of the preceding taxable year.

The "total insurance liabilities on United States business" of a foreign insurance company taxable under part I of subchapter L of chapter 1 of the Code (a foreign life insurance company) are described in section II.A(1)(a) of this Notice. The "total insurance liabilities on United States business" of a foreign insurance company taxable under part II of subchapter L (a foreign property and liability insurance company) are described in section II.A(1)(b) of this Notice.

(a) TOTAL INSURANCE LIABILITIES ON UNITED STATES BUSINESS OF A FOREIGN LIFE INSURANCE COMPANY. Section 842(b)(2)(B)(i) of the Code provides that the total insurance liabilities on United States business of a foreign life insurance company are the sum of the "total reserves" (as defined in section 816(c)) plus (to the extent not included in "total reserves") the items referred to in section 807(c)(3), (4), (5), and (6) as of the end of the taxable year. Under section 816(c), "total reserves" are the sum of (i) life insurance reserves (as defined in section 816(b)), (ii) unearned premiums and unpaid losses (whether or not ascertained) not included in life insurance reserves, and (iii) all other insurance reserves required by law. However, for purposes of section 842(b), the amount of any insurance liabilities attributable to "variable contracts," as defined in section 817(d), must be treated separately under the segregated asset account rules described in section II.D of this Notice.

For purposes of applying section 842(b) of the Code, the total insurance liabilities, as described above, of a foreign life insurance company shall be the amounts listed on lines 1, 2, 3, 4.1, 4.2, 5, 9, 10.1, 10.2, 10.3, and 11.1 of the "Liabilities, Surplus and Other Funds" statement of the life insurance company annual statement approved by the National Association of Insurance Commissioners (NAIC) as adopted by the insurance regulatory authorities of the state (as defined in section 7701(a)(10)) or states in which the foreign life insurance company is required to file the statement. In addition, a foreign life insurance company's total insurance liabilities on United States business include any items or amounts on lines 11.3 and 25 of the life insurance company annual statement to the extent that such items or amounts are includible in "total insurance liabilities on United States business" as defined in section 842(b)(2)(B)(i). In the case of a company that files NAIC statements in more than one state, or in no state, see paragraph II.A(1)(c) of this Notice.

(b) TOTAL INSURANCE LIABILITIES OF A FOREIGN PROPERTY AND LIABILITY INSURANCE COMPANY. Section 842(b)(2)(B)(ii) of the Code provides that the total insurance liabilities on United States business of a foreign property and liability insurance company are the sum, as of the end of the taxable year, of the company's unearned premiums and unpaid losses, including unpaid loss adjustment expenses (see sections 832(b)(5), 846(b)(1), and 846(f)(2)). For purposes of applying section 842(b) of the Code, the total insurance liabilities, as described above, of a foreign property and liability insurance company shall be the amounts listed on lines 1, 2, and 9 of the "Liabilities, Surplus and Other Funds" statement of the property and liability insurance company annual statement approved by the NAIC as adopted by the insurance regulatory authorities of the state (or states) in which the company is required to file the statement. In the case of a company that files NAIC statements in more than one state, or in no state, see paragraph II.A(1)(c) of this Notice.

A foreign insurance company that is taxable under part II of subchapter L as a property and liability insurance company must compute its total insurance liabilities on United States business on the basis of the rules applicable to a property and liability insurance company, notwithstanding that insurance regulatory authorities in one or more states may require the taxpayer to file a life insurance company annual statement. Therefore, a foreign property and liability insurance company that files a life insurance company annual statement with state regulatory authorities must prepare and attach to its federal income tax return the appropriate property and liability annual statement (or statements) showing the computation of total insurance liabilities on United States business. The foreign property and liability insurance company must prepare the property and liability annual statement (or statements) required by the preceding two sentences in accordance with the rules described in paragraph II.A(1)(c) of this Notice that are applicable to a foreign insurance company that is not required to file, or does not file, an annual statement in any state.

