How Tax Reform Will Impact Insurance Companies
The Tax Cuts and Jobs Act (the “Act”) was signed into law by the President on December 22, 2017. The Act lowers the corporate tax rate from 35 percent to 21 percent beginning in 2018 and makes significant changes to the tax law that will impact corporations in general, including insurance companies. In addition, the Act includes a number of insurance tax provisions that will specifically impact life insurance companies and/or property and casualty insurance companies.
This Alert summarizes the major general corporate tax provisions that impact insurance companies as well as the insurance-specific items.
General Corporate Tax Provisions
Summary of Changes Impacting All Corporations
Rate Reduction
The Act reduces the corporate tax rate from 35% to 21% for taxable years beginning after December 31, 2017.
This will impact all corporations, including insurance companies, beginning in 2018. It will also affect the calculation of deferred tax assets as of 4th quarter 2017 for both GAAP (ASC 740) and STAT (SSAP 101) purposes.
Alternative Minimum Tax (AMT)
The Act eliminates the corporate AMT for taxable years beginning after December 31, 2017.
Continues to allow the prior year minimum tax credit to offset the taxpayer’s regular tax liability for any tax year. For tax years beginning after 2017 and before 2022, the prior year minimum tax credit is refundable in an amount equal to 50% (100% for tax years beginning in 2021) of the excess of the credit for the tax year over the amount of the credit allowable for the year against regular tax liability.
Dividends Received Deduction (DRD)
The Act reduces the 80% DRD to 65% and the 70% DRD to 50%.
Full Expensing of Certain Business Assets
The Act allows full expensing for the cost of property placed in service after September 27, 2017. The 100% expensing rule is reduced gradually for property placed in service after December 31, 2022, and before January 1, 2027, with no expensing available for property placed in service after December 31, 2026.
Limitation on Business Interest Expense Deduction
The Act generally limits the deduction for net interest expense for businesses with average annual gross receipts over $25 million to the sum of (i) business interest income and (ii) 30% of the business’s “adjusted taxable income” (which is calculated as EBITDA for taxable years beginning before January 1, 2022, and as EBIT for taxable years beginning after December 31, 2021).
Disallowed interest is carried forward indefinitely. Contains a small business exception.
Net Operating Losses (NOLs)
The Act limits the NOL deduction to 80% of the taxpayer’s taxable income for taxable years beginning after December 31, 2017. However, NOLs generated in 2017 and earlier would retain their 20-year life and be available to offset 100 percent of taxable income, subject to certain limitations. The result is that taxpayers will have to track NOLs before and after the effective date separately. The Act also eliminates any carryback of NOLs and allows unused NOLs to be carried forward indefinitely (prior to the Act, NOLs were carried back 2 years and carried forward 20 years).
As discussed in more detail below, the Act treats “operations loss deductions” (OLDs) of life insurance companies in the same manner as NOLs for taxable years beginning after December 31, 2017 (prior to the Act, such OLDs were eligible for a 3-year carryback and a 15-year carryforward).
The Act also provides a special rule for property and casualty insurance companies that negates the changes described above and instead retains the 2-year carryback and 20-year carryforward rule for NOLs of such companies and allows such NOLs to be used to offset 100% of taxable income in such years.
Insurance Specific Tax Provisions
Summary of Changes
Implications for Insurance Companies
NOLs of Life Insurance Companies
As noted above, the Act changes the treatment of losses of life insurance companies. Under prior law, a life insurance company’s “operations loss deduction” was eligible for a 3-year carryback and a 15-year carryforward. This differed from the treatment of “net operating losses” for other companies (including property and casualty insurance companies) that were eligible for a 2-year carryback and a 20-year carryforward. The Act permits NOL deductions for life insurance companies under the general rule of IRC Section 172, determined by treating the NOL for any tax year generally as the excess of the life insurance deductions for that year over the life insurance gross income for that year.
These changes are effective for losses arising in tax years beginning after December 31, 2017. Accordingly, such losses are now subject to the general rule which eliminates any carryback, but are allowed to be carried forward indefinitely, along with the general rule limiting the use of such losses to 80% of taxable income.
None of these changes impact the consolidated return rules affecting the use of losses of life insurance companies against non-life insurance company income, and vice versa.
This change would negate DTA admissibility under paragraph 11.a. of SSAP-101.
NOLs of Property and Casualty (P&C) Insurance Companies
As noted above, the Act preserves the prior law rule for the NOLs of P&C insurance companies, allowing such losses to continue to be carried back for two years and to be carried over for 20 years, and for those losses to offset 100% of taxable income in such years.
Prior law is preserved.
Small Life Insurance Companies
Effective for tax years beginning after December 31, 2017, the Act repeals the small life insurance company deduction contained in IRC Section 806.
Small life insurance companies will lose a significant tax benefit that provided them with a special deduction against taxable income.
Computation of Life Insurance Company Tax Reserves
The Act makes several modifications to items taken into account in the computation of life insurance tax reserves. As a result of these modifications, life insurance companies will take into account the greater of (i) the net surrender value of the contract, or (ii) 92.81% of the reserve for the contract computed as required by the National Association of Insurance Commissioners (NAIC) at the time the reserve is determined, in calculating their deductible tax reserves under IRC Section 807.
