Continuing Developments in the Taxation of Insurance Companies*

Continuing D

evelopm

ents in the Taxation of Insurance Com

panies

2006 The Year in R

eview

Continuing Developments in the Taxation of Insurance Companies*

2006 The Year in Review

www.pwc.com

MC-NY-07-0607 © 2007 PricewaterhouseCoopers LLP. All rights reserved. "PricewaterhouseCoopers" refers to PricewaterhouseCoopers LLP (a Delaware limited liability partnership) or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP (US).

AcknowledgementsThis analysis represents the efforts and ideas of many individuals within PricewaterhouseCoopers’ National Insurance Tax Services Group. The text was prepared by a team of professionals, including:

Yasmin Noel, Anthony DiGilio, Clinton McGrath, Julie Goosman, Rick Irvine, Corina Trainer, Andrew Prior, Byron Crawford, Rob Finnegan, Tom Wheeland, Barbara Reeder, Joseph Foy, Elaine Church, and Chris Ocasal.

We also would like to thank Alison Gilmore, Meredith Wright, and Raquella Kagan.

Continuing Developments in the Taxation of Insurance Companies

2006The Year in Review

Foreword This monograph provides an overview of developments

affecting the taxation of insurance companies in 2006. We

have selected for specific review those developments of

major significance to the insurance industry.

An outpouring of cases and rulings would presumably increase our

knowledge and provide clarity with regard to previously clouded

areas. As often occurs, however, the cases and rulings generate

as many questions as they answer. Nonetheless, it is important to

recognize the impact of these cases and rulings on current income

tax filing requirements, as well as future tax planning; the tax

consequences are both immediate and far-reaching.

PricewaterhouseCoopers LLP

Global Insurance Industry Services Group, Americas

Washington National Tax Services

January 2007

This publication is produced by professionals in this particular field at

PricewaterhouseCoopers. It is not intended to provide specific advice on any matter,

nor is it intended to be comprehensive. If specific advice is required, or if you wish to

receive further information on any matter referred to in this publication, please speak

to your usual contact at PricewaterhouseCoopers or those listed in this publication.

This monograph provides an overview of developments

affecting the taxation of insurance companies in 2006. We

have selected for specific review those developments of

major significance to the insurance industry.

An outpouring of cases and rulings would presumably increase our

knowledge and provide clarity with regard to previously clouded

areas. As often occurs, however, the cases and rulings generate

as many questions as they answer. Nonetheless, it is important to

recognize the impact of these cases and rulings on current income

tax filing requirements, as well as future tax planning; the tax

consequences are both immediate and far-reaching.

PricewaterhouseCoopers LLP

Global Insurance Industry Services Group, Americas

Washington National Tax Services

January 2007

This publication is produced by professionals in this particular field at

PricewaterhouseCoopers. It is not intended to provide specific advice on any matter,

nor is it intended to be comprehensive. If specific advice is required, or if you wish to

receive further information on any matter referred to in this publication, please speak

to your usual contact at PricewaterhouseCoopers or those listed in this publication.

Contents01 The Year in Review 1

02 Legislation 20

03 Reserves 32

04 Captives 39

05 Tax Shelters 43

06 Reorganizations 56

07 International 69

08 Blue Cross Blue Shield 89

09 Products 98

10 Other 113

11 Multistate 128

12 Tax Accounting 140

13 Appendixes Appendix A 154 Appendix B 164



2 Continuing Developments in the Taxation of Insurance Companies

01

LegislationThe 109th Congress considered a variety of issues in 2006 including tax provisions related to Hurricane Katrina, tax shelters, retirement savings plans and healthcare.1

In May 2006, Congress passed and President Bush signed into law, the Tax Increase Prevention Reconciliation Act of 2005 (TIPRA), which extended through the end of 2010 the reduced rates on capital gains and dividends originally enacted by the Jobs and Growth Tax Relief Reconciliation Act. Specific to insurance companies, the bill extended the Subpart F exception for active financing and insurance income. TIPRA also increased the AMT exemption level for 2006; eliminated the income limitation on converting traditional IRAs to Roth IRAs beginning in 2010, effectively doing away with the income cap for Roth IRA contributions; and extended the increased expensing allowance for businesses.

The Pension Protection Act of 2006, the first legislation that makes permanent certain provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, was signed into law in August. These provisions include elements affecting pensions, IRAs, and the saver’s credit, which provides a government match for contributions by lower-income and moderate-income taxpayers to tax-deferred savings vehicles.2 Although the Act primarily deals with pension and retirement plan issues, Section 863 of the Act contains a provision impacting the corporate-owned life insurance (COLI) rules.

On their way out, the 109th Congress passed the Tax Relief and Health Care Act of 2006. This Act, a package of tax extenders and other tax breaks worth $45 billion over 10 years, was signed into law by President Bush on December 20, 2006.

Nontax legislation of specific interest to the insurance industry included H.R. 5637, the Nonadmitted and Reinsurance Reform Act of 2006, which was unanimously passed by the House of Representatives in September.

1 CRS Report for Congress, Major Tax Issues of the 109th Congress, November 28, 2006.

2 Tax Policy Center, “Tax Policy: Facts and Figures,” October 2006.

2006–The Year in Review 3

The Year in Review

Although it never became law, this bill would have reformed and modernized both the nonadmitted insurance (‘surplus lines’) and reinsurance sectors of the commercial insurance marketplace.

Meanwhile, Senator Trent Lott (R-MS) slipped a provision into the Home-land Security Appropriations Act that directs the Inspector General of Homeland Security to investigate claims resulting from Hurricane Katrina.

StormsA Quiet SeasonThe first hurricane of the 2006 season, Alberto, brought torrential rain to Cuba, but lost its momentum before reaching the U.S. mainland.3 Experts predicted an increase in the frequency and intensity of hurricanes and the nation prepared for another damaging hurricane season. However, 2006 produced much quieter storms than most expected in the aftermath of Katrina. Many experts say the lessons learned from hurricanes in recent years caused major insurers to rethink their exposure to catastrophe prone areas.4 As such, property-casualty insurers and reinsurers were better equipped to handle losses than they were in 2005.5

We Dodge a Bullet in This Hurricane Season6

0

1

2

3

4

5

6

7

’05’03’01’99’97’95

This year’s hurricane season has been less harsh than predicted. Major hurricanes (category 3-11 mph maximum sustained wind speed—or higher)

Source: National Hurricane Center/Tropical Prediction Center

3 Inman, Phillip. “Hurricane Warning of $100bn Loss,” The Guardian, July 3, 2006.

4 Kukendall, Lavonne. “Insurers Are in Better Shape to Handle Storm Season,” The Wall Street Journal August 29, 2006.

5 Id.

6 O’Driscoll, Patrick. “We Dodge a Bullet in This Hurricane Season,” USA Today, Page 3A, December 8, 2006.


01

Companies RespondThe economic effects of Katrina continued to resonate across the nation through significant increases in the cost of insurance. Catastrophe reinsur-ance premiums climbed sharply, with some rates up 76%.7 Many reinsurers and hedge funds made substantial bets on the weather in the hopes of reaping the benefits.8 With no hurricanes touching U.S. soil, there were strong financial results for many major insurers this year.9 Bets on a light hurricane season turned out to be one of the year’s best wagers in the financial markets.10

In 2006 the industry saw the emergence of many new products and services aimed at helping homeowners prevent severe losses; however, many say that these products and services are costly, and generally geared toward the wealthy. These insurers are taking a proactive stance and heading to clients’ homes before the storms to plan for safely storing valuables, to advise on how to better protect houses from heavy rains and to generally minimize damage. These measures are intended to avert high claim payouts after a storm.

Strategies to minimize risk in the wake of Katrina and other hurricanes continue as insurance companies try to avoid a repeat of the severe losses of 2005. Certain companies have listed several coastal regions nationwide where they will be cutting back homeowners insurance coverage. Reports indicate that approximately 12,000 homeowners in South Carolina, 4,000 North Carolina, and an unspecified number in Alabama could be dropped. Additionally, some insurance companies have refused to write new policies in coastal counties in Maryland and in Virginia.11 The companies argue that they must continue to manage their property-loss exposure along the coast for the sake of all their policyholders.12

7 Pleven, Liam. “Hot Investment: Calm Weather,” The Wall Street Journal, October 3, 2006.

8 McDonald, Ian; Pleven, Liam; Richardson, Karen. “Hot Investment: Calm Weather. Reinsurers Poised for Big Payoffs On Bets Against Storm Damage; Buffett’s Company Times It Right?” The Wall Street Journal, October 3, 2006.

9 Pleven, Liam. “Insurers Bask in Sun and Profits As Hurricane Season Nears End,” The Wall Street Journal, October 19, 2006.

10 Pleven, supra at 7.

11 USA Today. Nationaline. “Allstate Cuts Coverage in Coastal Areas,” December 22, 2006, 3A.

12 “State Farm to Drop Alabama-Coast Policies,” The Wall Street Journal, February 5, 2007.


The Year in Review

High Winds, Then Premiums13

0

88

176

264

352

440

$429,182

$34,790

2006 Insurance Premium

2005 Insurance Premium

In one example, several beach front properties in Alabama saw enormous increases in insurance premiums.

States RespondStates are not taking the reaction of insurance companies lightly. Governor Charlie Crist of Florida, signed legislation in January 2007 that promises to provide insurance reform, including rate reductions, and provisions that require insurers to pay claims within 90 days and disallow the dropping of policyholders during hurricane season. In summary, House Bill 1A provides the following changes to Florida’s insurance law: (1) The bill expands the Florida Hurricane Catastrophe Fund that allows insurers to purchase less expensive reinsurance and pass those savings on to consumers; (2) Allows Citizens Property Insurance Corp. to compete with private insurers. The bill freezes rates, repeals all 2007 rate increases and provides refunds for consumers who have already paid those increases; (3) Prevents insurance companies from raising rates without state approval, from dropping policyholders during hurricane season and from delaying payment of claims. Insurers are required to allow coverage options and installment payments for premiums. The Insurance Consumer Advocate is to provide a consumer rating for each insurance company for Floridians’ consideration when choosing an insurance company; (4) Eliminates regional exemptions to the Uniform Building Code, with the goal of reducing the number of buildings damaged or destroyed by storms, and requires insurers to take

13 Treaster, Joseph B. “High Winds, Then Premiums,” The New York Times, September 26, 2006.


01

into account hardening of homes when establishing rates, and; (5) Provides the first step in eliminating a practice where insurance companies can sell only automobile insurance and not property insurance in the state.14 Other states are expected to take similar actions.

Meanwhile, New Orleans Mayor, Ray Nagin, accused the federal govern-ment of abandoning its legal obligation to help his city recover from the devastation of Hurricane Katrina.15 As expected, the issues of coverage, wind vs. water damage, covered vs. excluded, have made their way to the courts. A federal judge ruled in November that insurance companies should pay for the widespread water damage to the homes and businesses of tens of thousands of people in New Orleans.16 This ruling came after U.S. Magistrate Judge Robert Walker had denied class certification to another group of Katrina victims who were suing insurance companies for denying their claims.17 Moreover, a jury awarded $2.5 million in punitive damages to a couple who sued an insurance company for denying their claim after Hurricane Katrina.18

Congress RespondsSenator Trent Lott (R-MS), a hurricane victim himself, included a provision into the Homeland Security Appropriations Act which directs the Inspector General of Homeland Security to investigate whether, and to what extent, in adjusting and settling claims resulting from Hurricane Katrina, insurers making flood insurance coverage available under the Write-Your-Own program improperly attributed damages from such hurricane to flooding covered under the insurance coverage provided under the national flood insurance program, rather than to windstorms covered under coverage provided by such insurers or by windstorm insurance pools in which such insurers participated.

14 “Fla. Gov. Crist Signs Property Insurance Bill,” Office of Florida Gov. Charlie Crist, January 25, 2007.

15 Eisler, Peter; Heath, Brad. “Nagin: Feds Have Abandoned New Orleans Recovery,” USA Today, December 7, 2006.

16 Treaser, Joseph B. “Judge Upholds Policyholders’ Katrina Flood Claims,” New York Times, November 29, 2006.

17 Advisen FPN. “DJ Judge: Katrina Homeowners Must Sue Insurance Cos Separately,” September 9, 2006.

18 Mitchell, Gary. “Insurer Told to Pay $2.5M in Katrina Suit,” USA Today, January 12, 2007.


The Year in Review

IRS Releases Publication for Taxpayers Affected by HurricanesThe IRS announced in IR-2006-18 the release of Pub. 4492, Information for Taxpayers Affected by Hurricanes Katrina, Rita, and Wilma. The new publication highlights changes to the tax law and relief provisions available to those affected by Hurricanes Katrina, Rita, and Wilma. It also lists the applicable disaster areas for each hurricane and explains which areas are eligible for IRS administrative relief and for special tax breaks under recently enacted provisions.

According to a report by Congressional Research Service, the damage from Hurricane Katrina raised at least four issues that might be addressed by tax policy. The first issue was that the effect of the disaster might contract the overall economy, suggesting some need for a fiscal stimulus. The second issue was whether the rise in energy prices should be addressed by some redistribution from energy producers to consumers, or some general relief. The third issue asked whether tax measures might be used to provide relief for the victims, and the final issue examined the role tax subsidies might play in the longer-term rebuilding of the disaster areas.19

The Eye of the Storm?In February 2007, a London based reinsurance advisory firm issued a report warning that Atlantic hurricane season activity will be above average for some time to come. The report, subtitled “Are We in The Eye Of the Storm?” points out that the quiet 2006 season, which saw a dramatic decrease in activity when compared to the 2004 and 2005 seasons, was merely an average year and the conditions that have driven increased storm activity in the Atlantic Ocean still exist.20

19 Gravelle, Jane G. Congressional Research Service Report for Congress, “Tax Policy Options After Hurricane Katrina,” October 23, 2006.

20 Jones, Mark. “Carvill Warns Atlantic Still Ripe for Intense Hurricane Activity,” BestWire Services, January 31, 2007.


01

ElectionsThe 2006 midterm elections were held on Tuesday, November 7, 2006. For the first time since 1994, the Democratic Party won a majority of the U.S. House and Senate seats. No Democratic incumbent lost, nor did Republicans capture any open House, Senate, or Gubernatorial seat previously held by a Democrat. Democrats won at least 27 Republican- held seats, as voters seemed to deliver a message of dissatisfaction to President Bush and his party.21

Nancy Pelosi (D-CA) became the first female speaker of the House of Representatives, remarking that her election marked “an historic moment for the women of America.”22 The House Democratic Caucus voted to approve Charles Rangel (D-NY) to be chairman of the Ways and Means Committee, John Dingell (D-MI) as head of the Energy and Commerce Committee, David Obey (D-WI) for the Appropriations Committee, Barney Frank (D-MA) for the Financial Services Committee, and Louise Slaughter (D-NY) for the Rules Committee.

Two years ago, President Bush won reelection and Republicans bolstered their control of Congress courtesy of a coalition that included fiscal conservatives, “values voters” and independents who were worried about terrorism. Surveys of voters as they left polling places in November showed fissures among some groups the Republicans have long counted on and others they were trying to cultivate.23 Republicans who helped capture control of Congress 12 years ago blame the party’s leaders for this year’s debacle at the polls, as many longtime lawmakers lost their seats.24

The most symbolic losses were those of several lawmakers who first arrived in Congress in 1994, the year their party took control of the House for the first time in 40 years. J.D. Hayworth (R-AZ), John Hostettler (R-IN),

21 USA Today, Bill Nichols and William M. Welch, “Tight Va. Race Could Hold Senate Key,” December 8, 2006.

22 Walsh, Deirdre. “Pelosi Becomes First Woman House Speaker,” CNN.com, http://www.cnn.com, January 5, 2007.

23 USA Today, Susan Page, “GOP Coalition Fractured by Opposition to War,” December 8, 2006.

24 USA Today, Richard Wolf, “Republicans of ‘94 Revolution Reflect on ‘06,” December 7, 2006.


The Year in Review

Sue Kelly (R-NY) and Charlie Bass (R-NH), from the class of “Republican revolutionaries” who helped bring their party into power in 1994, became “Republican casualties” of this year’s Democratic sweep. Longtime Republican incumbents Nancy Johnson (R-CT), Anne Northup (R-KY), Charles Taylor (R-NC), Jim Ryun (R-KS) and Clay Shaw (R-FL) lost their seats as did Melissa Hart (R-PA) and Jeb Bradley (R-NH) who did not seem to have competitive races.

The 110th Congress’ new faces include: a former NFL quarterback, Heath Shuler, (D-NC); the first Muslim member of Congress, Keith Ellison (D-MN); a Buddhist, Hank Johnson, (D-GA); the publisher of the Louisville Eccentric Observer, John Yarmuth; and New Hampshire’s first congress-woman, social worker Carol Shea-Porter, (D-NH).

The Six-Year Itch25

Many say that history may give us clear answers as to whether the Democratic victory will result in significant policy changes. According to the Wall Street Journal, in the post-Civil War years, there were two big sixth-year victories for the out party. The first was in 1874, when the opposition Democrats converted a 194-92 deficit in the House to a 169-109 majority. This was a revolt against Grant’s policy of stationing troops in the South. Americans had been growing weary of this strife and wanted the troops sent home. There was another great reversal 20 years later when the House flipped to 244-105 Republican from 218-127 Democrat. This was the beginning of the McKinley republican majority (said to be the model of Karl Rove). These sixth-term off-year elections were consequential indeed.

As the Democrats savored their successful campaign to end what they called the Republican Revolution, they promised that their tenure would be marked by civility, integrity, and fiscal responsibility.26 Democrats cited the AMT, the tax gap, and Social Security as issues that should top the 110th Congress’ agenda. Incoming Chairman of the Senate Finance Committee,

25 Barone, Michael. “The Six-Year Itch,” Wall Street Journal, October 31, 2006.

26 Glenn, Heidi; Shreve, Meg. “Democrats Promise Bipartisan Rule,” Tax Notes Today, 2006 TNT 217-2, November 9, 2006.


01

Max Baucus (D-MT), specifically called on Congress to tackle the AMT and the growing tax gap.27 In addition, the following were listed as areas that the Ways and Means Committee should address in 2007: health care, including Medicare and prescription drug coverage; retirement security; energy policy, including oil company tax breaks; tax issues in the gaming and mining industries; measures to spur economic growth for rural areas and small businesses; and the overall equities of the tax system.28

AMT ReformThe new Democratic leaders have vowed to make the alternative minimum tax (AMT) a centerpiece of 2007’s budget debate.29 Incoming House Ways and Means Committee Chairman Charles Rangel (D-NY) said that the alternative minimum tax’s creep into the middle class and the narrowing of the tax gap are issues that will top his agenda. He also indicated that lawmakers will discover that the AMT can only be fixed in the process of fundamental tax reform.30 While Senators Baucus and Grassley have proposed to repeal the alternative minimum tax (AMT) in 2007, the Tax Policy Center indicated that such a plan could be expensive and regressive, costing $850 billion by 2017.31

A Treasury Department official said in November that it is much more

likely that any federal tax reform will be more incremental as opposed

to sweeping, wholesale reform.

27 “Baucus Call for Solutions to AMT Reform, Tax Gap,” Tax Notes Today, 2007 TNT 7-41, January 9, 2007.

28 Ritterpusch, Kurt; Rothman, Heather M. “New Ways and Means Democrats Cite AMT, Social Security As Issues That Should Top Panel’s Agenda for 110th Congress,” BNA Daily Tax Report, January 3, 2007.

29 Montgomery, Lori. “Alternative Minimum Tax Targeted,” The Washington Post, November 11, 2006.

30 Ritterpusch, Kurt. “ Rangel Says Forging Bipartisan Alliances Will Be Priority Over AMT, Tax Gap Issues,” BNA Daily Tax Report, November 21, 2006.

31 “Repealing the AMT: Costly and Regressive” Tax Notes Today, 2007 TNT 6-19, January 9, 2007.


The Year in Review

32 “Repealing the AMT: Costly and Regressive” Tax Notes Today, 2007 TNT 6-19, January 9, 2007.