(c) NAIC STATEMENTS FILED IN MORE THAN ONE STATE, OR NO NAIC STATEMENT FILED, OR REQUIRED TO BE FILED, IN ANY STATE. If a foreign insurance company files an annual statement in more than one state, the company shall compute total insurance liabilities on United States business by using the annual statement of the state that results in the largest amount of total insurance liabilities on United States business. However, if the annual statement of the state that results in the largest amount of total insurance liabilities excludes insurance liabilities relating to a line of business reported on an annual statement filed in another state, the foreign insurance company must include in its total insurance liabilities on United States business the largest amount of the liabilities relating to that line of business reported on any annual statement to the extent that the inclusion does not double count any liability.

If a foreign insurance company is not required to file, or does not file, an annual statement with any state, then the company shall compute required U.S. assets by reference to the total insurance liabilities on United States business that the company would have reported on the appropriate annual statement if it had filed an annual statement with the insurance regulatory authorities of each state in which the risks insured or reinsured by the foreign insurance company are located. If a foreign insurance company would have filed an annual statement in more than one state, the company shall compute total insurance liabilities on its United States business by using the annual statement of the state that would have resulted in the largest amount of total insurance liabilities on United States business. However, if the annual statement of the state that results in the largest amount of total insurance liabilities excludes insurance liabilities relating to a line of business that would be reported on an annual statement filed in another state if the foreign insurance company filed an annual statement in each state in which the risks insured or reinsured by the foreign insurance company are located, the foreign insurance company must include in its total insurance liabilities on United States business the largest amount of the liabilities relating to that line of business that would be reported on an annual statement of any state in which the risks insured or reinsured by the foreign insurance company are located to the extent that the inclusion does not double count any liability. The company must complete and attach to the company's federal income tax return, in conformance with section 1.6012-2(c) of the regulations, that portion of the appropriate annual statement (or statements) necessary to compute the company's total insurance liabilities on United States business.

(2) DOMESTIC ASSET/LIABILITY PERCENTAGE. The Secretary determines the domestic asset/liability percentage separately for life insurance companies and property and liability insurance companies. The domestic asset/liability percentage applicable to each type of insurance company is the percentage determined by a fraction, the numerator of which is the mean of the assets of domestic insurance companies taxable under the same part of subchapter L as the foreign insurance company and the denominator of which is the mean of the total insurance liabilities of such domestic insurance companies. Section 842(b)(2)(C) of the Code. For the first taxable year beginning after December 31, 1987, the relevant asset/liability percentages are:

      120.5 percent for foreign life insurance companies

      10.0 percent for foreign life insurance companies

To compute its worldwide current investment yield, the foreign insurance company must use United States dollars to determine its net investment income and the value of its assets. The dollar value of readily marketable common stock must be determined by using the exchange rate in effect on the date for which the fair market value of the stock is calculated. The value of all other assets must be determined by using the average weighted exchange rate for the year in which the asset was acquired. Any reasonable method for determining the dollar value of net investment income will be accepted until further guidance under section 842 provides for a specific method, so long as the method selected is consistently applied to each qualified business unit, as defined in section 989(a), and is used in all taxable years.

The foreign insurance company may make the election to use its worldwide current investment yield in lieu of the domestic investment yield prescribed by the Secretary by using its worldwide current investment yield to compute the minimum effectively connected net investment income on the tax return for the first taxable year beginning after December 31, 1987 (or any subsequent taxable year), and by attaching to the return a statement indicating the election. If, for the first taxable year beginning after December 31, 1987, a foreign insurance company filed its tax return prior to the date the return would have been due had an extension been granted, then the company may make the election on an amended return that is filed by the extended due date. In addition to the election statement, the foreign insurance company must attach to its tax return for each taxable year a statement that (1) sets forth its gross investment income and the expenses deducted to derive net investment income; (2) explains in detail, and supports by computations, the method used for translating income in foreign currencies into United States dollars (including the currency exchange rates used); and (3) lists its assets (by type) and their values in United States dollars. The election applies to the taxable year for which it is made and for all subsequent taxable years unless revoked with the consent of the Secretary.