The Act maintains the rules providing that in no event shall the reserves exceed the amount which would be taken into account in determining statutory reserves.
Furthermore, the Act makes clear that no amount or item shall be taken into account more than once in determining any reserve. As under prior law, no deduction for asset adequacy or deficiency reserves is allowed. The amount of life insurance reserves may not exceed the annual statement reserves. The provision provides special reserve rules for supplemental benefits and retains the prior law rules regarding certain contracts issued by foreign branches of domestic life insurance companies. The effect of the new provision on computing reserves for contracts issued prior to the effective date of the Act should be taken into account ratably over the succeeding eight taxable years.
The new provision simplifies the calculation of tax reserves under IRC Section 807, by tying it into a percentage of the statutory reserve. It avoids what was a complex calculation of life insurance reserves under prior law and uses an approach that has been applied to property and casualty insurance reserves in the form of a discounting methodology.
Changes in Method or Basis of Calculating Life Insurance Company Reserves
Effective for taxable years beginning after December 31, 2017, the Act repeals IRC Section 807(f) (which provided for a 10-year spread of the impact of a change in the method or basis of calculating life insurance company tax reserves) and instead applies the general change in accounting method rules of IRC Section 481 to the income or loss resulting from a change in method or basis of calculating such reserves. Accordingly, such amounts should be taken into account consistently with IRS procedures for general changes in accounting (generally, income should be taken into account ratably over a 4-year period).
Changes in basis or method of life insurance reserves no longer have their own special rule, but will instead be treated like any other change in accounting method. Any such change in the method or basis of calculating life insurance reserves will continue to be an automatic change and accordingly, no prior approval of the IRS would be required to effect such a change.
Dividends Received Deduction (DRD) for Life Insurance Companies
The Act changes the so-called “proration” rules under IRC Section 812 that apply for purposes of determining how to calculate a DRD for dividends received by a life insurance company. The Act amends IRC Section 812 to provide that for purposes of IRC Section 805(a)(4), the term “company’s share” means 70% and the term “policyholder’s share” means 30%. The change applies with respect to taxable years beginning after December 31, 2017.
The Act simplifies the calculation that a life insurance company needs to make to determine what percentage of the DRD it is able to claim on its tax return. Under IRC Section 805(a)(4), a life insurance company can claim the DRD with respect to the “company’s share” of the DRD (other than a dividend eligible for the 100% DRD). Under prior law, the determination of the company’s share (allowed) and the policyholder’s share (disallowed) of the DRD was a complex calculation based on a prior system of life insurance company taxation. By setting the company’s share and policyholder’s share to fixed amounts, the calculation will be significantly less complex.
Proration Rules for P&C Insurance Companies
The Act modifies the proration rule for P&C insurance companies (which under prior law required that 15% of any tax-exempt interest and DRD would reduce reserves) by replacing the current 15% proration reduction with a percentage deduction that is fixed as equal to 5.25% divided by the top corporate tax rate. This would have resulted in maintaining the 15% proration percentage with the corporate tax rate set at the prior level of 35%. With the corporate tax rate at 21% in 2018, this proration percentage will be equal to 25% (5.25 divided by 21). When the corporate tax rate is adjusted, the proration percentage will automatically be adjusted under the new calculation. The new proration calculation is effective for taxable years beginning after December 31, 2017.
This change will result in additional amounts of DRD and tax-exempt income effectively being taxed by virtue of the increase in proration percentage (resulting from the lower tax rate). Such amounts would reduce reserve deductions and accordingly result in greater amounts of taxable income. However, any change in the corporate tax rate would further change the proration percentage automatically.
Modification of Discounting Rules for P&C Insurance Companies
P&C insurance companies will be required to use a higher discounting rate (based on the “corporate bond yield curve” issued by Treasury) to discount unpaid losses under IRC Section 846. Under prior law, the discounting rate was based on the “applicable mid-term federal rate.” Section 430(h)(2)(D)(i) defines the “corporate bond yield curve” as “with respect to any month, a yield curve which is prescribed by the Secretary for such month and which reflects the average, for the 24-month period ending with the month preceding such month, of monthly yields on investment grade corporate bonds with varying maturities and that are in the top 3 quality levels available.” For purposes of the discounting rules of IRC Section 846, the Act replaces “24-month period” with “60-month period.”
The Act also repeals the election contained in IRC Section 846 that allows a company to use company-specific historical loss payment patterns (rather than IRS prescribed industry wide historical loss payment patterns) in determining its loss reserves. Going forward, all companies must use the IRS prescribed industry payment patterns. These changes are effective for taxable years beginning after December 31, 2017, with a transition rule that would spread any adjustment relating to pre-effective date unpaid losses on a pro rata basis over an 8-year period.
It is expected that use of the “corporate bond yield curve” instead of the applicable federal mid-term interest rate will likely result in additional discounting and, accordingly, lower deductible tax reserves. The repeal of the elective use of the company payment pattern for discounting purposes eliminates the ability to elect such a method where it is more favorable to the taxpayer.