33 Montgomery, Lori. “Alternative Minimum Tax Targeted,” The Washington Post, November 11, 2006.

The Tax Policy Center updated for November a report on historical data and projections for the individual alternative minimum tax. According to the report, the AMT threatens to grow from a footnote in the tax code to a major component affecting tens of millions of taxpayers every year. Absent a change in law, more than 30 million taxpayers will become subject to the AMT by 2010. By 2017, about 39 million taxpayers will be subject to the AMT under current law, and almost 53 million if the tax cuts are extended. Many say that this explosive growth of the AMT from a tax affecting only 20,000 taxpayers in 1970 to one affecting 39 million or more in 2017 demands attention. For the most part, those affected have been concentrated in high-cost urban areas such as Washington, New York and San Francisco.32

Alternative Minimum Tax Reform33

Projected Increase In Filters affected by AMT

0

7

14

21

28

35

’10’09’08’07’06

30.127.8

25.323.0

3.8

Jurisdiction with Highest Percentage of taxpayers affected by AMT, 2006

1. New Jersey 7.0%

2. Connecticut 6.0

3. New York 5.5

4. The District 5.1

5. California 4.6

6. Massachusetts 4.6

7. Maryland 4.6

8. Rhode Island 3.1

9. Virginia 3.0

10. Minnesota 3.0


01

Tax GapThe tax gap, the difference between the amount of tax which is owed under law and what is voluntarily paid by taxpayers, is another area that the new Democratic leadership has promised will top the agenda of the 110th Congress. According to Kevin Brown, commissioner of the IRS Small Business/Self-Employed Division (SB/SE), the IRS can look less deeply and uncover 80 percent of the potential money in eight different audits for the same resources it would take to collect 100 percent in only four audits. Although, National Research Program figures show that three-quarters of the tax gap comes from small businesses, it appears that the government is making its focus as wide as possible to tackle the tax gap that has grown to $345 billion.34 The IRS estimates that $32 billion of the tax gap is attributable to corporate income tax, $245 billion to individual tax, $59 billion to employment tax, and $8 billion to estate tax.35

Commissioner of Internal Revenue Mark Everson said that the IRS will focus increasing resources on combating the use of international rules to evade taxes and potential abuses by tax-exempt organizations. Transfer pricing, the movement of intangibles in cross-border transactions, and international tax arbitrage transactions all are “vexing problems,” Everson said. He stressed the increasing cooperation between the United States and other tax jurisdictions in combating the problems. Moreover, the administration plans to unveil a “good basket” of proposals to help shrink the tax gap when the fiscal year 2007-08 budget is proposed.

According to data done by IRS researchers, in 2004 publicly traded companies reported $554 billion in profits on their financial statements but reported $394 billion of taxable income to the IRS. The research also showed companies may have been able to reduce their taxable income by about $35 billion through potentially abusive transactions. This other gap, the gap between book and tax income reported by U.S. corporations,

34 Stamper, Dustin. “IRS Audit Touching More Taxpayers, Digging less Deep, Brown Says,” Tax Notes Today, 2006 TNT 217-7, November 9, 2006.

35 U.S. Department of the Treasury, Office of Tax Policy. “A Comprehensive Strategy for Reducing the Tax Gap,” September 26, 2006.


The Year in Review

has also been a significant and growing concern for Congress and the administration in the years since the Enron and WorldCom scandals rocked the corporate community.36

Award Show Gift BagsThe IRS announced that bags received by movie stars appearing at the Academy Awards were not gifts but rather “noncash compensation” and therefore taxable. As such, movie stars will no longer receive the lavish goody baskets worth as much as $100,000 each. The IRS also engaged in similar talks with the Academy of Television Arts & Sciences, which hosts the Emmy Awards,37 and the Hollywood Foreign Press Association, hosts of the Golden Globe Awards.

Industry ImpactDemocratic control of the 110th Congress could mean that the life insur-ance industry agenda will fare better than it has under the last six years of the Bush administration. The Democratic victory in the House gives Paul Kanjorsk (D-PA) the chairmanship of the key Capital Markets, Insurance and Government-Sponsored Enterprises Sub-committee of the FSC. In the Senate, this victory has also resulted in Chris Dodd (D-CT), who is proud of his support of the insurance industry, becoming chairman of the Senate Banking Committee. Dodd was the primary author of the original Terrorism Risk Insurance Act, enacted in late 2002.38

Frank Keating, CEO of American Council of Life Insurers, has predicted that with this new leadership, the main priority for the life insurance industry should be enactment of legislation creating an optional federal charter. Keating also said, he “doesn’t see” the Democrats taxing

36 Bennett, Alison. “2004 Figures Show Big Discrepancy Between Book, Tax Profits Among Firms,” BNA Daily Tax Report, November 28, 2006.

37 Day, Kathleen. “IRS Targets Award Show Goody Bags,” The Washington Post, August 18, 2006.

38 Postal, Arthur. “Democratic Sweep Reshapes Congressional Landscape,” National Underwriter Life & Health-Financial Services, November 13, 2006.


01

annuities or the inside build-up in the life insurance policies. Keating states, “I have not heard that the Democrats seek to tax insurance products. It would further weaken the ability to deal with the crisis confronting retire-ment security, and weaken the incentive for people to save for their future.” He believes Republican initiatives for Lifetime Savings Accounts “are dead.” Proposals by the Commission on Tax Reform that would have limited or eliminated the tax incentives of most insurance products are also unlikely to surface in the new Congress.39

Comptroller General David Walker, who heads the congressional agency charged with auditing the budget, said that “there is absolutely no question that the tax preferences associated with life insurance represent one of the reasons why you’ve seen the proliferation of the use of life-insurance products. We need to review and reconsider all major tax preferences, including this one.”40

Gridlock is GoodAn economist with the U.S. Chamber of Commerce predicted that gridlock resulting from a divided government in the next Congress could help cut the federal deficit. According to Martin Regalia, Vice President and Chief Economist (economic and tax policy) with the U.S. Chamber of Commerce, one of the biggest problems facing the economy in the long term is the growing federal deficit. Regalia predicted there could be a “quick impact” if the economy continued to grow and Congress could rein in spending. By taking such measures as slowing mandatory spending to about four percent of gross domestic product and nondefense discretionary spending to under three percent, the deficit could drop to under $150 billion in two years, he said. The federal deficit for fiscal 2006 totaled $248 billion, according to Treasury Department figures. Regalia said that spending on defense is unlikely to decrease dramatically with the wars in Iraq and Afghanistan, but with only a narrow Democratic majority in the Senate, gridlock could prevent many discretionary spending programs from passing.41

39 Postal, Arthur. “Democratic Sweep Reshapes Congressional Landscape,” National Underwriter Life & Health-Financial Services, November 13, 2006.

40 Donmoyer, Ryan. “Life Insurers’ tax Break may become Revenue Target for Congress,” January 28, 2007.

41 Shreve, Meg. “Economist Predicts Gridlock Could Cut Deficit,” Tax Notes Today, 2006 TNT 241-7, December 15, 2006.


The Year in Review

What’s the Real Federal Deficit?42

The federal government keeps two sets of books. The set the government promotes to the public has a healthier bottom line: a $318 billion deficit in 2005. The set the government doesn’t talk about is the audited financial statement produced by the government’s accountants following standard accounting rules. It reports a more ominous financial picture: a $760 billion deficit for 2005. If Social Security and Medicare were included—as the board that sets accounting rules is considering—the federal deficit would have been $3.5 trillion.

-$318b

-$760b

-$3.5t

-$318 billion Official Deficit

-$760 billion Audited Version

-$3.5 trillion Corporate-style

The EconomyThe economy continued its expansion and registered positive real growth for 18 consecutive quarters. In 2006, the annualized growth rate was recorded at 5.6% in the first quarter, reduced to 2.6% in the second quarter and then 1.6% in the third. Federal Reserve Chairman Ben Bernanke characterized the economy as being in a “transition” phase.43

According to the Congressional Budget Office (CBO), the federal budget is projected to register a deficit equal to 2.0% of GDP in FY2006. This is the second consecutive year the deficit has fallen relative to the size of the economy; the deficit was 2.6% of GDP in FY2005 after reaching a level of 3.6% of GDP in FY2004. The CBO’s most recent budget report (released in August 2006) also projects a continued gradual decline in the deficit as percentage of GDP, assuming that current policies remain in place. The

42 Cauchon, Dennis. “What’s the Real Federal Deficit,” USA Today, August 3, 2006.



01

decline in the relative size of the projected deficit in FY2006 is said to be from an increase in revenues; receipts are estimated to have increased by 0.8% of GDP (to 18.3%) while outlays grew by 0.2% of GDP (to 20.3%). The expected increase in total receipts in FY2006 primarily reflects increases in individual and corporate income tax receipts.44

Graph Receipts and Outlays as a Percentage of GDP45

2002 2003 2004 2005 2006

Receipts 1,853 1,783 1,880 2,153 2,407

Outlays 2,011 2,160 2,293 2,472 2,654

Deficit (-) -158 -378 -413 -319 -248

Deficit as a percentage of GDP -1.5 -3.5 -3.6 -2.6 -1.9

On January 31, 2007, former Treasury Secretary Robert Rubin, addressing the Joint Economic Committee, said that continuing U.S. economic growth should not obscure a looming fiscal crisis facing the United States, that will likely force lawmakers to revisit policies dealing with tax and entitle-ment programs. Other critical imbalances, he said, are being created by projected increases in Social Security, Medicare, and Medicaid; a growing trade account deficit; and the heavy overweighting of dollar-denominated holdings in many foreign portfolios. “The combination of these factors is a deep and multifaceted threat to job creation, to standards of living, and to our economy,” Rubin, now a top executive with Citigroup, told the commit-tee at its first hearing of the year. Rubin acknowledged that GDP growth is good but said “the unsound fundamentals” underlying the U.S. economy could signal trouble in the future. He urged economic policies that have broad benefits instead of those that focus on a “very small top tier.” The financial imbalances that Rubin said must be addressed include: the deficits caused by tax cuts; a net national savings rate of about 2 percent of GDP; a projected increase in Social Security and Medicare and Medicaid as a percentage of GDP over the next 15 years of 50 percent; a current trade account deficit of almost 7 percent of GDP; and the overweighting of dollar dominated holdings in foreign portfolios.46


45 “CBO Estimates $49 Billion Deficit for October,” Tax Notes Today, 2006 TNT 216-17, November 6, 2006.

46 Ognanovich, Nancy. “Rubin Says Despite Current Growth Rates, Fiscal Problems Cloud U.S. Economic Outlook,” BNA Daily Tax Report, February 1, 2007.


The Year in Review

A Look AheadPriority Guidance PlanThe Treasury Department’s Office of Tax Policy and IRS released the Priority Guidance Plan for the 2006-2007 year in August 2006, which contains 264 projects to be completed over a twelve-month period, from July 2006 through June 2007. The Plan highlighted projects in areas such as consolidated returns; corporations and shareholders; employee benefits; exempt organizations; financial institutions and products; insurance companies; international issues; tax accounting; tax administration; tax exempt and general tax.

The Plan issued the following priority items for insurance companies: Guidance on the taxation of certain annuity contracts under Section 72; Guidance on the qualification of certain arrangements as insurance; Guidance on the taxation of variable contracts as described in Section 817(d); Final regulations under Section 7702 regarding the attained age of the insured for purposes of testing the qualification of a contract as a life insurance contract (Proposed regulations were published on May 24, 2005;) and, regulations regarding the taxing rule for filing life/ non-life consolidated returns (Temporary regulation Section 1/1502-47T was published on April 25, 2006.)

Other highlighted areas of interest for insurance companies in the guidance plan included: Guidance on the treatment of dual consolidated losses and mirror legislation; Notice under Section 6654 regarding waiver of estimated tax penalties in response to the Tax Increase Prevention and Reconciliation Act of 2005; Final regulations under Section 6655 regarding estimated tax payments by corporations (Proposed regulations were published on December 12, 2005 and a correction was published on December 15, 2005.); Guidance regarding frivolous arguments used by taxpayers in an attempt to avoid or evade tax; Regulations to facilitate electronic filing and reduce taxpayer burden (Temporary regulations were published on May 30, 2006;) and, Regulations revising Section 1.355-3 regarding the active trade or business requirement.


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Economic Substance Codification47

The economic substance doctrine, which is aimed at ensuring that transactions have a business purpose other than just tax benefits, was a hot item for the 109th Congress. This has been a fluid judicial construct that lets courts decide whether a transaction has economic substance. Senate Finance Committee leaders included a codification proposal in several tax measures over recent years, including a version in this past year’s tax reconciliation bill that was estimated to raise nearly $16 billion over a decade. The reconciliation bill provision would have clarified the application of the economic substance doctrine but would not change current law standards used by courts in determining when to utilize an economic substance analysis. It would have generated roughly $16 billion over ten years, utilizing a 20 percent accuracy-related penalty. A less drastic economic substance clarification offered by the Joint Committee on Taxation in a January 2005 report that included other possible revenue offsets would raise nearly $8 billion over ten years by clarifying and enhancing the application of the doctrine.

The issue has a long and controversial history. Outgoing House Ways and Means Committee Chairman William Thomas repeatedly turned away economic substance proposals. The proposals also faced stiff resistance from the Bush administration. Tax writers are certain to revisit proposals to codify or clarify the economic substance doctrine in the 110th Congress. It seems the revenue possibilities of codification seem to be the primary lure for lawmakers.

Nearly Half of Taxpayers Seek IRS Help Around 41% of taxpayer households contacted the Internal Revenue Service at least once over the past two years seeking help, says a survey commissioned by the IRS Oversight Board. The most common reasons for contacting the IRS: seeking help with tax law questions or returns, requesting forms and resolving disputes or errors. More than 80% said IRS service was better than or equal to service from other government agencies.48

47 Ritterpusch, Kurt. “Economic Substance Codification Seen More Likely in Next Congress,” BNA Daily Tax Report, ISSN 1522-8800 (December 4, 2006).

48 “Nearly Half of Taxpayers Seek IRS Help,” USA Today, November 29, 2006.


The Year in Review

Off and Running In its first weeks on the job, the 110th Congress is already faced with new legislation to consider. On January 4, 2007, Senate Finance Committee member John F. Kerry (D-MA) released an overview of S. 96, the Export Products Not Jobs Act (the “Act”). The Act makes several substantive changes to the current international tax laws by: (1) ending tax breaks that encourage companies to move jobs overseas by eliminating the ability of companies to defer paying U.S. taxes on foreign income; (2) simplifying current-law Subpart F rules; (3) closing abusive corporate tax loopholes; and (4) repealing the top corporate tax rate.49

Senate Finance Committee Chairman, Max Baucus (D-MT) and Ranking Member Chuck Grassley (R-IA) also unveiled a small business tax relief package. This legislation will provide assistance to America’s small businesses as the Senate considers a hike in the minimum wage. The $8 billion dollars in tax incentives include credits for small businesses that hire hard-to-employ workers and increased deductions for improving their buildings, as well as measures to help small businesses simplify their bookkeeping by allowing simpler expensing and accounting methods.50 In addition to Congress, by the end of January 2007, six members of the U.S. Senate had announced their intention to run in the 2008 Presidential Elections: Hillary Clinton, Barack Obama, Chris Dodd, Joe Biden, John McCain and Sam Brownback,51 as well as former Mayor of New York, Rudy Guiliani. The industry, which has much at stake, will be well advised to keep its eye on the race.

For timely updates throughout the year visit our website: www.pwc.com/us/insurance/tax

49 Kerry, Sen. John F. “S.96: Export Products Not Jobs Act,” Tax Notes Today, January 4, 2007.

50 U.S. Senate Committee on Finance. “ Baucus, Grassley Introduce Small Business Tax Package,” BNA Daily Tax Report, January 12, 2006.

51 Dick Morris, Eileen McGann. “Presidential Candidates AWOL in the Senate,” FrontPageMagazine.com, February 5, 2007.

02Legislation


Legislation02

IntroductionAs one of the last acts of the 109th Congress, the House and Senate passed the Tax Relief and Health Care Act of 2006 (the Act). The Act includes extensions of expired tax policies seen as key to the business community, most notably health savings account changes, and other tax breaks worth $45 billion over 10 years.52 The Act, signed into law by President Bush on December 20, 2006,53 comes after much opposition by critics and hard-fought negotiations. Senate Budget Committee Chairman Judd Gregg (R-NH) raised a budget point of order against the bill, arguing that the package is exceedingly expensive and includes targeted tax breaks that strain the budget, violating three budget rules. However, Senate Finance Committee Chairman Charles Grassley (R-IA) moved to waive the point of order, and refuted assertions that tax cuts are a “budget buster.” Grassley also refuted the characterization of tax provisions in the bill as virtual earmarks, saying those policies benefit numerous taxpayers in many states.54

Originally part of tax reconciliation legislation, the tax extender package was omitted and was expected to be attached to the pension legislation. Ultimately the extender provisions were also omitted from the pension bill. Grassley said it was because the reconciliation bill considered in the spring included several other priorities.55

On May 17, President Bush signed into law a five-year, $69 billion net tax cut “reconciliation bill,” H.R. 4297, the Tax Increase Prevention and Reconciliation Act of 2005. Then, on August 17, 2006, the President signed the Pension Protection Act of 2006 (the PPA). The PPA is a major overhaul of the pension rules and impacts many areas including; disclosure, funding, permitted investment advice, fiduciary responsibilities, accrual standards, portability, contributions, and distributions.

52 Ritterpusch, Kurt. “Congress Clears Long-Awaited Extenders, Health Care Package,” BNA Daily Tax Report, ISSN 1522-8800 (December 9, 2006).

53 Lunder, Erika. “Tax Provisions in the Tax Relief and Health Care Act of 2006 (H.R. 6111),” December 14, 2006.

54 Ritterpusch, Kurt. “Congress Clears Long-Awaited Extenders, Health Care Package,” BNA Daily Tax Report, ISSN 1522-8800 (December 9, 2006).

55 Id.


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Although the House of Representatives voted unanimously to pass H.R. 5637, the Nonadmitted and Reinsurance Reform Act of 2006, this bill was never passed by the Senate and never became law. The bill, which had been proposed in a previous session of Congress,56 would have reformed and modernized both the nonadmitted insurance (‘surplus lines’) and reinsurance sectors of the commercial insurance marketplace.

Enacted LegislationDespite continued distraction with the war in Iraq, the following relevant legislation was enacted: The Tax Relief and Health Care Act of 2006; Pension Protection Act of 2006; and the Tax Increase Prevention and Reconciliation Act of 2005.

Tax Relief and Health Care Act of 2006On December 20, 2006, the President signed into law H.R. 6111, Tax Relief and Health Care Act of 2006 (the Act). While there are no provisions that directly impact the insurance industry, the long-awaited tax relief package does contains a two-year, retroactive renewal of the research tax credit and other individual and business tax incentives that had expired at the end of 2005. The Act also extends certain expiring energy provisions, expands health savings account provisions, and provides other tax relief for individuals and businesses.

Tax Relief Provisions: The Act provides an extension through 2007 of numerous provisions, such as the deduction for state and local sales taxes. In addition, a number of provisions, such as the research and experimenta-tion tax credit and the work opportunity tax credit, have been enhanced to provide more valuable incentives and additional tax relief. Of special signifi-cance are provisions which reduce the depreciation period for leasehold improvements from 39 to 15 years and provide the IRS with authority to share certain tax information with other federal and/or state agencies.

56 H.R. 5637: Nonadmitted and Reinsurance Reform Act of 2006, 109th U.S. Congress (2005-2006).


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Energy Provisions: Another benefit that the Act affords is the extension through 2008 of numerous energy provisions that had been scheduled to expire at the end of 2007. This extension also continues for three years certain tax incentives and credits for alternative energy initiatives, providing taxpayers with certainty through 2008.

Healthcare Savings Accounts: The Act contains a package of provisions designed to improve Health Savings Accounts (HSAs). These changes include: FSA and HRA terminations to fund HSAs; repeal of annual plan deductible limitations on HSA contributions; modified cost-of-living adjustment; expanded contribution limitations for part-year coverage; modified employer comparable contribution requirements for contributions made to non-highly compensated employees; and one-time rollovers from IRAs into HSAs.

Other Tax Relief Provisions: The Act contains alternative minimum tax (AMT) relief for individuals who exercise incentive stock options (ISO). In particu-lar, the Act allows individuals to take advantage of a refundable credit with respect to certain long-term unused AMT credits existing prior to January 1, 2013. The annual credit amount, subject to a phase-out, is the greater of (i) the lesser of $5,000 or the amount of the long-term unused AMT credit, or (ii) 20 percent of the amount of the long-term unused AMT credit. The Act also imposes a new information reporting requirement on employers with respect to ISOs. In addition, the Act creates a new deduction for premiums for mortgage insurance. Finally, technical corrections were made with regard to the CFC look-thru rules.

Pension Protection Act of 2006The Pension Protection Act of 2006 (the PPA), was signed into law in August 2006. Although the PPA primarily deals with pension and retirement plan issues, Section 863 of the Act contains a provision impacting the corporate-owned life insurance (COLI) rules. Under the new provision, unless certain requirements are met, corporate policyholder’s lose the tax-free nature of the policy. Section 863 of the PPA amends Section


02

101 of the Internal Revenue Code to provide generally that in the case of an employer-owned life insurance contract, the amount excluded from taxable income shall not exceed an amount equal to the sum of the premiums and other amounts paid by the policyholder for the contract. Thus the excess death benefit would be included in income.