D. SPECIAL RULES FOR SEGREGATED ASSET ACCOUNTS. A foreign life insurance company must separately compute its minimum effectively connected net investment income with regard to segregated asset accounts under section 817 or comparable provisions under foreign law. For purposes of section 842(b), the minimum effectively connected net investment income of a foreign insurance company's segregated asset accounts will equal the net investment income of those accounts that is actually effectively connected with the conduct of the foreign insurance company's United States trade or business. Consequently, the foreign insurance company must include in its taxable income as computed under section 842(a) any net investment income from segregated asset accounts, but no additional investment income will be added by virtue of section 842(b)(1).

III. NET INVESTMENT INCOME.

If a foreign insurance company's net investment income, as defined in section 842(b)(5), that is actually effectively connected with the conduct of a trade or business in the United States is less than the company's minimum effectively connected net investment income determined under section 842(b)(1) and the rules set forth in this Notice, then the foreign insurance company shall determine its taxable income by increasing its income that is actually effectively connected with the conduct of a trade or business within the United States by the amount that such minimum effectively connected net investment income excess such net investment income.

A foreign insurance company's net investment income, as defined in section 842(b)(5), is the amount of its gross investment income (from assets other than segregated assets) within the meaning of section 834(b) (including tax-exempt interest) that is actually effectively connected with the conduct of a United States trade or business within the meaning of subchapter L and section 864(c), reduced by the expenses allocable to such effectively connected gross investment income under the principles of subchapter L, section 1.861-8 of the regulations, or other applicable provisions. In particular, gross investment income is reduced by capital losses, as specified in section 834(c)(6), and by expenses attributable to tax- exempt investment income. However, for life insurance companies, gross investment income is not reduced by either policy interest, as defined in section 812(b)(2), or gross investment income's proportionate share of policyholder dividends, as determined under section 812(b)(3). Similarly, for property and liability companies, gross investment income is not reduced by any portion of policyholder dividends or losses incurred that may be allocable to such gross investment income.

Notwithstanding any other provisions in this Notice, a foreign insurance company's minimum effectively connected net investment income includible in taxable income for the taxable year shall not exceed its worldwide gross investment income for the taxable year, determined in United States dollars, reduced by expenses allocable to the company's net investment income from its trade or business conducted in the United States. However, the Internal Revenue Service may disregard this limitation if distributions or other transfers between two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled, within the meaning of section 482, directly or indirectly by the same interests make it appropriate to consider the income and assets of other persons in order to reflect the proper amount of income and assets attributable to the foreign insurance corporation. See also section 845 regarding reinsurance transactions between related and unrelated persons.

IV. MINIMUM EFFECTIVELY CONNECTED NET INVESTMENT INCOME ATTRIBUTABLE TO UNITED STATES SOURCE PERIODICAL INCOME AND SUBPART F INCOME.

If a foreign insurance company must increase its taxable income under section 842(a) of the Code by an amount equal to the excess of its minimum effectively connected net investment income over its net investment income, as defined in section 842(b)(5), that is actually effectively connected with the conduct of its trade or business in the United States, then the amount of such excess reduces the company's income subject to taxation under section 881, to the extent thereof, and then reduces subpart F income of the foreign insurance company, if any. If the amount of income subject to taxation under section 881 is reduced, the amount of tax under section 881 shall be reduced (but not below zero) in conformance with section 842(c)(2). Income from sources without the United States that is treated as being subject to section 842(b) shall be treated as minimum effectively connected income notwithstanding section 864(c)(4)(D)(ii), which otherwise would exclude foreign source subpart F income from being taxed as income effectively connected with the conduct of a trade or business in the United States. However, the inclusion of such income under section 842(a) shall reduce the foreign insurance company's other income subject to United States tax in order to prevent any amount from being taxed twice.

V. ADJUSTMENT TO LIMITATION ON DEDUCTION FOR POLICYHOLDER DIVIDENDS IN THE CASE OF FOREIGN MUTUAL LIFE INSURANCE COMPANIES.