Treatment of Certain Policy Acquisition Expenses (Proxy DAC)
For taxable years beginning after December 31, 2017, the Act amends IRC Section 848 to increase the capitalization rates applicable to “specified insurance contracts.” The Act also extends the amortization period for amounts capitalized under IRC Section 848(a). Under the prior law, the capitalization rates were 1.75% for annuity contracts, 2.05% for group life insurance contracts, and 7.7% for individual life insurance, group and individual health insurance (to the extent such contracts are guaranteed renewable or non-cancellable), and any other specified insurance contract not included in the other categories). The Act amends those capitalization rates to 2.09% for annuity contracts, 2.45% for group life insurance contracts, and 9.20% for all other specified insurance contracts. In addition, the Act changes the amortization period from 120 months (10 years) to 180 months (15 years).
As a result of this provision, for taxable years beginning after 2017, additional amounts representing the cost of acquiring insurance contracts will need to be capitalized, and those capitalized amounts will be amortized over a longer period of time.
Special Estimated Tax Payments for P&C Insurance Companies
For taxable years beginning after December 31, 2017, the Act repeals the elective deduction and special estimated tax payment rules in IRC Section 847 applicable to insurance companies required to discount unpaid losses. IRC Section 847 was originally enacted to enable insurance companies who were required to discount unpaid losses to be able to admit (under old accounting rules) deferred tax assets resulting from the discounting rules. This provision has largely become unnecessary under FAS 109 (ASC 740) and, as a result, has been repealed in the Act.
As a result of the repeal, any company that has an existing account under Section 847 must include the balance of such account in income for the first taxable year beginning after December 31, 2017, and the entire amount of existing special estimated tax payments made under IRC Section 847 is applied against the amount of additional tax attributable to the inclusion. If there are excess estimated tax payments remaining after this offset, those amounts are treated as “regular” estimated tax payments under IRC Section 6655.
Taxpayers should be aware of the rule contained in IRC Section 847(7) whereby a tax rate reduction would require a corresponding reduction in Special Estimated Tax Payments.
Special Rule for Distributions to Shareholder from Pre-1984 Policyholder Surplus Account
The Act repeals the special rules contained in IRC Section 815 that imposed income tax on distributions from the pre-1984 Act Policyholder Surplus Account (PSA) of a stock life insurance company effective for taxable years beginning after December 31, 2017. For any stock life insurance company with an existing PSA balance, the company will be taxed on the balance of the account as of 12/31/17. The tax due would be paid ratably over the first eight taxable years beginning after December 31, 2017.
As a result of tax legislation enacted in 2004 that provided for a 2-year window for stock life insurance companies with a PSA account balance to distribute such balances on a tax-free basis (resulting in many companies significantly reducing or eliminating their PSA balances), the impact of this provision is limited.
Tax Reporting for Life Settlement Transactions, Tax Basis of Life Insurance Contracts, and Exception to Transfer for Value Consideration Rules
The Act imposes reporting requirements on the purchase of a life insurance contract in a reportable policy sale.
The Act additionally imposes reporting requirements on the payor in the case of the payment of reportable death benefits. The reporting requirements would be effective for reportable policy sales occurring after December 31, 2017, and reportable death benefits paid after December 31, 2017. In addition, effective for transfers occurring after December 31, 2017, the Act modifies the transfer for value rule in IRC Section 101 in a transfer of an interest in a life insurance contract in a reportable policy sale.
Lastly, effective for transactions entered into after August 25, 2009, the Act sets forth rules for determining the basis of a life insurance or annuity contract (effectively reversing certain rules set forth by the IRS in Rev. Rul. 2009-13).
Insurance companies will have to comply with additional information reporting rules regarding the sale of such contracts and the payment of death benefits. The Act’s changes to the transfer for value rules will, however, provide some amount of simplification with respect to those reporting requirements.
TACKLING TAX REFORM: 5 INTIAL STEPS INSURANCE COMPANIES CAN TAKE NOW
Here are five steps insurance companies should take now to tackle tax reform:
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Assess impact. Tax professionals will likely need to review the bill text manually, measure their organization’s specific circumstances against it to assess the impact of each provision, as well as the holistic effect on their bottom line.
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Assemble a team. While the heaviest burden may fall on accountants, companies and their finance teams will have an important role to play to gather all the necessary data.
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Dig into the data. Assessing the impact of tax reform requires a substantial amount of data. Organizations need to move from modeling the impact of tax reform to focus on data collection and computations as soon as possible. If you have an international presence, bear in mind that some of the information needed could date back to 1987.
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Establish priorities. When considering what to undertake in the limited time before year’s end, focus on the areas that could have the greatest impact on your organization.
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Initiate tax reform conversations with your tax advisor. Tax reform of this magnitude is the biggest change we’ve seen in a generation, and will require intense focus to understand not only how the changes apply at a federal level, but also navigate the ripple effect this is likely to have on state taxation as well.
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