Exceptions to General Rule

If the employer complies with new notice and consent requirements, there are two exceptions to the general rule, one based on the status of the insured and the other based on the policy proceeds being paid to the insured’s heirs. The first exception applies when:

(a) The insured was an employee within the last 12-month period before the insured’s death, or

(b) The insured was (at the time the contract is issued) a director, a highly compensated employee or a highly compensated individual.

For this purpose, such a person is one who is either: (1) a highly compen-sated employee as defined under the rules relating to qualified retirement plans, determined without regard to the election regarding the top-paid 20% of employees or (414(a)), or (2) a highly compensated individual defined under the rules relating to self-insured medical reimbursement plans, determined by substituting the highest paid 35% of employees for the highest paid 25% employees (105(h)(8)).

While the newly enacted provision requires the insured to have been a highly compensated employee at the time the policy is issued, it is not entirely free from doubt for which periods the insured must be a highly compensated employee. A reading of the section 414(q) provisions would suggest that an individual is a highly compensated employee if he/she met the earnings threshold in the prior year. This lookback approach, which permits certainty for pension plan purposes, presumably would also provide certainty for COLI purposes.


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If the company purchasing the policy elects to use the section 105(h)(8) definition of a highly compensated employee, questions arise as to how the top-paid group would be determined. For example, would the employ-ee group be limited to the employees of the corporate entity purchasing the policy or would it include all employees of the controlled group of corporations of which the purchasing entity was a component member? As a more practical matter, however, it is unlikely that many employers will have readily available data to determine the 35% threshold, so this provision may rarely be used.

Notice and Consent Requirements

In all cases, for the exceptions to apply, new notice and consent require-ments must be met. To comply with the notice and consent requirements, prior to the issuance of the contract, the employee must be notified in writing that the company plans to insure the employee’s life, the maximum potential amount of coverage, and that the company will be the beneficiary. Additionally, the employee must provide written consent that coverage may continue after employment terminates.

Reporting Requirements

Finally, the law requires that the company file a return (at such time and in such manner as Treasury prescribes) for each year showing:

n the number of employees of the policyholder at the end of the year

n the number of employees insured under such contracts at the end of the year

n the total amount of insurance in force at the end of the year under such contracts

n the name, address and EIN of policyholder (company) and the type of business in which the policyholder is engaged and

n a statement that the policyholder (company) has valid consent for each insured.


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These amendments are effective for contracts issued after the date of enactment, except for exchanges under IRC Section 1035. Certain material changes in contracts issued before the effective date will trigger these rules as well. Administrative changes, changes from a general to a separate account and increases in the death benefit that occur as a result of the operation of IRC Section 7702, or the changes to terms of the existing contract, (provided insurer’s consent is not required) will not be considered a material change. Companies contemplating COLI programs should review these provisions closely.

Tax Increase Prevention and Reconciliation Act of 2005On May 17, President Bush signed into law a five-year, $69 billion net tax-cut “reconciliation bill,” H.R. 4297, the Tax Increase Prevention and Recon-ciliation Act of 2005 (the Act). The Act extends increased expensing for small business, the 15 percent capital gains and dividends rates, and the Subpart F exception for active financing. It also includes temporary look-through treatment for payments between related controlled foreign corporations.

The law also contains provisions relating to the modification of the active business definition under Section 355, modification of treatment of loans to qualified continuing care facilities, alternative minimum tax relief, and time for payment of corporate estimated tax payments.

Revenue offsets signed into law include:

n application of earnings stripping rules to corporate partnerships

n reporting of interest on tax-exempt bonds

n denial of Section 355 for distributions involving “disqualified investment corporations”

n imposition of withholding on certain payments made to government contractors

n repeal of FSC-ETI binding contract relief, limitation of Section 199 to wages attributable to domestic production and


Legislation

n modification of the Section 911 inflation adjustment of the foreign earned income limitation and modification of the housing cost floor for citizens living abroad.

Items of Interest to the Insurance Industry:The bill extends the Subpart F exception for active financing for exempt insurance income by extending Sections 953(e) and 954(i) to taxable years beginning after December 31, 1998 and before January 1, 2009.

The new law also amends Section 6655 to change the timing of estimated tax payments for corporations with assets of not less than $1,000,000,000. The new law requires that the amount of any required installment of corporate estimated tax which is otherwise due in:

(A) July, August, or September of 2006 shall be 105 percent of such amount,

(B) July, August, or September of 2012 shall be 106.25 percent of such amount,

(C) July, August, or September of 2013 shall be 100.75 percent of such amount.

Finally, 20.5 percent of the amount of corporate estimated tax payments due in September 2010 shall not be due until October 1, 2010, and 27.5 percent of any required installment of corporate estimated tax which is otherwise due in September 2011 shall not be due until October 1, 2011.

H.R.5441 Department of Homeland Security Appropriations Act, 2007 Senator Trent Lott (R-MS), whose own home was damaged by hurricane Katrina, slipped a provision into the Homeland Security Appropriations Act signed into law by President Bush on October 4, 2006, directing the Inspec-tor General of Homeland Security to conduct certain investigations with regard to Katrina related insurance claims. Specifically, the Act requires investigations as to what extent, in adjusting and settling claims resulting from Hurricane Katrina, insurers making flood insurance coverage available


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under the Write-Your-Own program pursuant to Section 1345 of the National Flood Insurance Act of 1968 (42 U.S.C. 4081) and subpart C of part 62 of title 44, Code of Federal Regulations, improperly attributed damages from such hurricane to flooding rather than to windstorms. Such flooding is generally covered by the insurance coverage provided under the national flood insurance program, whereas windstorm damages are generally covered under coverage provided by such insurers or by windstorm insur-ance pools in which the insurers participated. Moreover, the Department of Homeland Security Inspector General must submit a report to Congress not later than April 1, 2007, setting forth the conclusions of the investigation

Noteworthy Legislation Not EnactedNonadmitted and Reinsurance Reform Act of 2006 The House of Representatives voted unanimously to pass H.R. 5637, the Nonadmitted and Reinsurance Reform Act of 2006, which if passed by the Senate would have reformed and modernized both the nonadmitted insurance (‘surplus lines’) and reinsurance sectors of the commercial insurance marketplace. This bill came in the wake of the terror attacks of September 11, 2001 and the catastrophic storms of 2004 and 2005, which caused insurers to withdraw or reduce their underwriting coverage in critical sectors of the insurance market.

The House Financial Services Committee Report (H. Rpt. 109-649) stated that the bill would have created a uniform system for nonadmitted insur-ance premium tax payments based upon the policyholder’s home state, encouraged the states to develop a compact or other procedural mecha-nism for uniform tax allocation, and established regulatory deference for the home state of the insured. More specifically, the bill adopted uniform eligibility requirements for nonadmitted insurers as developed and promul-


Legislation

gated by the National Association of Insurance Commissioners (NAIC) in the Nonadmitted Insurance Model Act, allowed direct access to the nonadmitted insurance markets for certain sophisticated commercial purchasers, and streamlined the regulation of reinsurance by applying single state regulation for financial solvency and credit for reinsurance.

Nonadmitted Insurance: Nonadmitted insurance provides coverage for unique or hard to place risks where coverage is generally unavailable. A problem arises however because premium tax allocation and remittance formulas and procedures vary significantly from state to state and are often in direct conflict. As such, multiple taxation or noncompliance often results. In State Bd. of Ins. v. Todd ShipyardsSS Corp., 370 U.S. 451 (1962), the Court ruled that a state is not entitled to tax or regulate surplus lines transactions merely because a surplus lines policy insures property or risk located in that state. H.R. 5637 codifies this ruling. By codifying this ‘‘single situs’’ approach, the Committee recognizes that an insured’s purchase of noncompulsory surplus lines coverage protects against the potential financial risk posed to the insured, with that risk being located in, and fully apportioned to, the state of the insured’s principal place of business.

Reinsurance: State laws on credit for reinsurance determine the conditions under which a ceding insurer can take credit for reinsurance either as an asset or as a reduction of liabilities on their financial statements. Some states refuse to accept findings by ceding insurers’ domiciliary states that their reinsurance contracts qualify for credit for reinsurance, causing the ceding insurers’ balance sheets to vary from state to state and limiting the value of the reinsurance. Under H.R. 5637, the state of domicile of the ceding insurer will have exclusive authority over credit for reinsurance determinations, and reinsurance solvency regulation will also be exclusively controlled by the state of domicile of the reinsurer, provided that the state is NAIC-accredited or has financial solvency requirements substantially

similar to the requirements for NAIC accreditation.


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According to the performance-related goals and objectives set forth in H. Rpt. 109-649, this legislation, by applying exclusive domiciliary state regulation and uniform standards, was expected to simplify, streamline, and improve the regulation of the nonadmitted insurance and the reinsur-ance marketplace. Since the Senate did not pass this bill when it returned in mid-November this year, the bill died with the 109th Congress, and will have to be reintroduced next year.

Tax ReformAs midterm election results became clearer on November 8, 2006, with Democrats picking up a substantial majority in the House, prospective House Ways and Means Committee Chair Charles B. Rangel (D-NY), began laying out his plans for the 110th Congress. Rangel, who served as the ranking minority member of the House tax-writing committee, reiterated in a conference call with reporters his desire to do away with the partisan-ship that has marked Congress in recent years and focus on reforming the alternative minimum tax (AMT) for the long term. “Tackling this very complex problem would be a good test of bipartisanship,” Rangel told reporters. Lawmakers have taken to extending on an annual basis the AMT “patch” to prevent additional taxpayers from becoming ensnared by the levy. But Rangel has repeatedly said he would like to see a permanent AMT fix, despite the costs of such legislation. Some estimates put the costs of permanent AMT repeal at about $1 trillion.57

Despite many calls for tax reform, key players in the Tax Reform Act of 1986 have noted that a divided government was an important factor in reaching a deal 20 years ago, and although the recent midterm elections put Democrats in control of Congress, tax reform is likely to remain on the back burner for the next few years. For one, the tax-writing committees are expected to have their plates full of must-do items next year, and it appears that, despite calls from some of their members to tackle tax

57 Elmore, Wesley. “AMT Reform, Bipartisanship Top Rangel’s Agenda as W&M Chair,” Tax Notes Today, 2006 TNT 217-1, November 9, 2006.


Legislation

reform, there may be no room to squeeze in a comprehensive overhaul of the tax code. Two items promise to keep tax-writers extremely busy: reforming the AMT and finding revenue offsets.58 Treasury Department’s deputy assistant secretary for tax analysis, Robert Carroll, said it is much more likely that any federal tax reform will be more incremental as opposed to sweeping, wholesale reform. Carroll told reporters that changes in the political landscape over the last month, rather than a shift in course within the administration, make incremental reform more likely from a practical perspective.59

Taxpayer Advocate Releases Study60

National Taxpayer Advocate Nina E. Olson released a report to Congress that urges Congress to enact fundamental tax simplification. Olson stated that the tax code should be revised to incorporate six core principles:

(1) It should not “entrap” taxpayers; (2) It should be simple enough so that taxpayers can prepare their own returns without professional help, simple enough so that taxpayers can compute their tax liabilities on a single form, and simple enough so that IRS telephone assistors can fully and accurately answer taxpayers’ questions; (3) It should be written in a way that anticipates the largest areas of noncompliance and minimizes them; (4) It should provide some choices, but not too many choices; (5) It should not necessarily avoid refundable credits but, if it includes them, it should design them in a way that is administrable; and (6) It should require a periodic review of its provisions.

By statute, the National Taxpayer Advocate is required to identify at least 20 of the most serious problems encountered by taxpayers. The Taxpayer Advocate Service is an independent organization within the IRS, led by the National Taxpayer Advocate. Each state has at least one Local Taxpayer Advocate. The Taxpayer Advocate did not make many recommendations specific to corporations, but her comments on simplicity and IRS taxpayer service are applicable to both individuals and corporations.

58 Elmore, Wesley; Glenn Heidi. “News Analysis: Tax Reform Likely to Remain on Ice in Next Congress,” Tax Notes Today, 2006 TNT 225-3, November 22, 2006.

59 Ritterpusch, Kurt. “Treasury’s Carroll Expects Incremental Reforms Rather Than Sweeping Change,” BNA Daily Tax Report, ISSN 1522-8800 (November 29, 2006).

60 National Taxpayer Advocate’s 2005 Annual Report to Congress, January 10, 2006.

03Reserves


Reserves

IntroductionThe insurance industry is financially strong despite the numerous natural disasters of recent years. These storms have, however, caused insurance companies to rethink how they reserve for future exposures. Even life insurers are considering a change.

State insurance regulators at the National Association of Insurance Commissioners are working with life insurers and actuaries to develop a new reserving system.61 The association is looking at many facets of such a new system. As part of that overview, regulators are discussing an exposure draft of the Principles-based Valuation Review Opinion model regulation. Many in the industry feel that a system based on actuarial principles rather that formulaic reserves would make more efficient use of capital and a more competitive life insurance industry. However, some regulators feel that the governance measures need to be in place to ensure that companies accurately portray their financial picture and do not make assumptions that are overly aggressive.

There was not much new guidance in 2006 on the subject of tax reserves. Nonetheless, the IRS remained aggressive in its efforts to address reserve issues on audit. Many companies continue to see the application of the results of Utah Medical and Minnesota Lawyers Mutual.62 The question of “margin” has been a significant audit issue for many companies.

The IRS released a field directive in an effort to provide direction to agents on the background, identification, examination, and reconciliation of Section 847 accounts, and invited the general public to comment on Form 8816, Special Loss Discount Account and Special Estimated Tax Payments for Insurance Companies. We also saw the release of final regulations on how to determine the attained age of an insured for purposes of testing whether a contract qualifies as life insurance for federal tax purposes.

61 “Principles-based Reserving Actuarial Opinion Discussed Should An Opinion Be Required? And, If So, How?,” The National Underwriter Company, October 30, 2006.

62 Utah Medical Insurance Association v. Commissioner, T.C. Memo 1998-458 (1998) and Minnesota Lawyers Mutual Insurance Company and Subsidiaries v. Commissioner of Internal Revenue, 285 F. 3d 1086 (8th Cir. 2002).


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Section 847IRS Releases Field Directive63

In its Large and Midsize Business (LMSB) Field Directive, the IRS provided direction to agents on the background, identification, examination, and reconciliation of Section 847 accounts. Before a deduction for loss reserves can be claimed, the unpaid losses must be discounted under Section 846. Under Section 847 an insurance company required to discount unpaid losses may elect to take a deduction equal to the amount of the discount. By claiming a deduction for discounted losses under Section 846, and the additional deduction under Section 847, the taxpayer in essence is deduct-ing its full, undiscounted, reserve for losses. In order to take the Section 847 deduction, the taxpayer must make special estimated tax payments (SETP).

Taxpayers use Form 8816 to report the “special loss discount account” and SETP. In each subsequent year, a Form 8816 must be filed for each accident year for which a deduction is claimed until all the income is brought back in. Each subsidiary electing Section 847 in a consolidated return must file its own Form 8816. On Form 8816, each accident year is reported separately.

According to the IRS, errors can easily occur in accounting for the Section 847 election. The IRS lists the most common errors as: taxpayers not maintaining adequate workpapers; taxpayer payments not properly transferred from master file accounts to the SETP ledger account; SETP balances not properly transferred when there are changes to the consoli-dated group; and, examination reports adjusting unpaid losses but not adjusting Section 847 deduction/income.

The guidelines for the audit of companies electing to take a Section 847 deduction included the following: determine whether the IRS account balance reconciles with the taxpayer’s records; trace SETP payments from the master file transcript to the ledger account and determine that the payments have been posted to the account for the correct year and amount; reconcile the ledger account to Forms 8816 on a company-by-company basis; reconcile the amount reported for the additional deduction

63 DeNard, Paul. “Field Directive on Examination of IRC § 847,” January 13, 2006.


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to the taxpayer’s discount workpapers from the Form 8816 and request an explanation of any discrepancies; recalculate the additional deduction and SETP payments for any changes made to the unpaid losses and loss adjustment expenses during the audit and prior audits; determine if the taxpayer calculated the SETP payment correctly; and determine if the taxpayer calculated its Alternative Minimum Tax correctly.

The Directive also addresses the effect of a NOL carryback into a year involving a Section 847 election, sale of subsidiary stock when a Section 338(h)(10) election is made, and interest payable on SETP refunds. It is important to note that relatively few taxpayers take advantage of the 847 election as it requires taxpayers to make SETP. Those that do generally do so to obtain a surplus or a state tax benefit. Taxpayers making the election may expect a review upon future exams and may wish to do an internal review beforehand.

Form 8816The general public and other federal agencies were invited to comment on Form 8816, Special Loss Discount Account and Special Estimated Tax Payments for Insurance Companies. Form 8816 is used by insurance companies claiming an additional deduction under Internal Revenue Code section 847 to reconcile estimated tax payments and to determine their tax benefit associated with the deduction. The information is needed by the IRS to determine that the proper additional deduction was claimed and to ensure the proper amount of special estimated tax was computed and deposited.

There are no changes being made to the form at this time; however, comments are invited on the following: (a) whether the collection of information is necessary for the proper performance of the functions of the agency, including whether the information shall have practical utility; (b) the accuracy of the agency’s estimate of the burden of the collection of information; (c) ways to enhance the quality, utility, and clarity of the information to be collected; (d) ways to minimize the burden of the collection of information on respondents, including through the use of


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automated collection techniques or other forms of information technology; and (e) estimates of capital or start-up costs and costs of operation, maintenance, and purchase of services to provide information.

Climate Change Already Has a Chilling Effect64 The big buzz in the insurance industry today is climate change. The 2005 hurricane season gave the United States supposedly once-in-a-century storms, one right after the other. Katrina, Rita and Wilma were among the seven most expensive hurricanes ever to hit the country. Companies had to absorb $51.5 billion in losses. The trouble is that their traditional means of calculating what is an acceptable risk—and how much to charge for it—is based on history.

Loss DiscountingRev. Proc. 2007-9 and Rev. Proc. 2007-10On December 14, 2006, the IRS prescribed the loss payment patterns/discount factors and the salvage discount factors for the 2006 accident year. These factors are for use in computing discounted unpaid losses and estimated salvage recoverable under Section 846 and Section 832 of the Internal Revenue Code. These Revenue Procedures apply to any taxpayer that is required to discount unpaid losses under Section 846 for a line of business using discount factors published by the Secretary, or that is required to discount estimated salvage recoverable under Section 832. As in the prior year, these Revenue Procedures include composite discount factors as promised by Revenue Procedure 2002-74.

64 Garreau, Joel. “ A Dream Blown Away; Climate Change Already Has a Chilling Effect on Where Americans Can Build Their Homes,” The Washington Post, Page C01, December 2, 2006.


Reserves

Prevailing State Assumed Rates UpdatedThe IRS released Rev. Rul. 2006-25 which provided the rates for calculating the reserves for life insurance and supplementary total and permanent disability benefits, individual annuities and pure endowments, and group annuities and pure endowments. However, in announcement 2006-35 the IRS corrected the rates provided in Rev. Rul. 2006-25.

Prevailing State Assumed Interest Rates—As Originally Released

A. Life Insurance Valuation: Guarantee Duration (Years) Calendar Year of Issue (2006)

10 or Fewer 4.50

11-20 5.25

21 or More 5.00

Prevailing State Assumed Interest Rates—As Corrected

A. Life Insurance Valuation: Guarantee Duration (Years) Calendar Year of Issue (2006)

10 or Fewer 4.50

11-20 4.25

21 or More 4.00

Rules on Determination of Attained Age of Insured65

A significant ruling announcing the final regulations on how to determine the attained age of an insured for purposes of testing whether a contract qualifies as life insurance for federal tax purposes was released by the IRS this year. After consideration of one written comment, the final rules adopt several modifications to the proposed version of the rules which were issued in 2005.

Section 7702(a) of the Internal Revenue Code provides that, for a contract to qualify as a life insurance contract for federal income tax purposes, the

65 71 F.R. 53967-53971


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contract must be a life insurance contract under applicable law and must either satisfy a cash value accumulation test under section 7702(b) or meet both the guideline premium requirement of section 7702(c) and fall within the cash value corridor provided in section 7702(d). Determination of the attained age of the insured is necessary to determine whether these conditions are met.

The final regulations indicate that the attained age of the insured under a contract insuring the life of a single individual is either:

n The insured’s age determined by reference to his or her actual birthday as of the date of determination; or

n The insured’s age determined by reference to contract anniversary, so long as the age assumed under the contract is within 12 months of the actual age.