Section 842(c)(3) requires that, for purposes of section 809, the equity base of any foreign mutual life insurance company as of the close of any taxable year shall be increased by the excess of the required U.S. assets of the company (as determined under section 842(b)(2)) over the mean of the assets held in the United States during the taxable year. The mean of the assets held in the United States by a foreign mutual life insurance company is one-half of the sum of (1) the admitted assets reported on the company's annual statements for the current taxable year and the preceding taxable year, and (2) the nonadmitted financial assets described in section 809(b)(3)(B) at the end of the current taxable year and the preceding taxable year.

VI. ESTIMATED TAXES.

Notice 88-52, 1988-1 C.B. 537, provides that for the first taxable year beginning after December 31, 1987, a foreign insurance company must compute its estimated tax and its installment payments of estimated tax on investment income by using its actual investment income that is effectively connected with the conduct of the company's United States trade or business. A foreign insurance company that computes its taxable income using the minimum effectively connected income under section 842(b) must submit by the due date for payment of tax under section 6151 the difference, if any, between the sum of the estimated tax payments and the tax due. However, no payment of additional tax is required because of any underpayment of tax for any required installment in the first taxable year beginning after December 31, 1987, due prior to the publication of this Notice, if the conditions set forth in Notice 88-52 have been met.

To compute estimated tax and the installment payments of estimated tax due for taxable years beginning after December 31, 1988, a foreign insurance company shall compute its estimated tax payments by adding to its income other than net investment income the greater of (i) its net investment income, as determined under section 842(b)(5), that is actually effectively connected with the conduct of a trade or business within the United States for the relevant period, or (ii) the minimum effectively connected net investment income that would result from using the most recently available domestic asset/liability percentage and domestic investment yield, provided that the most recently available domestic asset/liability percentage and domestic investment yield have been published at least 20 days prior to the due date of the installment. If the installment is due within 20 days or less from the date of publication of the most recently available domestic asset/liability percentage and domestic investment yield, the domestic asset/liability percentage and domestic investment yield for the preceding taxable year shall be used to compute the minimum effectively connected net investment income. To determine required U.S. assets, the foreign insurance company shall compute its total insurance liabilities on United States business as the mean of such liabilities from the end of the prior taxable year to the end of the quarter of the taxable year immediately preceding the payment date of estimated tax. For the first installment of estimated taxes in any taxable year, however, the foreign insurance company may use the mean of its total insurance liabilities from the preceding taxable year to compute required U.S. assets. No additions to tax will be made for any underpayment of estimated tax for any required installment in the first taxable year beginning after December 31, 1988, caused by the foreign insurance company's reliance on this Notice or Notice 88-52.

VII. ADJUSTMENTS IN SUCCEEDING TAXABLE YEARS.

Section 842(d) requires the Secretary to prescribe such regulations as may be necessary or appropriate to provide for proper adjustments in succeeding taxable years where the company's actual net investment income for any taxable year that is effectively connected with the conduct of an insurance business within the United States exceeds the amount required under section 842(b)(1). Guidance on this adjustment provision will be issued at a later date.

VIII. SEPARATE DETERMINATIONS FOR FOREIGN PROPERTY AND LIABILITY COMPANIES.

Section 842(d)(4) permits the Secretary to prescribe separate domestic asset/liability percentages and domestic investment yields for separate categories of property and liability insurance companies. No guidance will be issued at this time because individual company analysis suggests that separate calculations would not be appropriate.

IX. PROCEDURAL INFORMATION.

This Notice serves as an "administrative pronouncement" as that term is used in section 1.6661-3(b)(2) of the regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure.

X. DRAFTING INFORMATION.

The principal authors of this Notice are Philip L. Garlett of the Office of Associate Chief Counsel (International) and Frederick Campbell-Mohn of the Office of Associate Chief Counsel (Technical). Mr. Gerlett can be telephoned at (202) 566-6645, and Mr. Campbell- Mohn can be telephoned at (202) 566-3432. Written comments should be sent, in duplicate, to Internal Revenue Service, Office of the Associate Chief Counsel (International), 1111 Constitution Avenue, N.W., Washington, D.C. 20224, Attention: CC:INTL:Br2, Room 4712.