In one regard, the final regulations mirror the 2005 proposed regulations by providing that the attained age of the insured, under a contract insuring multiple lives on a last-to-die basis, is the attained age of the youngest insured, and the attained age under a first-to-die multiple lives contract is the oldest insured. However, contrary to the proposed regulation, the final regulation includes a provision for last-to-die contracts that would take into account the age of the youngest surviving insured if the contract undergoes modifications to both the cash value and the future mortality charges under the contract, so that the attained age assumptions used for federal income tax purposes are consistent with those used under the terms of the contract. Additionally, the IRS clarifies that the attained age of the insured under a contract, once determined, changes annually.

The final rules apply to life insurance contracts that are either issued after December 31, 2008, or issued October 2007, and based on the 2001 commissioner’s standard ordinary (CSO) mortality and morbidity tables. As such, issuers will be allowed to make any changes required by this final regulation concurrently with the changes required by the adoption of the 2002 CSO mortality tables. In addition, taxpayers may apply the regulations for contracts issued before October 1, 2007, provided they do not later determine qualifications of those contracts under section 7702 in a manner inconsistent with the regulations.

04Captives


04

IntroductionNew alternative capacity markets are emerging that represent a more widespread challenge to the traditional insurance mechanism while the alternative insurance market legacy structures, such as retention groups and single parent captives, are reaching maturity. A recent study, “Alterna-tive Markets: Structural and Functional Evolution,” presents the history and current situation in alternative markets and analyzes the capacity markets that are now evolving. This new wave of alternative-capacity markets is being driven by the growth of low-frequency, high-severity exposure. These alternatives focus on the need for affordable capacity that will permit corporations to manage increasingly complex risk in the high-severity layers.66 As long as alternative insurance structures continue to evolve, questions as to proper tax treatment of such structures will exist.

In 2006 the IRS ruled that amounts paid for product liability and other coverages by a taxpayer and its operating subsidiaries were treated as “insurance premiums” for purposes of determining the deductions under Section 162. The Service summed up 20 years of captive history in this quintessential ruling. The ruling incorporated every major development in the captive area; a large number of domestic and foreign risks shifted at arms length to a well capitalized and organized insurance company.

In 2005, for the first time, the United States overtook Bermuda as the world’s largest captive domicile. The number of U.S. captives rose from 987 in 2004 to 1,109 in 2005. The number of Bermuda captives dropped from 1,000 to 987 during the same period.67

66 “Alternative Capacity to Challenge Traditional Insurers,” Insurance Newslink, September 10, 2006.

67 “Captives” Insurance Fact Book 2007, Insurance Information Institute.


Captives

Deductible Insurance PremiumsP.L.R. 200636085In this ruling, the IRS makes clear that amounts paid for product liability and other risk coverage by a Foreign Parent’s wholly-owned subsidiary and its operating subsidiaries to an insurance affiliate are insurance premiums for purposes of determining business expense deduction under Section 162. Taxpayer is a wholly-owned subsidiary of Foreign Parent incorporated in Foreign Country G. Foreign Parent has diverse business operations and, in the United States, Foreign Parent’s operations are conducted by Taxpayer. Taxpayer operates through 22 corporate operating subsidiaries (Subsidiar-ies 1 through 22) which join in the filing of Taxpayer’s consolidated return.

As a result of a significant loss event in Year 1 impacting the insurance industry, insurers increased the premiums for excess liability insurance and drastically reduced the coverage they were willing to provide. At the end of Year 1, Foreign Parent’s insurers cancelled Foreign Parent’s insurance program. As a result Foreign Parent was forced to secure insurance on significantly less favorable terms. Foreign Parent began to explore alternatives, including the creation of Insurance Subsidiary. In year 2, Insurance Subsidiary was formed as an indirect wholly owned subsidiary of Foreign Parent to insure its worldwide operations. Neither Taxpayer nor its subsidiaries has an ownership interest in Insurance Subsidiary. Insurance Subsidiary currently is funded via the receipt of premiums and the return on its investments.

Of the policies issued annually, Insurance Subsidiary issues to Foreign Parent (as the named insured) and covers the losses of Foreign Parent and all its subsidiaries and affiliates worldwide, including those in the United States. The other policies issued by Insurance Subsidiary provide that Taxpayer is a named insured.


04

The risks inherent in Insurance Subsidiary policies were found to be reason-able. Insurance Subsidiary has also entered into reinsurance agreements with Reinsurer M, which is also a wholly-owned indirect subsidiary of Foreign Parent. Neither Taxpayer nor Subsidiaries 1 through 22 has an ownership interest in Reinsurer M. Currently, Insurance Subsidiary bills Subsidiaries 1 through 22 directly for their respective portions of the premiums.

The billing is accomplished on the basis of a percentage of sales. Insurance Subsidiary’s operations are independent of the operations of Foreign Parent, Taxpayer and Subsidiaries 1 through 22. In connection with this ruling request it is represented as follows: (1) Insurance Subsidiary’s obligations are not guaranteed by Foreign Parent or its subsidiaries; (2) Insurance Subsidiary, considering risk exposure and reinsurance coverage, is adequately capitalized; (3) none of the insured companies has more than 15% of the total risks covered by Insurance Subsidiary; (4) premiums paid Taxpayer and its subsidiaries reflect commercial rates for the insurance involved. In the present case, “W” covered companies shifted to Insurance Subsidiary their product liability and other common commercial risks. These risks were insurance risks, and the arrangements were regulated as insurance and constituted insurance in the commonly accepted sense. Insurance Subsidiary distributed these risks by accepting premiums, determined at arms length, from those numerous insureds and agreed to indemnify those insureds in the event of loss. Accordingly, the arrange-ments qualify as insurance contracts for federal income tax purposes.

Finally, the IRS concluded that, for purposes of determining the deduction for ordinary and necessary business expenses under Section 162, the amounts paid for product liability and other coverages by Taxpayer and its operating subsidiaries to Insurance Subsidiary are treated as “insurance premiums.”

Alternative market mechanisms cover about 30 percent of the U.S. commercial market, according to a 2006 Conning Research Study. 68

68 “Captives” Insurance Fact Book 2007, Insurance Information Institute.

05Tax Shelters


05

IntroductionTax shelters continued to be at the forefront of the legislative and regulatory agendas during 2006. The IRS remained unrelenting in its efforts to identify and deter abusive tax transactions, keep the public advised through pub-lished guidance, and promote disclosure by those who market and participate in abusive transactions.69 This year there were several developments which provide new reporting requirements with respect to the disclosure of informa-tion relating to transactions that present the potential for tax avoidance.70

First, recognizing that the Schedule M-3 provided it with substantially similar information, the IRS eliminated the book-tax difference category of reportable transactions. The new Schedule M-3 requires significant detail and, many have argued, is difficult to follow. In 2006 special form Schedule M-3’s were designed and released for insurance companies, S corps, and partnerships. The IRS released final drafts of these forms and instructions and introduced new Form 8916, Reconciliation of Schedule M-3 Taxable Income with Tax Return Taxable Income for Mixed Groups, and new Form 8916-A, Reconciliation of Cost of Goods Sold Reported on Schedule M-3.

With the release of the instructions to the forms the IRS addressed the industry’s concern about reconciling GAAP income to taxable income in a statutory world. Finally, living up to its promise that the tax shelter regulations are a work in process and will evolve, the IRS announced proposed and temporary regulations which revise the existing final regulations relating to reportable transactions and issued specific regulations directed at material advisors.

69 http://www.irs.gov/businesses/corporations, “Abusive Tax Shelters and Transactions.”

70 Id.


Tax Shelters

Schedule M-3 Notice 2006-6At the beginning of 2006 the IRS announced the elimination of the book-tax difference category of reportable transactions. The IRS stated that the book-tax difference category of reportable transactions is no longer necessary because the new Schedule M-3 provides detailed information on transac-tions with significant book-tax differences. The Schedule M-3 currently must be filed by corporations with total assets of $10 million or more.

The Notice became effective for transactions with a significant book-tax difference that otherwise would have to be disclosed by taxpayers on or after January 6, 2006, irrespective of whether the taxpayer would have disclosed the transaction on a Form 8886 or a Schedule M-3. The removal of this category also covered transactions with a significant book-tax difference that otherwise would have to be disclosed by material advisors under Treas. Reg. Section 6111 on Form 8264, Application for Registration of a Tax Shelter, on or after January 6, 2006.

Notice 2006-6 did not relieve taxpayers or material advisors of any disclosure, registration or list maintenance obligations for transactions that should have been disclosed or registered, or for transactions for which lists should have been prepared and maintained, prior to January 6, 2006. The IRS advised that if a transaction with a book-tax difference also met the definition of another category of reportable transaction (e.g., listed transaction, loss transaction, etc.), then the transaction would still be reportable by the taxpayer under the other category and material advisors will have a registration and/or list maintenance obligation with respect to that transaction.

Final Draft of Schedule M-371

Following the elimination of the book-tax difference category of reportable transactions, the IRS released updated drafts of Schedule M-3 for the 2006 tax year for Forms 1120, 1120-L, 1120-PC, 1120S, and 1065.72 Also released at that time was a new Form 8916, Reconciliation of Schedule M-3

71 IR 2006-114.

72 IR 2006-51.


05

Taxable Income with Tax Return Taxable Income for Mixed Groups, to be filed by certain insurance-related corporations. Key changes in the initial update included:

n Form 8916, Reconciliation of Schedule M-3 Taxable Income with Tax Return Taxable Income for Mixed Groups, and changes in Part II of the Schedule M-3 for Forms 1120, 1120-L, and 1120-PC.

n The draft Schedule M-3 for Form 1065 which included a new line in Part I to report net income of other includible entities, and new lines in Part III to report state, local, and foreign taxes.

n The draft Schedules M-3 for Forms 1120S and 1065 which included separate reporting of depletion.

n Form 1065 filers were asked to provide additional information in the checkboxes at the top of Schedule M-3 that partnerships use to indicate the reasons they are required to file the Schedule M-3.

Later in the year, the IRS released the final draft forms and instructions for Schedules M-3 and Form 8916 for the 2006 tax year. The final draft Schedules M-3 are for Forms 1120, 1120-L, 1120-PC, 1120S and 1065. Relevant changes in the final drafts noted by the IRS include:

n Form 8916, Reconciliation of Schedule M-3 Taxable Income with Tax Return Taxable Income for Mixed Groups, has a new line for dual consolidated losses disallowed.

n The first date for reportable entity partners to report to the partnership has been changed to September 15, 2006 from June 30, 2006.

n Schedule M-3, Part I, line 10 (for Forms 1120, 1120-L, and 1120-PC) now provides for reporting other adjustments of financial statement income in more detail, with line 10a for intercompany dividend adjust-ments, line 10b for other statutory accounting adjustments, and line 10c for other adjustments.

The instructions state the amount reported on Schedule M-3, Part I, line 11 should agree with statutory accounting net income (Annual Statement). Final 1120-L and 1120-PC M-3 forms and instructions for line 10, “Other adjustments to reconcile to amount on line 11,” have been revised to reflect three sublines: “Intercompany dividend adjustment,” “Other statutory


Tax Shelters

accounting adjustments,” and “Other adjustments to reconcile to amount on line 11.” For these items a supporting schedule is required that pro-vides, for each corporation, the name, EIN, amount of net income included in Part I before any adjustments, the amount of net income on Part I, and the amount of the net adjustment related to the reconciling item.

As the tax shelter regulations specifically require the use of GAAP income the industry had long been struggling with how to reconcile between GAAP income and Statutory income (the starting point for the tax return). The final draft M-3 forms and instructions make clear that the reconciliation, or GAAP to STAT adjustments as they are commonly referred to, are to be included on line 11 of Schedule M-3. Moreover, the instructions specify that only the “net adjustment” is required.

Tax Shelter Victories73 Recent government victories in tax shelter litigation will have a lasting effect on structured transactions and will serve the government well in its fight over abusive tax shelters. Several Appeals Court decisions, including those in Black & Decker74 and Coltec75 , have been hailed by IRS as proof the tide is turning in shelter litigation. “The IRS is not in the business of chilling all legitimate business activity,” said Steven Musher, IRS associate chief counsel, “but at some point engineering transactions so that they undermine the purposes of the applicable code sections achieves unrealistic results.” The IRS forewarned that it would issue a new round of tax shelter regulations in the fall of 2006 to replace the interim guidance issued after the American Jobs Creation Act of 2004. As promised, in November and December 2006 the IRS issued proposed and temporary regulations with regard to taxpayer disclosures and Material Advisors registration and list maintenance obligations.

73 Tandon, Crystal. “Senior IRS Officials Tout Tax Shelter Victories,” Tax Notes Today, 2006 TNT 179-1, September 15, 2006.

74 Black & Decker, Corp. v. United States, 436 F.3d 431 (4th Cir. 2006).

75 Coltec Industries, Inc. v. U.S., 454 F.3d 1340 (2006).


05

Tax Shelter RegulationsAJCA Modifications76 On November 1, 2006, the Internal Revenue Service released,77 proposed and temporary regulations to revise the existing final regulations relating to reportable transactions under Sections 6011, 6111, and 6112 for both taxpayers and material advisors. As proposed, the regulations eliminate the significant book-tax difference of reportable transactions, modify the brief asset holding category and add a new category of reportable transaction, the “transaction of interest.” The proposed regulations also accelerate certain disclosure obligations and modify the definition of material advisor for registration and list maintenance purposes. Finally, the regulations make significant changes to the ruling process both for taxpayers and material advisors. Highlights of the proposed and temporary regulations follow.

Transactions of Interest: Of particular importance is the addition of the new category for “transactions of interest.” This classification is meant for any transaction the government believes “has a potential for tax avoidance or evasion, but for which the IRS and Treasury Department lack enough information to determine whether the transaction should be identified specifically as a tax avoidance transaction.” A transaction of interest is a transaction that is the same as or substantially similar to one of the types of transactions that the IRS has identified by notice, regulation, or other form of published guidance as a transaction of interest. When the regulations are finalized, this category will apply to transactions entered into on or after November 2, 2006.

76 71 F.R. 64488-64496.

77 American Jobs Creation Act of 2004.


Tax Shelters

New Category of Reportable Transactions Proposed78 The government’s creation of a new category of shelter deals that must be reported to the IRS, known as “transactions of interest,” does not automatically mean the structures will be viewed as prohibited, Treasury Department attorney-adviser Anita Soucy said November 21, 2006. The new category was announced as part of a sweeping package of tax shelter rules that would tighten disclosure rules for both taxpayers and material advisers.

Designation of a particular deal as being “of interest” means only that there may be a potential for tax evasion and the IRS wants more information about the structure to make a decision, Soucy said. “This isn’t necessarily a precursor to listing a transaction,” she told practitioners, noting the IRS and Treasury have “no permanent design or plan for the result.”

The proposed rules are part of a guidance package on tax shelter changes made in 2004 by the American Jobs Creation Act (AJCA).

Book-Tax Differences, Leasing and Brief Asset Holding Addressed: Consistent with guidance issued in Notice 2006-6, the IRS removed the category that required taxpayers to report deals with a book-tax difference of more than $10 million, noting that because the IRS will obtain substan-tially similar information from the new Schedule M-3, it wants to reduce the administrative burden of the book-tax difference category on taxpayers. The regulations also propose the elimination of the special rules pursuant to which customary commercial leases of tangible personal property that met the criteria of Rev. Rul. 2001-18 were exempt from disclosure. The IRS noted that this special exemption no longer appeared necessary “because the confidential transaction category has been narrowed and the significant book-tax difference transaction category is being removed, the IRS and Treasury Department believe that leasing transactions should be subject to the same disclosure rules as other transactions.” The regulations also proposed modifying the brief asset holding period transaction to exempt transactions producing only foreign tax credits.

78 Bennet, Alison. “ New Category of Tax Shelter Deals Not Automatically Deemed Abusive, Official Says,” BNA Daily Tax Report, ISSN 1522-8800 (November 22, 2006).


05

Other Notable Changes to Disclosure Obligations: Of greatest significance is the marked acceleration of taxpayer disclosure obligations with respect to both listed transactions and transactions of interest. Under the proposed regulations, taxpayers would be required to file a disclosure statement with the Office of Tax Shelter Analysis within 60 days of the issuance of guidance identifying a transaction as either a listed transaction or a transaction of interest. Finally, in an effort to provide more flexibility for pass-through taxpayers who may not have realized they were in a reportable transaction until Schedules K-1 are filed by other participants, the regulations provide that where a pass-through first receives a timely K-1 from another entity fewer than 10 calendar days before the return due date, including extensions, disclosures will be considered timely if they are filed within 45 days of the return due date, including extensions. It is noteworthy that the preamble specifically notes that taxpayers may rely on this provision currently.

Material Adviser Definition Significantly Altered: The proposed regulations modify the definition of material advisor to take into account the AJCA changes—i.e., a material advisor is redefined as a person who provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring or carrying out any reportable transaction if such person receives (directly or indirectly) gross income in excess of the threshold amount (which definition is far more expansive than the previously applicable definition—generally a person who made or provided a tax statement and received fees in excess of the threshold). This definition will include any person that makes or provides a tax statement with respect to a transaction to or for the benefit of (i) a taxpayer required to disclose the transaction (or would have been required to disclose if it were identified as a listed transaction or transaction of interest before the statute of limitations expired); (ii) a taxpayer that the advisor knows or has reason to know will be required to disclose the transaction (because it is or is reasonably expected to become a reportable transaction); (iii) a material advisor required to disclose the transaction; or (iv) a material advisor that the advisor knows or has reason to know will be required to disclose the transaction (because it is or is reasonably expected to become a reportable transaction). The regulations also clarify the various fee thresholds at which an advisor will be deemed to be a material advisor.


Tax Shelters

New Material Advisor Obligations: With respect to the material advisor’s list maintenance obligation under Section 6112, the proposed regulations specifically clarify that the list to be maintained by the material adviser and furnished to the IRS upon request consists of three separate components: (1) an itemized statement of information, (2) a detailed description of the transaction, and (3) copies of documents relating to the transaction. The itemized statement of information must contain all of the requested information in a form that is easy to understand (for example, in a format such as a list, spreadsheet, or table). Similarly, the proposed regulations also make changes to the present registration process. The IRS will replace the existing Form 8918, which will supersede the Form 8264 currently being used for material advisor disclosures. Additionally, the proposed regulations make it explicit that no disclosure on new Form 8918 will be considered complete (and/or protect the advisor from Section 6707 penalties) unless the information provided:

n describes the expected tax treatment and all potential benefits expected to result from the transaction

n describes any tax result protection and

n identifies and describes the transaction in sufficient detail to enable the IRS to understand the tax structure and identify the material advisors.

The preamble also notes that an incomplete form stating that information will be available upon request will not be considered a complete disclosure statement.


05

Appeals Procedure for Cases Involving Shelters79

The Internal Revenue Service Appeals unit will return unresolved cases involving listed transactions to IRS operating divisions for review before the cases advance to court, IRS Appeals Chief Sarah Hall Ingram announced.

The new procedure affects nondocketed, unresolved Appeals cases in which one of the disputed issues involves a transaction the IRS has labeled a listed transaction. Under the procedure, the case will be sent back to the IRS operating division that developed the case to ensure the case is ready to proceed to court. The procedure “is another tool that the IRS is going to use to ensure that in the end, in cases with listed transactions, the government puts its best arguments forward and prevails on behalf of tax administration and all of those honest taxpayers out there,” she said.

Material Advisors80

On December 4, 2006, the IRS published proposed regulations which provide the rules relating to disclosure of reportable transactions by material advisors under Section 6111. Under the proposed regulations, each material advisor with respect to any reportable transaction (as defined in Section 1.6011-4(b)(1)) must file a return by the date prescribed in the regulations. For this purpose, a person is a material advisor with respect to a transaction if the person provides any material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any reportable transaction, and directly or indirectly derives gross income in excess of the threshold amount for the material aid, assistance, or advice. A person provides material aid, assistance, or advice with respect to organizing, managing, promoting, selling, implementing, insuring, or carrying out any transaction if the person makes or provides a tax statement to or for the benefit of certain persons. The IRS and Treasury Department also may identify other types or classes of persons as material advisors in published guidance.

79 Joyce, Stephen. “IRS Modifies Appeals Procedure for Cases Involving Shelters to Aid Litigation Position,” BNA Daily Tax Report, ISSN 1522-8800, (December 6, 2006).

80 71 F.R. 64496-64500.


Tax Shelters

These proposed regulations also provide the threshold amount of gross income that a person may derive, directly or indirectly, for providing any material aid, assistance or advice. The threshold is $50,000 in the case of a reportable transaction, substantially all of the tax benefits from which are provided to natural persons, and $250,000 in any other case. These amounts decrease to $10,000 and $50,000 respectively when the reportable transaction is a listed transaction. A person will be treated as becoming a material advisor when all of the following events have occurred: (A) the person provides material aid, assistance or advice; (B) the person directly or indirectly derives gross income in excess of the threshold amount; and (C) the transaction is entered into by the taxpayer.

Form 8918, Material Advisor Disclosure Statement, will be published for use by material advisors. An incomplete form containing a statement that information will be provided upon request is not considered a complete disclosure statement. Persons who file incomplete disclosures under Section 6111 are subject to penalties under Section 6707.

Tax Result Protection: The IRS and Treasury Department previously removed tax result protection from that category of reportable transaction. The IRS and Treasury have since become aware of taxpayers who have obtained tax result protection for the tax benefits of a listed transaction from a third-party provider. Accordingly, while a transaction will not be a reportable transaction simply because there is tax result protection for the transaction, tax result protection provided for a reportable transaction may subject a person to the material advisor disclosure rules under Section 6111 because a tax statement includes third-party tax result protection that insures the tax benefits of a reportable transaction.

Designation Agreements: The proposed regulations include a provision allowing designation agreements for disclosure of reportable transactions similar to the provision in the current regulations. However, parties to the designation agreement may still be liable for the penalty under Section 6707 if the designated material advisor fails to disclose the reportable transaction under Section 6111.


05

Post-Filing Advice: The IRS and Treasury Department believe that a person should be considered a material advisor for certain post-filing advice. Consequently, the proposed rule provides that an exception will not apply to a person who makes a tax statement with respect to the transaction if it is expected that the taxpayer will file a supplemental or amended return reflecting additional tax benefits from the transaction.

Protective Disclosures: The IRS and Treasury Department have added clarifying language in the proposed regulation that allows protective disclosures to be filed in situations where a person is unsure of whether the transaction should be disclosed under Section 6111. However, the disclosure is effective only if the rules of Section 301.6111-3 and Section 301.6112-1 are followed.

Tolling Provision: These proposed regulations modify the existing regula-tions by eliminating a provision to toll the time for providing disclosure when a potential taxpayer or material advisor requests a ruling on a transaction. Under the proposed regulations, a taxpayer or potential material advisor may request a ruling under Sections 6011 or 6111 on a transaction under the regular procedures for requesting a ruling, provided the ruling request is not factual or hypothetical, but the time for providing disclosure under Sections 6011 or 6111 will not be tolled. The temporary regulations issued concurrently with these proposed regulations eliminated, effective for all ruling requests received on or after November 1, 2006, the tolling of the time for providing disclosure when a taxpayer or material advisor requests a ruling on a transaction.

List Maintenance RequirementsProposed regulations under Section 6112 of the internal Revenue Code provide the rules relating to the obligation of material advisors to prepare and maintain lists with respect to reportable transactions. These regulations affect material advisors responsible for keeping lists under Section 6112.81

81 71 F.R. 64501-64504


Tax Shelters

Where the Money Goes82

Although no precise estimates are possible, as much as $1.6 trillion in North American wealth is likely held in offshore accounts, according to a 2005 report by the Tax Justice Network, an international group opposed to tax avoidance. These are among the offshore locations where many are said to have transferred income:

n Belize. Caribbean nation has eight banks, one insurance company, 23 trust companies and 38,741 registered offshore corporations.

n British Virgin Islands. A territory of the United Kingdom, it has more than 500,000 registered offshore corporations.

n Cayman Islands. United Kingdom territory is home to more than 500 banks and trust companies, 7,100 mutual and hedge funds.

n Isle of Man. A crown dependency of the United Kingdom, the Irish Sea island is home to 171 offshore service providers.

n Panama. This Central American nation has 34 offshore banks and about 350,000 offshores.

n St. Kitts and Nevis. A federation of two Caribbean islands that has one offshore bank, 50 trust and company service providers and 15,000 offshore corporations.

82 Senate Permanent Subcommittee on Investigations, August 2006 Report.

06Reorganizations


Reorganizations

IntroductionThe rate of insurance company reorganizations has been relatively stable for the last five years. However, in terms of numbers; the value of those deals has increased dramatically, from $9.2 billion to $65.2 billion.83 As the industry continues to merge and reorganize itself for operational efficiencies and global reach, the IRS struggles to keep pace with these changes.

In March 2006, the IRS asked for public comments on proposed regulations84 issued under Section 338 that treats a deemed asset sale by an insurance company or an acquisition of an insurance business as an assumption reinsurance transaction. These proposed regulations were issued in March 2002. Pursuant to Section 7805(e)(2), temporary and proposed regulations expire if they are not finalized within three years. Because the proposed regulations were not finalized within three years of being issued, the proposed regulations “expired” in March 2005.

In April 2006, final regulations were issued by the IRS under Sections 338 and 1060. These regulations have been long awaited and address some, but not all, of the industry’s comments on the proposed regulations issued in March 2002.

While the once popular trend of demutualization seems to have slowed, in 2006 the IRS issued another consistent ruling on the tax-free nature of a demutualization, a positive result for taxpayers. The IRS also reiterated its position that distributions from a demutualization are not policyholder dividend deductions, and therefore are taxable when received. Finally, the IRS released temporary and proposed regulations under Section 1502, eliminating the separation of loss activities condition of the tacking rules.

83 Mergers and Acquisitions, The I.I.I. Insurance Industry Fact Book, 2006.

84 71 F.R.26826


06

Asset AcquisitionsSection 33885

On April 7, 2006, the IRS released the long-awaited final and temporary regulations relating to an actual or deemed acquisition of an insurance company’s assets. The final regulations under Sections 338 and 1060 apply to the following: an actual or deemed acquisition of an insurance company’s assets pursuant to an election under Section 338; a sale or acquisition of an insurance trade or business subject to Section 1060; and, an acquisition of insurance contracts through assumption reinsurance.

Final regulations under Section 381 were issued to address the effect of certain corporate liquidations and reorganizations on certain tax attributes of insurance companies. Temporary and proposed regulations were also released under the following Sections: Section 197 relating to the determi-nation of adjusted basis of amortizable Section 197 intangibles with respect to insurance contracts; Section 338 relating to increases in reserves after a deemed asset sale; and, Sections 338 and 846 relating to the effect of a Section 338 election on a Section 846(e) election.

The proposed regulations were released in March 2002 and generally treat the deemed transfer of insurance or annuity contracts pursuant to a Section 338 election consistently with the treatment of assumption reinsurance transactions entered into in the ordinary course of business. In addition, the proposed regulations provide similar rules for acquisitions of insurance businesses governed by Section 1060, whether affected through assumption or indemnity reinsurance. While the proposed regulations provided welcome guidance on many of the tax intricacies of such transactions, practitioners took issue with some of the proposed guidance and asked for further clarification on several unclear issues. In general, the final and temporary regulations follow the approach of the proposed regulations. The following is a summary of material departures between the 2006 final and temporary regulations and the 2002 proposed regulations.

85 71 F.R. 17990-18007


Reorganizations

Reserve Increased by New Target after the Deemed Asset Sale: The 2002 proposed regulations generally require capitalization of increases in reserves for the acquired contracts in excess of cumulative annual increases of two percent per year from the acquisition date reserves. The IRS received many comments relating to the rule requiring capitalization for certain increases in reserves post-transaction. Many tax practitioners took issue with this approach due to the disregard shown for the Subchapter L provisions that apply to the determination of tax basis insurance reserves and losses incurred.

In response to comments, the 2006 temporary and final regulations adopt the “asset model” capitalization requirement of the proposed regulations but in limited form (the compromise given to accommodate the “service model” generally used to effect insurance transactions). Under the temporary regulations, capitalization is required only for increases in reserves that clearly reflect a so called “bargain purchase.” Because the temporary regulations limit the total amount of capitalization for increases in reserves for acquired contracts, the IRS believes that it is no longer necessary to provide a time limit on when increases in reserves for acquired contracts are to be capitalized or to provide a floor below which increases in reserves are not capitalized. However the temporary regulations retain the other limits on capitalization in the proposed regulations.

The more limited application of the capitalization provision is a welcomed one, but not a complete win from the taxpayer’s perspective. We can still feel the IRS’ struggle with accommodating insurance transactions in an asset acquisition model. However, taxpayers continue to have a clear methodology for determining whether a bargain purchase exists and capitalization is required, thus removing much of the uncertainty in applying this provision.

Determination of adjusted basis of amortizable Section 197 intangibles: The 2002 proposed regulations resulted in significant complications and uncertainty in addressing the interplay of Sections 197 and 848 in a Section 338 transaction. The IRS has attempted to ease the burden of the interdependent calculations by providing simplifying assumptions and clarifications.


06

Under the 2006 temporary and proposed rules, the amount of expenses capitalized under Section 848 as a result of an assumption reinsurance transaction equals the lesser of (A) the required capitalization amount for the transaction, or (B) the amount of general deductions allocable to the transaction. The temporary and proposed rules also clarify that in the event that the acquirer purchases more than one category of specified insurance contracts, the determination of the amount capitalized under Section 848 is made as if each category were transferred in a separate assumption reinsurance transaction. Under the temporary and proposed rules, an acquirer will determine its general deductions as if the entire amount paid or incurred for the acquired contracts were allocable to an amortizable Section 197 intangible. In the event that the amount of required capitalization exceeds the general deductions limitation, taxpayers will have the ability to agree to forgo the general deductions limitation in making the determination.

The simplifying assumptions appear to achieve the intended result and are purported by the IRS to result in more of the purchase price being allocated to shorter-lived Section 848 DAC (maximum 10-year life) versus Section 197 intangibles (15-year life).

The temporary and proposed regulations generally apply, on a cut-off basis, to acquisitions and dispositions on or after April 10, 2006. However, taxpayers may elect to apply the regulations on a retroactive basis to a transaction, with the resulting adjustment being treated as a Section 481(a) adjustment.

Effect of Section 338 Election on Section 846(e) Election by Old Target: The proposed regulations did not provide any special rules under Section 846 for New Target to apply Old Target’s historical loss payment pattern as a result of a Section 846(e) election made by Old Target. Because New Target is generally treated as a new corporation that may adopt its own accounting methods without regard to the methods used by Old Target, it was unclear whether an election pursuant to Section 846(e) would carry over to New Target in a Section 338 transaction. The 2006 temporary


Reorganizations

regulations contain a new rule that treats New Target and Old Target as the same corporation for purposes of the Section 846(e) election. Thus, New Target will continue to have the ability to use Old Target’s historical loss payment pattern for purposes of discounting reserves, unless it revokes the election made by Old Target and defaults to the industry wide factors prescribed by the IRS. Moreover, the 2006 temporary regulations contain a provision that will allow New Target to use Old Target’s historical payment pattern in making a new Section 846(e) election.

This issue was hotly debated upon the issuance of the proposed regulations. The final and temporary regulations provide welcome clarity.

Application of IRC Section 381: The final regulations use much of the proposed regulations in this area. However, the final regulations do provide a significant clarifying point with respect to the application of Section 381 to asset acquisitions: Section 381 applies to tax attributes, including DAC and Policyholders Surplus Accounts (PSAs) whether the acquirer is a life or non-life insurance company.

The 2002 proposed regulations provide that if one corporation distributes or transfers at least fifty percent (50%) of an insurance business to another corporation in a transaction to which Section 381 applies, then the acquir-ing corporation succeeds to the distributor corporation’s shareholders surplus account (SSA), PSA, and other accounts. However, under the proposed regulations, if an acquiring corporation acquires less than 50% of the corporation’s insurance business, then the acquiring corporation succeeds only to a ratable portion of the corporation’s SSA, PSA, and other accounts. Practitioners questioned whether the IRS has the authority to provide for ratable allocation of the accounts in a Section 381 transaction. The IRS believes that the rule in the proposed regulations is appropriate and that there is sufficient authority. Therefore, the 2006 final regulations adopt the rule in the proposed regulations, but provide that a successor corpora-tion can succeed to these accounts whether it is a life or non-life company.


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The 2002 proposed regulations also provide that any remaining balances of DAC or excess negative DAC carry over to a successor insurance company in a Section 381 transaction. The 2006 final regulations retain the rule in the proposed regulations that the remaining balances of DAC or excess negative DAC carry over to a successor insurance company in a Section 381 transaction. However, the 2006 final regulations adopt the application of the 50% rule enumerated above with respect to SSAs and PSAs to DAC.

This was another of the often-debated issues stemming from the 2002 proposed regulations. The IRS has ruled favorably with respect to this issue, allowing for the carryover of the PSA accounts to non-life companies. However, with the Section 815(g) special distribution rules in effect for the 2005-2006 period allowing for the tax-free distribution of PSAs in certain cases, will be interesting to see if many taxpayers continue to have a need for such a provision.

The IRS also addressed taxpayer comments on the following two items but declined to make changes in the proposed regulations:

Recovery of Basis on Dispositions of Acquired Contracts: The 2002 proposed regulations provide that basis recovery with respect to a Section 197(f)(5) intangible transferred through indemnity reinsurance is permitted when sufficient economic rights relating to the insurance contracts that gave rise to the Section 197(f)(5) intangible have been transferred.

Several commentators requested that the final regulations clarify when sufficient economic rights in a Section 197(f)(5) intangible are transferred through indemnity reinsurance as well as additional examples to address situations relating to transfers through indemnity reinsurance of less than 100 percent of the insurance contracts that gave rise to the Section 197(f)(5) intangible. The IRS declined to provide examples or further clarification, stating that “the rules contained in these regulations should refer to general tax principles,” and that, as needed, the IRS will address these issues in future published guidance.


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Allocation of ADSP and AGUB to Specific Insurance Contracts: The 2002 proposed rules provide that for purposes of allocating AGUB and ADSP, the fair market value of a specific insurance contract or group of insurance contracts is the amount of the ceding commission a willing reinsurer would pay a willing ceding company in an arm’s-length transaction for the reinsurance of the contracts if the gross reinsurance premium for the contracts were equal to old target’s tax reserves for the contracts. The IRS reiterated that tax reserves are the basis for valuing the contracts.

IRS Corrects Section 338 Regulations86

In May 2006, the IRS issued corrections to the final, temporary, and proposed Section 338 regulations which were issued in April 2006. As published, the IRS felt that the regulations contained errors that could prove to be misleading and were in need of clarification.

In the final and temporary regulations, Par. 2. Section 1.388.11T contained a typographical error. The original language, “B equals old target’s undiscounted unpaid losses (determined section 846(b)(1) as of the close of the acquisition date,” was revised for an error. The error was corrected by revising paragraph (d)(3)(ii)(2) to read as follows: “B equals old target’s undiscounted unpaid losses (determined under section 846(b)(1) as of the close of the acquisition date.”

In the proposed regulations paragraph, instruction for Par. 5. also contained a typographical error. The original language, “Par. 5. Section 1.846-2 as amended by adding new paragraph (d) to read is follows,” was revised to read “Par. 5. Section 1.846- 2 is amended by adding new paragraph (d) to read as follows.”

86 71 F.R. 26826


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DemutualizationPLR 200613011Among other rulings this year, PLR 200613011 announced that a mutual insurance company’s conversion to stock form, and the redomestication of a foreign target, involved a series of tax-free reorganizations under Section 368.

Insurance Company, a mutual life and health insurance company, owns all the membership interests in LLC 1. LLC 1 recently sold all the member-ship interests in LLC 2. Target, a Country A corporation, serves as the parent holding company of U.S. and foreign affiliates primarily engaged in the insurance business. The stock of Target is owned by U.S. persons. Target has never been a controlled foreign corporation or conducted business in the U.S.

Holding Company was incorporated at the direction of Insurance Company, and Insurance Company’s Board of Directors adopted a plan to convert Insurance Company from a mutual company to a stock company (Converted Company) and to simultaneously sell all of the Converted Company’s stock to Holding Company. Target will merge into SubCo, a newly formed wholly-owned subsidiary of Holding Company (Merger). In the Merger, the Target stock will be exchanged for a combination of cash and Holding Company stock. Holding Company will become an insurance holding company and be the parent holding company of the Converted Company, SubCo, and their subsidiaries after the Conversion and the Merger.

Conversion Ruling. Under Rev. Proc. 2005-3, the IRS will not rule as to the qualification of a transaction as a Section 368(a)(1)(E) reorganization unless it determines that there is a significant issue that is not clearly and adequately addressed by published authority. The IRS determined that a significant issue existed and ruled that the conversion and exchange of the Membership Rights will constitute a Section 368(a)(1)(E) reorganization. Furthermore, the IRS determined that the Converted Company will be the same entity as the Insurance Company for federal income tax purposes, and that the policyholders of Insurance Company will be treated as transferring their Membership Rights to Holding Company in exchange for Subscription


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Rights to buy Stock. Thus, gain or loss will be recognized on the exchange, and the basis of the policyholders in their Membership Rights is zero.

Domestication Ruling. The IRS ruled that the Domestication will be treated as a transfer by Target of its assets to “New Target” in exchange for New Target’s stock and its assumption of the liabilities of Target, followed by the distribution by Target to its shareholders of the New Target stock in exchange for Target stock. The Domestication will constitute a reorganization under Section 368(a)(1)(F).

Merger Ruling. The IRS ruled that SubCo’s acquisition of substantially all of New Target’s assets in exchange for Holding Company stock, cash, and SubCo’s assumption of New Target’s liabilities will constitute a Section 368(a)(1)(A) reorganization by reason of Section 368(a)(2)(D). New Target shareholders who receive Subscription Rights in their capacity as New Target shareholders pursuant to the Plan of Conversion will be treated as receiving the Subscription Rights in the Merger. Gain will be recognized by New Target shareholders who exchange their New Target stock for Holding Company stock and cash in the Merger, but not in excess of the amount of cash received, pursuant to Section 356(a)(1).

Eugene A. Fisher et al. v. United States87

Seymour P. Nagan Irrevocable Trust (the Trust) acquired a $500,000 life insurance policy-issued by Sun Life Assurance Company of Canada (Sun Life). At the time that the Trust acquired the policy, Sun Life was a mutual life insurance company. The insurance policy was a “participating policy” which entitled the Trust to receive dividends from the company declared out of surplus, distributions in the event of a liquidation, and voting rights in the election of directors and other matters relating to the company.

Sun Life subsequently converted from a mutual life insurance company to a stock life insurance company. As a result of the demutualization of Sun Life, the Trust became entitled to receive 3,892 shares of common stock of Sun Life Financial Services. The Trust elected to have the Sun Life Financial Services shares sold upon issuance and received net proceeds of $31,759 from the sale.

87 Eugene A. Fisher et al. v. United States, 69 Fed.Cl. 193 (2006).


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The Trust reported the net proceeds of $31,759 from the sale on its income tax return for 2000, utilizing a tax basis of zero. The Trust subsequently filed a claim for refund with the IRS for the taxes that it had paid as a result of the Sun Life Financial Services sale in 2002. In the refund claim, the Trust stated, “the treatment of [demutualization proceeds] as subject to capital gains with a zero basis, either currently in the case of cash received, or in the future in the case of stock received when subsequently sold, is totally incorrect and unsupportable.”

The IRS rejected the Trust’s claim and the Trust filed suit, filing a motion for class-action status. The Claims Court denied the Trust’s motion for class-action status, finding that (1) the Trust failed to demonstrate that the class would be so numerous that it would be impracticable to settle each case individually, and (2) the Trust failed to establish that it could provide adequate representation for itself and others in a class-action lawsuit.

The taxpayer was attempting to win the underlying tax issue of whether or not the distributions from the demutualization are taxable distributions or a tax-free policyholder dividend. The issue was decided against another taxpayer in UNUM Corporation v. U.S., 886 F. Supp. 150 (1995). Despite denying the motion for class-action status, the Court did find that the Trust had satisfied the prerequisite of commonality and established that its claims were “typical” of those of the class it sought to represent.

Tacking Rules88

Modified Tacking Rules The tacking rules provide requirements for the inclusion of insurance companies in a life-nonlife consolidated income tax return. In a release earlier this year, the IRS provided temporary and proposed regulations under Section 1502, eliminating the separate condition of the tacking rule in Reg. Sec. 1.1502-47(d)(12).

Life insurance companies generally must meet a five-year affiliation require-ment before qualifying to be included in the filing of a consolidated income tax return. An exception to this requirement (the tacking rule) provides that,

88 71 F.R. 23856-23857


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where an existing member of the group transfers property to a new member of the group, the period during which the old corporation is affiliated with the group can be “tacked” onto the period for the new corporation if five conditions are met. The temporary regulations eliminate the third condition on the separation of profitable activities from loss activities. In light of changes to the taxation of life insurance companies, the IRS believes the separation condition should be eliminated because the rationale for adopting the condition is no longer relevant under current law. The temporary regula-tions apply to taxable years for which the due date (without extension) for filing returns is after April 25, 2006.

Consolidated groups operating with life and non-life insurance companies are now relieved of the condition requiring separation of profitable activities from loss activities. Life insurers contemplating securitization transactions involving certain reserve lines should assess the impact of this guidance.

Tax-Free Liquidation PLR 200617024Declining to rule on certain issues relating to the tax treatment of expenses and or/liabilities paid by a subsidiary on behalf of the Parent, the IRS declared that the liquidation of an insolvent insurance company subsidiary into the parent company will be tax free under Section 332.

Subsidiary, a non-life insurance company, has qualified as a tax exempt insurance company under Section 501(c)(15) since 1995. Parent is a holding company which owns the stock of Subsidiary and Subsidiary2. Together, Parent, Subsidiary and Subsidiary2 are referred to as the “Companies.”

Court1 placed the Companies into receivership and appointed the Commis-sion as Permanent Receiver. The Receiver suspended the issuance of new insurance business. Since being placed in receivership, Subsidiary’s financial condition significantly improved. Subsidiary is now able to pay 100 percent of claims. Subsidiary continues to process claims and maintains insurance reserves for its unpaid reported and unreported losses. In order to implement a windup of the Companies, Receiver proposed the following transaction:


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All of the remaining assets and liabilities of Subsidiary will be transferred pursuant to the plan of liquidation to Parent within 3 years after the end of the first taxable year in which the first liquidating distribution occurs. The Liquidation Order also approves the proposed plan to liquidate the Parent at some point in the future.

The IRS ruled that: (1) No gain or loss will be recognized by Parent upon the receipt of the assets and liabilities of Subsidiary under Section 332; (2) No gain or loss will be recognized by Subsidiary on the distribution of its assets to, or the assumption of liabilities by, Parent in complete liquidation under Section 337(a); (3) Parent’s basis in each asset received from Subsidiary will be the same as the basis of that asset in the hands of Subsidiary immediately prior to its liquidation; (4) Parent’s holding period in each asset received from Subsidiary will include the period during which that asset was held by Subsidiary; and (5) Parent will succeed to and take into account the items of Subsidiary described in Section 381(c), subject to the conditions and limitations specified in Sections 381 thru 384 and the regulations thereunder.

PwC Releases M & A Asian Taxation Guide 2006 This year, PwC released the PwC’s Mergers & Acquisitions Asian Taxation Guide 2006. The guide was officially launched at the 2006 Global Tax Symposium in Bangkok on 24-26 May 2006 and showcased at the recent Asia Pacific Advisory Conference held in Singapore.

This thought leadership publication is an essential read for both present and potential investors planning a business merger or acquisition in the Asia Pacific region. It provides a summary of the tax and regulatory landscape in 14 countries across the Asia Pacific region, highlighting key issues relevant to both purchasers and sellers when transferring business ownership.

The information within the publication is drawn from the breadth and depth of expertise that exists within our Asia Pacific network of M&A tax professionals. The countries showcased in this edition include Australia, China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia, New Zealand, Philippines, Singapore, Sri Lanka, Taiwan and Thailand. This publication may be accessed on our Insurance Tax website at: http://www.pwc.com/us/insurance/tax/publications.

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IntroductionThe assimilation of world capital markets carries increasingly important implications for the impact of tax policies on the insurance industry. Mounting demand for transparency associated with international transac-tions, increasing competition, electronic commerce, and the emergence of new risks are among the many challenges faced by global insurers. These developing trends pose global challenges for inbound and outbound insurance companies. Insurance companies and corporations in general engaged in international activities should scrutinize their practices involving international transactions to a greater degree in the coming years as the Internal Revenue Service has publicly stated it will.

The American Jobs Creation Act of 2004 added Section 7874 to significantly curtail inversion transactions. Since then the Treasury Department has issued proposed and temporary regulations in an effort to provide specific guidance to taxpayers. While the Court of Federal Claims ruled on issues of foreign tax credit and excess gain, the IRS issued guidance under Subpart F, more specifically, under Sections 953 and 954. Final regulations were issued relating to the withholding of income tax on certain U.S. source income. Finally, as they do every year, the IRS provided the domestic asset/liability percentages and domestic investment yields needed to compute minimum effectively connected net investment income under Section 842(b).

Inversions89

Although enacted to address “inversions,” Section 7874 may have an adverse impact on other, more commonplace cross-border M&A transac-tions. Temporary regulations issued in December 2005 provide relief for many internal restructuring and joint venture transactions, but others remained at risk. In June of 2006 the IRS issued temporary and proposed regulations under Section 7874 to expand the scope of Section 7874 to cover certain transactions and provide guidance on several other issues.

89 71 F.R. 32437-32448


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Temporary and Proposed Inversion Regulations90

Regulations were issued under Section 7874 to set forth rules relating to the determination of whether a foreign entity shall be treated as a surrogate foreign corporation under Section 7874(a)(2)(B). The temporary regulations address the indirect acquisition of properties, stock held by reason of holding an interest in a domestic entity, the substantial business activities of an expanded affiliated group (EAG), prevention of the avoidance of Section 7874, and effects of treatment as a domestic corporation.

For purposes of Section 7874(a)(2)(B)(i), an acquisition by a foreign corporation of stock in a domestic corporation is considered to be an indirect acquisition of a proportionate amount of the properties held by the domestic corporation, as is a similar acquisition of an interest in a partnership that holds stock in a domestic corporation. A foreign corporation’s acquisition of stock in a second foreign corporation is not considered an indirect acquisition by the first foreign corporation of any properties held by a domestic corporation or domestic partnership owned wholly or partly by the second foreign corporation.

For purposes of Section 7874(a)(2)(B)(ii), stock of the acquiring foreign entity that is received in exchange for stock of a domestic corporation, or in exchange for a capital or profits interest in a domestic partnership, is considered to be stock held by reason of holding stock in the domestic corporation or interest in a domestic partnership. Where other property is also contributed to the foreign entity in exchange for stock, the amount held by a former shareholder or partner for Section 7874 purposes is determined by the relative value of the property.

The regulations provide an all-facts-and-circumstances test and a bright-line safe harbor test of whether an EAG has substantial business activities in the acquiring foreign entity’s country of incorporation. The IRS identified two categories of transactions requiring a special rule in order to prevent avoidance of Section 7874: publicly traded foreign partnerships and options and similar interests held by a former shareholder or former partner of the expatriated entity. The regulations provide that a foreign corporation

90 71 F.R, 47158-01


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that is treated as a domestic corporation under Section 7874(b) is treated as converting to a domestic corporation pursuant to a reorganization described in Section 368(a)(1)(F) immediately before the commencement of the acquisition.

Section 7874 applies to transactions where three conditions are met:n An entity that otherwise would be considered a foreign corporation

makes a “direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation or substantially all of the properties constituting a trade or business of a domestic partnership” (“Substantially All Test”).

n After the acquisition, the former shareholders or partners of the domestic entity own a specified percentage of the foreign entity “by reason of” their previous interest in the domestic entity (“Ownership Test”).

n The “expanded affiliated group” which includes the foreign entity does not have substantial business activities in the foreign country in which the entity is created or organized, when compared with the total business activities of the group (“Insubstantial Business Activities Test”).

If the former shareholders or partners own (or are considered to own) at least 80 percent (by vote or value) of the acquiring foreign entity, the foreign entity is treated as a domestic corporation for all U.S. Federal tax purposes. If they own less than 80 percent but at least 60 percent, certain limitations apply to the domestic entity’s use of tax attributes to reduce tax on income from transactions with related foreign persons.

REG-112994-06The new regulations provide as a general rule that the three-part test for inversion transactions articulated above is applied based on all of the facts and circumstances. They also provide a non-exclusive list of relevant factors to be considered in making this determination. In addition, the regulations provide a safe harbor, under which the acquiring foreign entity will be


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considered to have substantial business activities in it home country if at least 10 percent of group employees (by headcount and compensation), group assets (by FMV or tax book value), and group sales are in that country.

For non-U.S. based multinational groups, this requirement to determine the fair market value or U.S. tax basis of their worldwide assets may make this safe harbor prohibitively expensive. For purposes of this safe harbor, group assets means tangible property used or held for use in the active conduct of a trade or business by a group member, and group sales means sales and the provision of services by group members. In light of these restrictive definitions, it is not clear whether or how an insurance company may be able to qualify for this safe harbor.

The new regulations provide that options and stock interests that are similar to options (including warrants and convertible debt) held by a person “by reason of” holding stock in the acquired domestic corporation or a capital or profits interest in the acquired domestic partnership shall be treated as exercised—but only if the effect is to cause Section 7874 to apply.

The new regulations also confirm the general understanding of how Section 7874 operates in a number of respects, including the following:

n The acquisition of stock of a domestic corporation, or of an interest in a domestic or foreign partnership owning stock of a domestic corporation, is considered an indirect acquisition of a proportionate amount of the properties of the corporation. However, the acquisition of stock of a foreign corporation owning stock of a domestic corporation is not considered an indirect acquisition of the properties of the domestic corporation.

n Stock interests held “by reason of” holding an interest in the acquired domestic entity means only the stock received in exchange for such interest.

n When an acquisition causes a foreign entity to be treated as a domestic corporation under Section 7874(b), Section 367 does not apply to any transfer of stock or other property to the entity as part of the acquisition (and thus gain does not need to be recognized under Section 367(a)).


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n When a foreign entity is treated as a domestic corporation under Section 7874(b), that status continues indefinitely, even if one of the three conditions for the application of Section 7874 no longer exists (e.g., if the acquiring foreign entity subsequently has substantial business activities in its home country).

Domestic Asset and Liability Percentages Rev. Proc. 2006-39This Revenue Procedure provides the domestic asset/liability percentages and domestic investment yields needed by foreign life insurance companies and foreign property and liability companies to compute their minimum effectively connected net investment income under Section 842(b) of the Internal Revenue Code, for taxable years beginning after December 31, 2004.

The domestic asset/liability percentages are determined separately for life insurance companies and property and liability insurance companies. For the first taxable year beginning after December 31, 2004 the relevant domestic asset/liability percentages are as follows:

n 133.5 percent for foreign life insurance companies; and

n 181.6 percent for foreign property and liability insurance companies.

Additionally, separate domestic investment yields were prescribed for foreign life insurance companies and for foreign property and liability insurance companies. For the first taxable year beginning after December 31, 2004, the relevant domestic investment yields are:

n 5.8 percent for foreign life insurance companies; and

n 3.8 percent for foreign property and liability insurance companies.

For a foreign insurance company to compute the estimated tax and installment payments of estimated tax due for taxable years beginning after December 31, 2004, it must compute its estimated tax payments by adding to its income other than net investment income, the greater of (i) its net


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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 under Section 842(b) that would result from using the most recently available domestic asset liability percentage and domestic investment yield.

Foreign Tax CreditsAddressing a series of complicated and technical issues, the Court of Federal Claims ruled on issues of foreign tax credit and excess gain in Travelers. These consolidated cases presented the most recent round of litigation in a complex federal income tax dispute that had been ongoing for almost two decades. In case numbers 88-494T and 89-262T, the Court previously published two opinions dealing with the tax dispute relating to the IRS’ audit of Travelers’ tax returns in the late 1970s and early 1980s.91

The Travelers Insurance Company v. United States92

The Court of Federal Claims granted summary judgment, on a case remanded from the U.S. Court of Appeals for the Federal Circuit, on issues of excess gain from operations, and on its ruling that the policyholders’ share should be excluded from an insurance company’s taxable income for foreign tax credit purposes.

In 1988 and 1989 Travelers filed complaints in the Court of Federal Claims challenging the IRS’ determination of its foreign source taxable income for purposes of its allowable credit for foreign taxes paid. Travelers argued two issues: excess gain from operations over taxable income under general sourcing rules should not be allocated to its Indonesia oil gross income under general sourcing rules and second, that the policyholders’ share should not be allocated to Indonesia using the same sourcing rules. The Court ruled in favor of Travelers concluding that the policyholders’ share was a deduction and was properly allocated to Travelers’ gross domestic insurance business and not to its Indonesian oil investments. In a footnote, the Court noted that the “excess GFO deduction” was similarly sourced.

91 The Travelers Insurance Company v. United States, 72 Fed.Cl. 316 (2006).

92 Id.


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During the original proceedings, Travelers asserted that neither excess gain from operations over taxable investment income (excess GFO) nor the policyholders’ share were allocable to its Indonesia oil gross income under general sourcing rules. This was because Travelers was not underwrit-ing policies in Indonesia, nor collecting premiums from policyholders in that country. According to Travelers, excess GFO should be sourced to the United States regardless of its classification as a deduction, exclusion, or deferral of income. On the policyholders’ share issue, Travelers alleged that the Government could not source this income to Indonesia because the policy-holders’ share was part of the reserve for the payment for future policyhold-ers’ insurance claims and thus should be treated with a separate deduction for reserves increases and policy benefits sourced to the United States.

After the Federal Circuit Court ruled in favor of the Government, Travelers petitioned for panel rehearing. Here, the Court clearly concluded that, having accepted the Government’s position on the policyholders’ share issue, they also accepted the Government’s position, by implication, that the excess GFO was excluded from the definition of life insurance company taxable income for purposes of the foreign tax credit calculation. The Court of Federal Claims concluded that the Federal Circuit’s order was a complete rejection of Traveler’s position.

Section 953(d) ElectionIn April 2006, the IRS advised examiners on the filing requirements, assessment and collection periods, and penalties related to the revocation of tax-exempt status for certain controlled foreign corporations that were improperly classified as tax-exempt insurance companies. In May 2006, two taxpayers’ requests for an extension of time to make an election under Section 953(d) were granted, while noting that the granting of an extension of time was not a determination that a taxpayer was otherwise eligible to make the I.R.C. Section 953(d) election.


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FAA 20062201FThe IRS issued a Field Attorney Advice (FAA) addressing questions for controlled foreign corporations (CFCs) previously classified as insurance companies. The IRS has determined that a number of CFCs that have made elections under Section 953(d) and that were previously classified as tax-exempt insurance companies pursuant to Section 501(c)(15) do not qualify for tax-exempt status since they do not qualify as insurance companies and has issued determination letters revoking the entities’ tax-exempt status. The IRS addressed the following questions in the advice:

What is the appropriate filing requirement and applicable statute of limitations for assessment and collection of tax after the IRS has determined it is not properly classified as a tax-exempt entity?

For the year in which the tax-exempt status is revoked the entity becomes subject to U.S. taxation. As a result of the Section 953(d) election, the foreign corporation is still treated as a domestic U.S. Corporation for the first year the IRS determines tax-exempt status is no longer proper. If the entity determined in good faith that it was an exempt organization and filed an exempt organization return and, subsequently, the taxpayer is held to be a taxable organization, the three-year period for assessment or collection starts to run on the date the exempt organization return was filed.

When is the 953(d) election terminated? In the year the IRS determines the entities are not tax-exempt insurance companies the Commissioner may terminate the Section 953(d) election as of the beginning of the next year. The practical effect of terminating the Section 953(d) election is to treat the entities as CFCs beginning in the year after the determination.

What is the effect of the 953(d) election termination for purposes of Section 367? Immediately after the outbound transfer on the first day of the taxable year after the 953(d) election termination, the entity will be treated for U.S. tax purposes as a controlled foreign corporation.


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Are the current Forms 2848, Power of Attorney and Declaration of Representative, valid if they identify the entities, the years involved, but do not identify the type of tax as a result of the revocation? The Forms 2848 solicited at the beginning of the entities’ income tax examination should identify the return the entities are required to file as a result of the tax-exempt status revocation (e.g., 1120). If Forms 2848 have already been secured for the entities but identify the Form 990, the Forms 2848 should be resolicited.

Top 5 “Leading Companies” Globally93

Rank Company Revenues Country Industry

1 ING Group $138,235 Netherlands Life/health

2 AXA 129,839 France Life/health

3 Allianz 121,408 Germany Property/casualty

4 American International Group 108,905 U.S. Property/casualty

5 Assicurazioni Generali 101,404 Italy Life/health

In granting extension of time to make an Section 953(d) election, the IRS has consistently held that it is willing to grant waivers where the taxpayer has shown good faith, as seen in the ruling below.

PLR 200614004 In this ruling, Taxpayer represented to the IRS that: (1) it is not seeking to alter a return position for which an accuracy-related penalty has been or could be imposed under Section 6662; (2) the request for relief was submitted before the failure to file the election was discovered by the IRS; and (3) it intended at all times to make the election and that no specific facts have changed since the due date to make the election that make the election advantageous to the Taxpayer. Treas. Reg. Section 301.9100-1(c) provides that the IRS Commissioner has discretion to grant a taxpayer a reasonable extension of time to make regulatory elections. Treas. Reg. Section 301.9100-3(a) provides that requests for relief will be granted when the taxpayer provides the evidence to establish that the taxpayer acted reasonably and in good faith, and the grant of relief will not prejudice the interests of the Government. The IRS determined that based on the

93 The Fact Book 2007, Insurance Information Institute


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facts and information submitted, Taxpayer satisfies Treas. Reg. Section 301.9100-3(a). Accordingly, Taxpayer was granted an extension of time of 60 days from the date of the ruling letter to make the election provided by Section 953(d).

PLR 200617033Once again, the IRS granted an extension of time to file under Section 953(d). In this case, the IRS concluded that Taxpayer acted reasonably and in good faith because relief was requested before the failure to make the regulatory election was discovered by the IRS. Additionally, the IRS concluded that the granting of an extension of time to make the election would not prejudice the interests of the Government. Therefore, the IRS granted Taxpayer an extension of time of 60 days to make an election under Section 953(d) to be treated as a domestic corporation. The IRS continues to grant extensions to taxpayers who show that they acted reasonably and in good faith.

PLR 200622017Taxpayer, a foreign captive insurance company, insures the risks of Law Firm A and Consulting Firm B. Since its formation, Taxpayer has been owned by varying employees of Law Firm A and Consulting Firm B. Taxpayer employed a consulting firm to form the company and to provide advice with regard to U.S. income tax issues. It also employed an accounting firm to perform an audit of Taxpayer’s financial statements and to provide tax advice. At that time, it was clear that Taxpayer was not a CFC. However, Congress thereafter passed legislation which modified the general definition of a CFC and U.S. shareholder in the context of captive insurance companies. Taxpayer was unaware of the legislative modifications and its effect on its status as a CFC. As a result, Taxpayer continued to take the position that it was not a CFC. The IRS concluded that Taxpayer satisfied Treas. Reg. Section 301.9100-3(a) and granted an extension of time of 60 days from the date of the ruling letter to make the election provided by Section 953(d) to be treated as a domestic corporation for U.S. tax purposes.


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PLR 200622003Taxpayer, a property and casualty insurance company, was organized in a foreign jurisdiction, by a domestic parent. Parent’s internal tax department, as well as tax professionals from a law firm and an accounting firm, recommended that Taxpayer make a Section 953(d) election. Accordingly, Parent’s tax department prepared and executed the documentation required for Taxpayer to make that election. Although a copy of Taxpayer’s Section 953(d) election was attached to Parent’s timely filed, consolidated return, in which Taxpayer joined, Parent’s tax department failed to properly submit Taxpayer’s original election statement to the IRS. Since 1997, Taxpayer had assumed that Parent properly filed the documentation required to make a Section 953(d) election. Parent first became of aware of its failure to properly make a Section 953(d) election in November of 2005, when it undertook a review of its records. The IRS concluded that Taxpayer acted reasonably and in good faith because Taxpayer reasonably relied on qualified tax professionals who failed to properly make the election and granted an extension of time until 60 days from the date of the letter ruling to make an election under Section 953(d) to be treated as a domestic corporation.

Qualified Insurance IncomeCFC Partnership Income94

The IRS issued guidance under subpart F relating to partnerships.95 The temporary regulations affect CFCs that are qualified insurance companies, as defined in Section 953(e)(3), that have an interest in a partnership and U.S. shareholders of such CFCs.

Investment income that is excluded from Subpart F insurance income as exempt insurance income under Section 953(e) may nevertheless be treated as Subpart F income if it falls within the definition of “foreign personal holding company income” under Section 954(c) and the exception contained in Section 954(i) is not satisfied.

94 71 F.R. 2496-2497

95 71 F.R. 2462-2464


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For taxable years beginning after December 31, 1998 and before January 1, 2007, Section 954(i) provides that a foreign personal holding company does not include Qualified Insurance Income of a Qualifying Insurance Company. While not immediately apparent, this exception provides for the exclusion of two amounts under the definition of Qualified Insurance Income.

Qualified Insurance Income means income of a Qualified Insurance Company equal to the sum of two amounts: the unrelated ordinary and necessary investment income attributable to Exempt Contracts and the unrelated investment income attributable to Exempt Contracts from required surplus. These two amounts parallel two former exceptions to Section 954(c): former Section 954(c)(3)(B) and former Section 954(c)(3)(C). Furthermore, these exceptions reflect a refinement of former Section 954(h).

The first amount representing Qualified Insurance Income is income of a Qualifying Insurance Company received from a person other than a related person (within the meaning of Section 954(d)(3)) and derived from the investments made by a Qualifying Insurance Company or a Qualifying Insurance Company Branch, in the case of its property and casualty and life insurance business, of its reserves allocable to Exempt Contracts or, in the case of property and casualty insurance business, of 80 percent of its unearned premiums from Exempt Contracts.

The second amount representing Qualified Insurance Income is income of a Qualifying Insurance Company received from a person other than a related person (within the meaning of Section 954(d)(3)) and derived from the investments made by a Qualifying Insurance Company or a Qualifying Insurance Company Branch received from a person other than a related person (within the meaning of subsection (d)(3)) and derived from invest-ments made by a Qualifying Insurance Company or a Qualifying Insurance Company Branch of an amount of its assets allocable to exempt contracts equal to (a) in the case of property, casualty, or health insurance contracts, one-third of its premiums earned on such insurance contracts during the taxable year (as defined in Section 832(b)(4)), and (b) in the case of life insurance or annuity contracts, 10 percent of the Life Reserve Amount for such contracts.


07

Under the 2002 final Section 954 regulations, a controlled foreign corpora-tion’s distributive share of partnership income was not excluded from foreign personal holding company income under Section 954(i) unless the controlled foreign corporation partner was a Qualifying Insurance Company, as defined in Section 953(e)(3) (determined by examining premiums written by the controlled foreign corporation and any partnerships or other qualified business units, within the meaning of Section 989(a), of the CFC partner), and the partnership, of which the controlled foreign corporation is a partner, generated Qualified Insurance Income within the meaning of Section 954(i)(2) (taking into account only the income of the partnership). Thus, the 2002 final Section 954 regulations appeared to apply Section 954(i) to only Qualified Insurance Income of a partnership.

Commentators expressed concern that this 2002 final regulation as drafted would never permit a CFC’s distributive share of partnership income to qualify for the exclusion under Section 954(i), as an entity engaged in an active insurance business is required to be treated as a corporation and, thus, the 2002 final regulations would never apply. Accordingly, the application of Section 954(i) for items earned through a partnership with one or more CFC partners was an open issue being actively considered by the IRS, as announced in its 2005-2006 Priority Guidance Plan.

In response to these efforts, the IRS issued temporary and proposed regulations addressing the application of Section 954(i) for items earned through a partnership. The temporary regulations provide that a CFC’s distributive share of partnership income will qualify for the exception contained in Section 954(i) if the CFC is a Qualifying Insurance Company and the income of the partnership would have been Qualified Insurance Income under Section 954(i) if received by the CFC directly. Thus, whether the CFC partner’s distributive share of partnership income is Qualified Insurance Income is determined at the CFC partner level.


International

Withholding Payments to Foreign Persons96

The IRS issued final regulations relating to the withholding of income tax on certain U.S. source income paid to foreign persons and related requirements governing collection, deposit, refunds, and credits of withheld amounts. The final regulations adopt, with revisions, the proposed regulations published in March 2005. In response to taxpayer comments, the final rules ease the taxpayer identification number requirement for some foreign grantor trusts and provide new rules on the reporting of treaty-based return positions.

Reporting relief for U.S. payors in U.S. possessions: The regulations provide that U.S. payors are not required to report on Form 1099 income from sources in a U.S. possession that is exempt from tax under Section 931, 932, or 933 if the payor could reliably associate the payment with documentation that the owner of the payment is a resident of the U.S. possession.

Use of documentary evidence in possessions of the U.S.: The provision in Notice 2001-4 that documentary evidence may be used in lieu of Form W-8 in a possession of the U.S. is implemented by the regulations.

Information reporting of foreign source services income: The regulations provide that a U.S. payor will not be required to report, under Section 6041, income paid for services performed outside the U.S. if (1) the payee of the income is an individual, (2) the U.S. payor does not know that the payee is a U.S. citizen or resident, (3) the payor does not know, and has no reason to know, that the income is (or may be) effectively connected with the conduct of a trade or business within the U.S., and (4) all of the services for which payment is made were performed outside the U.S.

Reporting/withholding on payments to financial institutions in U.S. possessions: The regulations provide that a U.S. branch of certain foreign banks or foreign insurance companies can be treated as a U.S. person in certain cases. A withholding agent that makes regular or frequent payments in foreign currency is permitted to convert the amount withheld into U.S. dollars at the spot rate on the day the tax is deposited, if the deposit is made within seven days of the payment.

96 71 F.R. 13003-13008


07

The final regulations generally are effective March 14, 2006. The removal of Reg. Sec. 1.1441-1(e)(4)(vii)(G) is effective as of January 1, 2001. In addition to the changes in the proposed regulations, the final regulations introduce two additional modifications. The first is in connection with the elimination of the former W-8BEN validity requirement that a TIN be disclosed on a Form W-8BEN obtained from foreign grantor trusts with five or fewer grantors, retroactively effective with respect to withholding certificates executed on or after January 1, 2001. The second is in connection with amendments made to the treaty based return filing requirements that in certain instances exempt from the Form 8833 filing requirements, payments that are properly reported on

Form 1042-S: In other specific instances the filing threshold for Forms 8833 has been increased from $10,000 to $500,000, thus reducing the incidence of the required reporting requirement.

U.S. Tax Agreements and TreatiesWhile competent authorities of the United States and the United Kingdom ratified an important new income tax agreement to prevent “double dipping” by U.S. corporations who use losses to offset the taxable income in both countries, the IRS advised that payments from the foreign branch of a U.S. life insurance company to a nonresident taxpayer would result in U.S.-source income subject to applicable withholding taxes.

Dual Consolidated Loss97

Losses of U.K. branches of U.S. corporations may be used to offset income of U.S. or U.K. affiliates under a competent authority agreement between the United States and the United Kingdom published by the IRS on October 6, 2006. The dual consolidated loss rules under Section 1503(d) of the Code are intended to prevent “double dipping” by U.S. corporations that might seek to use operating losses to reduce both

97 U.K./U.S. Dual Consolidated Loss Competent Authority Agreement, October 2006.


International

U.S. tax on income of domestic affiliates and the foreign taxes of foreign affiliates. The United Kingdom has similar rules under S403D(1)(c) ICTA1988 by the action of S403D(6) ICTA88, which provide for the disallow-ance of trading losses under certain circumstances. The interaction of these two sets of rules may result in no relief for a loss in either country, thereby producing double taxation.

Under the Agreement, however, certain taxpayers may now elect to use, or relieve, losses in either the United States or the United Kingdom to the extent permitted by the rules of the contracting state, as modified by the Agreement. More specifically, subject to the terms and conditions of the Agreement, a U.S. corporation with a loss attributable to a U.K. permanent establishment may elect either to use the loss to offset the taxable income of a domestic affiliate, notwithstanding the anti-mirror rule of Treas. Reg. Section 1.1503-2(c)(15)(iv), or to surrender the loss to a U.K. affiliate as permitted by S402 ICTA88 and S403D ICTA1988 without the restriction provided by S403D(6), but not both.

Some taxpayers historically have taken the position that the Section 1503(d) anti-mirror rule does not apply to losses incurred by U.K. branches of U.S. corporations. Such taxpayers should consider electing the relief provided by the Agreement to avoid any unnecessary dispute regarding the scope of that rule. Annex A of the Agreement provides the rules and conditions that must be satisfied for a taxpayer to use dual consolidated losses, with respect to which relief is available under the terms of the Agreement, in the United States to offset taxable income of a domestic affiliate. It also provides the time, place, and manner for various filings and notifications required under the Agreement and Section 1503(d) of the Code and the regulations thereunder. Transition relief is provided for prior losses incurred in open tax years.


07

U.S.-Source IncomeA taxpayer making payments from the foreign branch of a U.S. life insurance company to a nonresident taxpayer was advised that such payments would result in U.S.-source income subject to applicable withholding taxes.

PLR 200646001Taxpayer is a corporation that conducts business in the United States and Country X, and sells a number of different types of insurance products to individuals living in the United States and Country X. Taxpayer represents that these insurance products are life insurance and annuity contracts under the Internal Revenue Code. Residents of Country X pay premiums to Taxpayer. Under a life insurance contract, Taxpayer agrees to pay the face amount of a certificate (less any outstanding loan balance) to a beneficiary upon the death of the insured. Under an annuity contract, Taxpayer agrees to pay a certain amount each year to the owner of the contract based on the selection of a payment option by the contract owner. Taxpayer represents that premiums from sales to residents of Country X of Taxpayer insurance products are deposited in a Country X account and are invested in Country X income-producing assets, such as stocks and bonds.

Rev. Rul. 2004-75 held in part that income received by nonresident alien individuals under life insurance and annuity contracts issued by a foreign branch of a U.S. life insurance company is U.S. source fixed or determinable annual or periodical income (“FDAP income”) that is subject to 30 percent tax and withholding under Sections 871(a) and 1441.

Taxpayer requested a ruling under the United States-Country X income tax treaty (the Treaty). For purposes of the Treaty, the source of distributions under the annuity and life insurance contracts issued by Taxpayer is determined under U.S. law. The Treaty applies to determine how periodic distributions under the annuity contracts issued by Taxpayer to Country X residents are taxed in the United States. The periodic annuity distributions are subject to 15 percent U.S. withholding tax on the portion of the distribution that would not be excluded from U.S. taxable income if the beneficial owner were a resident of the United States.


International

Relevant articles of the Treaty apply to determine how amounts withdrawn from the accumulation value of the annuity contracts distributions under the life insurance contracts are taxed in the United States. Because the relevant article does not contain a limit on the source state rate of tax, the (U.S. source) amounts withdrawn from the accumulation value of the annuity contracts and the (U.S. source) distributions under the life insurance contracts would be subject to 30 percent U.S. withholding tax, to the extent that such amounts constitute gross income for purposes of U.S. tax law. The Treaty’s saving clause permits the United States to tax its citizens and certain former citizens as if there were no Treaty between the United States and Country X. Accordingly, residents of Country X who are U.S. citizens or, in certain cases, former U.S. citizens would not be subject to U.S. withholding tax with respect to distributions under Taxpayer-issued life insurance and annuity contracts, but would be subject to net-basis U.S. tax on such distributions to the extent that the distributions constitute gross income for purposes of U.S. tax law.

Guidance to Taxpayers Seeking Competent Authority Tax Treaty AssistanceIn November 2006, the IRS issued Revenue Procedure 2006-54, which provides taxpayers with guidance on obtaining government assistance related to currently enacted tax treaties.

Organisation for Economic Co-operation and Development (OECD)Insurance Consultation Meeting—Paris 2006In June 2005 the OECD issued a Discussion Draft of the Report on the Attribution of Profits to a Permanent Establishment—Insurance (“Part IV”). The OECD had a consultation meeting with representatives from the Insurance Industry on this paper in Paris on March 31, 2006. This meeting represented a key stage in the debate on the future taxation of permanent


07

establishments. Joseph Foy, PwC’s global insurance tax leader, co-presented the discussions around Functions in the Insurance Business. The essence of Part IV is that a branch or permanent establishment (PE) should be treated as if it were a separate entity dealing at arm’s length with the rest of the entity and with other parties. It is clear that Part IV of the report was heavily influenced by the previous work done in relation to the OECD drafts Parts II and III which comment on banks and global trading. The consulta-tion meeting was focused on discussion of the following four broad topics:

n Functions in the insurance business. The main issue for discussion was what functions of an insurance business are Key Entrepreneurial Risk Taking functions that determine the profits of the enterprise.

n Dependent agent PEs in the insurance business. They key issue is when a dependent agent PE is created in an overseas jurisdiction.

n Attributing investment income to the PE covering methods for allocating investment yield and the impact of regulatory regimes on attribution of investment income.

n Internal reinsurance dealings covering whether internal reinsurance between a head office and its PEs should be recognized for tax purposes.

The day-long meeting saw a lively debate between representatives of industry, global accounting firms and fourteen revenue authorities from around the world. The discussion was wide ranging and, at times, impas-sioned. At the end of the meeting there were still some parts of the Draft Report that needed to be finalized and the OECD promised that a second draft would be produced for review and consultation by the industry. The OECD plans to release the revised draft sometime during 2007.

08Blue Cross Blue Shield


08

IntroductionEstimates released by the Census Bureau in 2006 show a rise in the level of uninsured Americans; 46.6 million people lacked health insurance in 2005, up from 45.3 million in 2004.98 As the 109th Congress adjourned to make way for the 110th, it passed, and the President signed into law, the Tax Relief and Health Care Act of 2006, which provides for several provisions to enhance healthcare benefits and control costs.99

Although the subject of healthcare continued to be an area of much concern and discussion in the media and legislatively, tax guidance in the area was slight. Of specific interest to Blue Cross Blue Shield organizations, the IRS addressed material change and reconfirmed that fresh start asset basis is lost upon a material change. In other guidance, the IRS discussed the safe harbor method of accounting under Rev. Proc. 2002-46 and its interaction with deferred compensation expense.

In May, the LMSB Division of the IRS issued a coordinated settlement offer for the Intangible Asset Abandonment Loss issue. While most Blues found the offer favorable, issues stemming from the complicated calculations will ensure continued negotiation and debate on valuating the settlements. Currently, companies are moving forward to address the impact this settlement has on their FAS 5/FIN 48 analyses.

Material ChangeTAM 200607020Taxpayer was incorporated as a mutual insurance company. Taxpayer engaged in several acquisitive transactions in which a mutual insurance company merged into Taxpayer such that the business of five mutual insurance companies were transferred to Taxpayer’s newly formed wholly-owned subsidiaries, which were stock insurance companies. Taxpayer converted from a mutual insurance company to a publicly traded stock insurance company, issuing stock and securities.

98 Appleby, Julie. “Ranks of Uninsured Americans Grow,” USA Today, August 29, 2006.

99 “Tax Relief and Health Care Act of 2006,” December 20, 2006.


Blue Cross Blue Shield

Prior to these transactions, Taxpayer and its subsidiaries were existing Blue Cross Blue Shield organizations within the meaning of Section 833(c). In computing their taxable income, several of the subsidiaries claimed the Special Deduction provided by Section 833(a)(2) and Taxpayer and subsidiaries claimed the “Fresh Start” tax basis provided by Section 1012(c)(3)(A)(ii) of the Tax Reform Act of 1986.

The following issues were ruled upon: (1) whether the conversion of Taxpayer from a not-for-profit mutual insurance company to a for-profit stock insurance company, which involved the offering of stock and securi-ties traded on a public exchange, constitutes a material change in its operations or structure under Section 833(c)(2)(C) (2) if such a conversion is a material change in structure, does it negate the application to Taxpayer and its subsidiaries of Sections 833(a)(2) providing for the Special Deduc-tion and 833(a)(3), providing for the exemption from the Unearned Premium Haircut (3) if such a conversion is a material change in structure, does the change preclude application to Taxpayer and its subsidiaries of the benefits of Section 1012 of the Tax Reform Act of 1986.

In keeping with prior year rulings, the IRS concluded that the conversion of a Blue Cross Blue Shield organization from a not-for-profit mutual insurance company to a for-profit stock insurance company constitutes a material change in its structure under Section 833(c)(2)(C).

Further, Taxpayer’s conversion negates the application of Sections 833(a)(2) and (a)(3) to Taxpayer and its subsidiaries for the years involved, and the material change precludes application of the benefits of Section 1012 of the Tax Reform Act of 1986.

Health Plan Aims to Cut Costs In another sign that healthcare will return as a major issue as Democrats take control of Congress, a prominent Democratic senator unveiled an ambitious proposal to provide medical insurance for all Americans while reining in costs. The plan by Sen. Ron Wyden, (D-OR), came a month after the health insurance industry offered its comprehensive proposal as politicians and the business community show new willingness to tackle a subject that has been off limits since the mid-1990s collapse of President Clinton’s sweeping healthcare reform package.100

100 Alonso-Zaldivar, Ricardo. “ Health Plan Aims to Cut Costs, Insure All,” Los Angeles Times, December 14, 2006


08

Safe Harbor Not Available for Deferred CompensationTAM 200610016This ruling stands for the IRS’ position that a taxpayer cannot use the safe harbor method of accounting for premium acquisition expenses provided in Rev. Proc. 2002-46 to deduct the liability shown on its annual statement with respect to a deferred compensation plan for independent contractor insurance agents.

Taxpayer, a non-life insurance company, sells property and casualty insurance through independent contractor agents located throughout the U.S. Each agent enters into a written agreement with Taxpayer that requires the agent to act as Taxpayer’s exclusive agent in the sale and servicing of insurance business and provides that the agent will be treated as an independent contractor for all purposes, including the responsibility for paying all federal, state, and local income and self-employment taxes. Under the agreement, the agents are entitled to receive regular commissions.

The agreement also contains a deferred compensation arrangement called the Plan under which Taxpayer agrees to pay participating agents addi-tional amounts on their retirement or termination depending on the agent’s past business performance. Payments under the Plan are based on the agent’s regular commissions for certain prior periods, which in turn reflect the amount of premiums that the agent generated.

Taxpayer’s contractual liability to pay these additional amounts is depen-dent upon there being a “qualified cancellation” of the agreement. Taxpayer filed Form 3115, requesting an automatic change in accounting method to treat the net increase in the liability shown on its annual statement with respect to the Plan as premium acquisition expenses incurred for the tax year under the safe harbor method provided by Rev. Proc. 2002-46.

Issues: (1) Whether Taxpayer may apply the safe harbor method for premium acquisition expenses provided in Rev. Proc. 2002-46 to deduct the liability shown on its annual statement with respect to a deferred



compensation plan for independent contractor insurance agents prior to the taxable year for which this compensation is deductible under Section 404(d)? (2) If the conclusion with respect to Issue 1 is adverse to Taxpayer, whether this conclusion is to be applied without retroactive effect pursuant to Section 7805(b)?

Conclusion—Issue 1: The issue is twofold: (1) Rev. Proc. 2002-46 was not intended to override the provisions of Section 404(d) and therefore does not provide for the deduction of unpaid agent’s commissions otherwise not deductible pursuant to Section 404(d), (2) The Taxpayer is not entitled to retroactive relief under Section 7805(b).

Premium Acquisition Expenses: The definition of premium acquisition expenses set forth in Rev. Proc. 2002-46 was intended to restrict the expenses eligible to be accounted for under the safe harbor method to those expense categories for which there was a direct nexus between the expenses incurred by the insurance company and the amounts included by the company in gross premium written with respect to new and renewal insurance policies when determining premiums earned under Section 832(b)(4).

The TAM provides that, arguably, the liabilities relating to Taxpayer’s Plan do not bear a direct nexus to the amounts taken into account by Taxpayer as gross premiums written on new and renewal insurance contracts because the deferred benefits that an agent receives under the Plan may vary depending on the overall level of the agent’s business performance, the agent’s age and years of service, and other factors specified in the Plan. Further, Taxpayer’s method of measuring the liability implicitly treats the deferred compensation as being funded by a combination of Taxpayer’s current income and future investment earnings.

Despite these differences, the IRS acknowledged that the definition of premium acquisition expenses set forth in Rev. Proc. 2002-46 does not specifically provide that such expenses must be based exclusively on the amount of gross premiums written on the underlying insurance policies. For purposes of this TAM, the IRS concluded that Taxpayer’s deferred compensation liabilities met the definition of premium acquisition expenses under Rev. Proc. 2002-46.


08

Deduction Limitations Under Section 404: The IRS determined that nothing in Rev. Proc. 2002-46’s description of the safe harbor method suggests this method would override the deduction limitations of Section 404. Instead, “when Rev. Proc. 2002-46 is placed alongside the provisions of Sections 404(a)(5) and (d), it is evident that the deduction limitations of Section 404 must be satisfied independently of Rev. Proc. 2002-46.” Sections 404(a)(5) and (d) specifically provide that if an employer’s contributions or compen-sation with respect to a nonqualified plan of deferred compensation would otherwise be deductible, such compensation shall not be deductible under the employer’s regular method of accounting, but shall be deductible under Section 404(a)(5) for the taxable year in which amounts are includible in the gross income of the persons participating in the plan.

The TAM concludes that taxpayer cannot use the safe harbor method of accounting for premium acquisition expenses provided in Rev. Proc. 2002-46 to deduct the liability shown on its annual statement with respect to a deferred compensation plan for independent contractor insurance agents.

Taxpayer requested that the technical advice be applied without retroactive effect pursuant to Section 7805(b). Taxpayer also suggested that if the IRS believed that its application of the safe harbor method was inappropriate the IRS should modify Rev. Proc. 2002-46 to carve out the long-term compensation from the definition of premium acquisition expenses to apply on a prospective basis.

Taxpayer represented it relied upon this definition of premium acquisition expenses in changing its method of accounting and that if the IRS determined that the safe harbor method does not override Section 404, it will be to the Taxpayer’s detriment because other non-life companies that filed under the revenue procedure treated unpaid agents commissions as premium acquisition expenses, without regard to Section 404.

The IRS concludes that Taxpayer may have met the standards of Treas. Reg. Section 601.201(l)(5) in interpreting the definition of premium acquisition expenses. However, Taxpayer did not meet those standards for the change in method of accounting because the safe harbor method of



accounting described in Rev. Proc. 2002-46 does not override Sections 404(a)(5) and (d). Accordingly, the IRS denied Taxpayer’s request for relief under Section 7805(b).

Ranks Of Uninsured Americans Grow101

0 10 20 30 40 50 60 70

No insurance

Government

Private68.2%

67.7%

2004

2005

27.3%

27.3%

15.6%

15.9%

Intangible Asset Abandonment LossesThe LMSB Division of the IRS evaluated the Intangible Asset Abandonment Loss Issue as claimed by many Blue Cross Blue Shield entities in calendar year 1987 and subsequent tax periods, and in May 2006, made a settle-ment offer to many Blue Cross Blue Shield organizations.102 Most plans have accepted the offer and have begun revising settlement calculations accordingly in hopes of reaching ultimate resolution with the receipt of the IRS’ signed closing agreement.

LMSB Settlement OfferThe IRS promised to resolve the issue on the following terms:

1. The government agrees that a loss deduction is allowable upon termination of an individual subscriber or provider contract with respect to which the taxpayer claims an adjusted basis derived from Section 1012(c)(3)(A)(ii) of the Tax Reform Act of 1986.

101 Appleby, Julie. “Ranks of Uninsured Americans Grow,” USA Today, August 29, 2006.

102 Internal Revenue Service, LMSB Division, “Intangible Asset Abandonment Losses” Settlement Offer, May 12, 2006.


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2. The Taxpayer will concede that no deduction is allowed for the termination of employment contracts or workforce in place intangibles.

3. If the appraised value of the subscriber intangible asset is not more than 20 percent of the December 31, 1986 net subscriber premiums, the government will allow 80 percent of the appraised value of the subscriber intangible asset. If the appraised value of the subscriber intangible asset is more than 20 percent of the December 31, 1986 net subscriber premiums, the government will adjust the appraised value down to 20 percent of the December 31, 1986 net subscriber premiums, then allow 80 percent of the new value, effectively allowing 16 percent of the December 31, 1986 net subscriber premiums. For purposes of this offer, appraised values shall be the value determined in the most recent appraisal used by the Taxpayer in claiming loss deductions for years through 2004.

4. If the appraised value of the provider intangible asset is not more than 2 percent of the December 31, 1986 net subscriber premiums, the government will allow 50 percent of the appraised value of the provider intangible asset, If the appraised value of the provider intangible asset is more than 2 percent of the December 31, 1986 net subscriber premiums, the government will adjust the appraised value down to 2 percent of the December 31, 1986 net subscriber premiums, then allow 50 percent of the new value, effectively allowing 1 percent of the December 31, 1986 net subscriber premiums. For purposes of this offer, appraised values shall be the value determined in the most recent appraisal used by the Taxpayer in claiming loss deductions for years through 2004.

5. The government will accept the timing of the loss deductions claimed for years through 2004.

6. The remaining adjusted basis of subscriber and provider intangible assets as of January 1, 2005 will be computed on an allowed or allowable basis and included in a Closing Agreement (Form 906). For years after 2004, the Taxpayer must establish the timing of any deduction claimed and the amount of the remaining adjusted basis allocable to each contract for which a deduction is claimed.



7. For each year at issue, Taxpayer must establish that it is an organization entitled to use the adjusted basis provided in Section 1012(¢)(3)(A)(1I) of the Tax Reform Act of 1986.

The Taxpayer must provide the following information in order to enter into this settlement:

a. The December 31, 1986 net subscriber premiums.

b. The appraisal used to claim the loss for the years 1987 through 2004.

c. The amount of the loss deducted or claimed for each year from 1987 through 2004.

d. The status of each of those years (i.e., in LMSB, in Appeals, docketed, closed, claim disallowed, claim partially allowed, claim allowed, etc.).

In addition, if the IRS requests supplemental information or documents necessary to effect a settlement, the Taxpayer must agree to provide those documents within 20 calendar days of the request. The Internal Revenue Service will grant extensions only in exceptional circumstances and subject to its sole discretion.

The agreement is favorable, but fails to address some of the difficulties Plans are encountering in applying the agreement, including:

1. Incorporating the intangibles abandonment deductions into the calculations of Adjusted Surplus pursuant to Section 833(a)(2)

2. Determining the amount of documentation required by IRS agents in supporting the valuation of the intangibles abandonment deductions

3. Applying the premium cap provisions to the intangibles—on an individual asset basis, a line of business basis or in the aggregate.

09Products


Products

IntroductionCorporate-owned life insurance (COLI) continued to be at the forefront of product tax issues in 2006. In Dow Chemical v. U.S., the Court held that Dow’s COLI plans were economic shams and, thus, disallowed interest deductions associated with the plans. The trial judge reviewed both subjective intent and objective evidence of why Dow needed the program for non-tax reasons and why it would make mid-term (future) payments to accomplish its non-tax objective.103 Nonetheless, some feel that in an effort to produce a unified result for all COLI plans, the majority ignored the facts that clearly distinguished Dow’s plans from those that had been previously before the courts.

An area central to COLI is that of “insurable interest.” While not tax specific, without insurable interest, a policy is generally flawed and, as such, the tax benefits inherent in insurance disappear. In a decision earlier this year, the Office of General Counsel in New York opined that insurance interest laws preclude the use of life insurance solely as an investment vehicle by a disinterested third party, and is contrary to the long established public policy against “gaming” through life insurance purchases. This case highlights the need for compliance with proper state insurable laws when structuring a COLI/BOLI program.

The IRS addressed several notable issues in 2006: Form 712, Life Insurance Statement, separate asset account look-through rules, and the tax treatment of an exchange of property for an annuity contract, were a few of the areas that the IRS addressed this year. Finally, as it has done repeatedly, the IRS granted waivers for life insurance contracts that failed to satisfy the requirements of Sections 101(f) and 7702 where the taxpayer has shown reasonable cause.

103 Dow Chemical Co. v. U.S., 435 F.3d 594 (2006).


09

COLIDow Chemical Co., the only taxpayer-favorable case for COLI, was reversed. Meanwhile, Eileen J. O’Connor, assistant attorney general for the Justice Department Tax Division, said that the results were a “meaningful victory” for the Justice Department.104

Dow Chemical Company v. United StatesIn a split decision the Sixth Circuit Court of Appeals reversed the District Court‘s decision in Dow Chemical v. U.S. and held that Dow’s COLI plans were economic shams and its interest deductions associated with the plans were properly disallowed.

In 1988 and 1991, The Dow Chemical Company (Dow) purchased corpo-rate-owned life insurance (COLI) policies on the lives of thousands of its employees. In the taxable years 1989 to 1991, Dow claimed deductions for interest incurred on loans used to pay the COLI premiums and for fees related to the administration of the policies. The IRS disallowed these deductions and assessed tax deficiencies and interest, which Dow paid under protest and attempted to recover by suing for a refund. Following a bench trial, the District Court ruled that the IRS had improperly disallowed the deductions and ordered judgment in Dow’s favor. The government appealed. On appeal, the Court ruled in three areas:

Pre-deduction Cash Flows: The District Court had determined that, unlike the COLI plans in AEP, CM Holdings, and Winn-Dixie, Dow’s plans were not projected to be cash-flow negative for their entire durations. Specifically, Dow intended to infuse large sums of cash into the plans during their middle years, which would provide tax deferred or tax-free “inside buildup” that Dow could use to fund part of its post-retirement medical benefits obliga-tions and would make the plans cash-flow positive in their later years. Because the plans were projected to have both cash-flow-negative and cash-flow-positive years, the District Court applied a net present value (NPV) analysis to determine the overall cash flow and used the discount rate utilized by Dow’s experts to find that the NPV of each plan was positive.

104 O’Connor, Eileen J., “O’Connor Calls Court’s Dow Chemical Decision ‘Meaningful Victory’,” Tax Notes Today, 2006 TNT 17-24, January 23, 2006.


Products

The government objected to the District Court’s finding that Dow intended to inject large amounts of cash into the plans in their middle years, and the Appeals Court agreed. The Appeals Court reasoned that “Dow had heretofore made no similar cash infusions, [and] such additional spending would be a drastic departure from the taxpayer’s past conduct. Moreover, there was no contractual provision requiring Dow to make substantial cash infusions in the future.” The Appeals Court continued, “When the future infusion of cash is properly removed from the analysis, only negative cash flows remain. Therefore, without the benefit of the interest deductions, the COLI plans were cash-flow negative for all relevant periods, which is a ‘hallmark of an economic sham.’”

Inside Build-up: The District Court found that “on the last day of each of policy years four through seven, the cash value of Dow’s Great West and MetLife policies was fully encumbered, yielding virtually zero net equity.” The District Court also noted that an actuarial consultant who advised Dow on the COLI plans “stated that for some of the years the purpose was to have low net equity.” Based on its finding that in the future Dow would infuse the plans with large sums of cash, the District Court held that the company “stood to realize substantial economic gain from tax-free inside build-up” with respect to both plans. The Appeals Court took issue with this reasoning for the same reasons discussed in the context of cash flows (i.e., that large cash investments might be, but did not have to be, made in the future). Instead, the Appeals Court determined that “given the District Court’s factual findings with respect to Dow’s actual conduct of maintaining little or no net equity, a simple application of AEP, CM Holdings, and Winn-Dixie yields the result that Dow would have been unable to realize the benefit of inside build-up, [further suggesting] that the COLI plans were an economic sham.”

Mortality Gains: “The District Court found that the plans contained features designed to neutralize the taxpayer’s ability to realize mortality gains. The District Court nevertheless found that the COLI plans were not mortality neutral because neither one ’contain[ed] a 100% retrospective adjustment mechanism,’ a requirement that the court divined from the three prior COLI-plan decisions.”


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The Appeals Court reviewed the same cases and determined that “two of the three previously challenged plans clearly did not eliminate 100% of all mortality gains and losses.” The Court continued, “When this erroneously high bar is removed, it is clear that the COLI plans were designed to reduce (even if not by 100%) Dow’s ability to realize mortality gains … This conclusion provides further evidence that the COLI plans were an economic sham.”

Dissent: The dissenting judge’s opinion strongly disagreed with the Court of Appeals majority’s holding that, “as a matter of law, future profits contingent on taxpayer action are an appropriate component of the economic substance calculus only when that action comports with the taxpayer’s actual past conduct related to the transaction in question.” He argued that there is no such precedential rule of law and no warrant for creating one in this case.

Pension Protection Act of 2006The Pension Protection Act of 2006 (the PPA) enacted new laws that impact COLI rules. Please refer to the Legislative Chapter of this monograph for more information.

Insurable Interest for Investment-Owned Life Insurance105

The Office of General Counsel issued an opinion on December 19, 2005 representing the position of the New York State Insurance Department on certain investment-owned life insurance products. The inquirers sought the Department’s views regarding certain transactions structured as follows:

Third-party banks (Loan Providers) propose to loan money to high net worth individuals (Clients) to purchase insurance policies from life insurance companies and pay premiums due under an option agreement to sell the Policy to a third party on a predetermined date at least two years from the

105 State of New York, Office of General Counsel (December 19, 2005).


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date of the loan. The full recourse loans provided to the Clients by the Loan Providers would be secured by the Policies and by the rights of the Clients under a Put Option. In the event that the Client dies before the maturity (or repayment) of the Loan, the Loan would be repaid out of the Policy’s death benefit, with the remainder paid to the beneficiary of the Policy or the Client’s estate. Under the Put Option, a hedge fund would commit to purchase the Policy from the Client at a predetermined point in time (Exercise Date) for a predetermined price, which would cover the Loan repayment as well as Loan interest. Under the program no Loan payments would be due prior to the Exercise Date. If the Client failed to exercise the Put Option, the Client would be responsible for future payments under the Policy and repayment of the Loan and interest.

In its reply, the Office of General Counsel stated that it appeared that the arrangement was intended to facilitate the procurement of policies solely for resale and that the plan did not conform to the requirements of New York Insurance Law. First, the policies obtained by the Clients are arguably not obtained “on [their] own initiative” as required by N.Y. Ins. Law Section 3205(b)(1). Secondly, the potential transferees do not appear to have a legitimate “insurable interest” in the lives of the Clients.

The Office of General Counsel stated, “While it is true that N.Y. Ins. Law Section 3205(b)(1) expressly allows an individual to procure and immedi-ately transfer or assign to another a policy on his own life, irrespective of the existence of an insurable interest in the assignee, it is the department’s view that the transaction presented involves the procurement of insurance solely as a speculative investment for the ultimate benefit of a disinterested third party, which is contrary to the long established public policy against “gaming” through life insurance purchases.”


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Separate Asset AccountsThe IRS addressed separate asset accounts and related issues in several rulings in an effort to address ongoing areas of concern.

PLR 200601007The IRS ruled that a taxpayer whose foreign subsidiary issues variable containing segregated accounts backed by publicly available funds con-tracts will not be considered the owner of the underlying investment assets.

Taxpayer is a stock life insurance company with a wholly-owned subsidiary, Subsidiary A. Taxpayer began to issue group variable annuity contracts through its branch office in Country X (Contracts). The assets supporting the Contracts are held in a Separate Account. The income, deductions, assets, and liabilities associated with the Separate Account will be maintained separately from Taxpayer’s other accounts.

The Contracts are issued to pension plan trustees to fund defined contribu-tion pension plans (Plans). The Plans are established under the laws of Country X. The Plans belong to the Contract holders. Under the Plans, amounts are contributed by employee Plan members (Members), and then used to fund the Contracts. Taxpayer plans to establish an “account” for each Member to account for that Member’s Contract amounts.

The Contract amounts are invested in one or more of the investment options available under the Contracts, as directed by the Members. The number of investment options varies by Plan, but there is no limit on the maximum number of investment options that can be made available. The investment options are the equivalent of the sub-accounts or subdivisions of a separate account used in connection with U.S. variable contracts. Each sub-account invests in one or more of three different types of assets: (1) units of Country X investment funds, which are the equivalent of U.S. “private placement” investment funds; (2) units of Country X investment funds which are the equivalent of U.S. mutual funds; and (3) shares of stock of the Country X employer that established the Plan.


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All of the assets that fund the Plans are available for purchase directly by the public without the purchase of a Contract, although some of the assets are available to only large, sophisticated investors. The Contracts do not impose any surrender charges. However, periodic asset-based fees and charges are imposed on each account. The Contracts do not comply with Section 72(s), do not qualify as “variable contracts” for purposes of Section 817(d), are not “pension plan contracts” within the meaning of Section 818(a), and do not comply with the diversification requirements of Section 817(h). The IRS pointed out that in the legislative history of Section 817, enacted as part of the Deficit Reduction Act of 1984 (Pub. L. No. 98-369), Congress expressed its intent to deny life insurance treatment to any variable contract containing segregated accounts backed by publicly available funds. After studying the legislative history and Revenue Rulings from 1980 to present which deal with investor control, the IRS determined that Taxpayer would not be considered the owner of the Underlying Investment Assets.

PLR 200601006Taxpayer, a life insurance company, issues deferred and immediate variable annuity contracts (Contracts). The Contracts currently offer variable investment options and a fixed investment option. Only Taxpayer can add or remove investment options under the Contracts.

The net premium, allocated by the owner of a Contract to a fixed investment option, is held in Taxpayer’s general account. The portion of a net premium allocated to the variable investment options under a Contract is held in a separate account. The assets of the Separate Account are allocated among sub-accounts (Existing Sub-Accounts) that correspond to the variable investment options under the Contracts. The owners of the Contracts do not possess investment control and sufficient other incidents of ownership over the assets in the Existing Sub-Accounts to be considered the owner of those assets. Each Existing Sub-Account invests all of its assets in a regulated investment company (Existing Fund).


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Taxpayer will establish New Sub-Accounts of the Separate Account. Each New Sub-Account will invest all of its assets in a regulated investment company (New Fund). All segregated asset accounts are adequately diversified under Section 817(h) and, except as otherwise permitted, all the beneficial interests in each of the Existing Funds and New Funds are held by one or more insurance companies and public access to each of the Insurance Funds is available exclusively through the purchase of a variable contract. Initially, each New Fund will invest solely in funds from a certain subset of the Existing Funds (Second-Tier Insurance Funds). However, each New Fund can choose to invest a portion of its assets from Public Funds, which are managed by an affiliate of Taxpayer. Percentages of the Public Funds contained in each account will be carefully monitored so as not to exceed certain limits. Other than a Contract owner’s ability to allocate premiums and transfer dollars among the various New Funds, all investment decisions regarding the New Funds will be made by the Investment Manager in its sole and absolute discretion.

The IRS ruled that, based on all the facts and circumstances, a Contract owner does not have direct or indirect control over the Separate Account or any sub-account asset. Therefore, the owner of a Contract will not be treated as the owner of the investments underlying the Contract by reason of the addition of the New Funds. As long as the Contracts continue to satisfy the diversification requirements and Taxpayer’s and Contract owner’s future conduct is consistent with the facts of the ruling request, the Contract owner will not be required to include the earnings on the assets held in the New Sub-Accounts in income under Section 61.

PLR 200613028106

The IRS ruled that beneficial interests held by a variable-annuity pension plan will not prevent the regulated investment companies from meeting the requirements of Treas. Reg. Section 1.817-5(f)(2)(i), as long as the contracts meet certain terms and conditions.

Taxpayer is a life insurance company and a wholly-owned subsidiary of Parent. Company, an affiliate of Taxpayer, is the investment manager of certain trusts (Trusts) comprised of Funds. Each Fund is treated as a separate corporation for federal income tax purposes and is a regulated

106 PLR 200613028 (March 31, 2006).


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investment company (RIC) under Section 851. The Funds serve as investment media for variable contracts under Section 817(d). The variable contracts supported by the Funds include contracts issued by Taxpayer, its subsidiary, and unaffiliated life insurance companies. The contracts include nonqualified variable annuity contracts, nonqualified variable life insurance contracts, and variable annuity contracts that are pension plan contracts under Section 818(a).

All beneficial interests in each of the Funds are held by segregated asset accounts of insurance companies, and public access to each of the Funds is available only through the purchase of a variable contract. Shares of the Funds might be held by other RICs that qualify for look-through treatment as part of “fund-of-funds” structures. In certain cases, the other RICs involved in such tiered fund structures include those that are not affiliated with the Funds. Taxpayer intends to allow trustees of qualified pension or retirement plans that intend to be an arrangement within the meaning of Treas. Reg. Section 1.817-5(f)(3)(iii) (Plans) to acquire shares in the Funds. These other RICs might allow beneficial interest in themselves to be acquired by Plans.

The IRS ruled that satisfaction of the requirements of Treas. Reg. Section 1.817-5(f)(2)(i) by each Fund will not be prevented by reason of beneficial interests in the Fund that are held by a Plan that is intended to be an arrangement within the meaning of Treas. Reg. Section 1.817-5(f)(3)(iii), provided that each Fund satisfies certain terms and conditions including:

n The Plan’s application includes a written representation that the Plan qualifies under Rev. Rul. 94-62, and that it is not aware of anything that would result in the Plan’s failure to satisfy the qualification.

n Each Fund will solicit representatives of the Plans that held beneficial interests in the Fund on the preceding December 31st to reaffirm their qualified status. Nonresponding Plans may be involuntarily redeemed.

n Each Fund will maintain records identifying each investing Plan or RIC.

n Each Fund will not sell a beneficial interest to another RIC which intends to qualify for look-through treatment unless each Fund obtains a repre-sentation from the other RIC that either it will not sell any interest in the RIC to a Plan or that it has obtained a favorable letter ruling from the IRS.


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n Taxpayer and the Funds will establish procedures designed to assure that all Plan and RIC applications and agreements are complete, properly executed, and retained.

“From Risk to Opportunity: How Insurers Can Proactively and Profitably Manage Climate Change”107

A report by Ceres Investor Coalition issued on August 22, 2006 highlights the insurance industry’s unique, powerful role, and identifies 190 innovative products and services available or in the pipeline from dozens of insurance providers in 16 countries. Many provide win-win benefits, by reducing financial losses and greenhouse gas emissions. More than half of the activities come from U.S. companies, covering climate change solutions including energy efficiency, green building design, carbon emissions trading and sustainable driving practices.

Dozens of new insurance activities, such as ‘green’ building credits and incentives for investing in renewable energy, are emerging to tackle the causes of climate change and rising weather-related losses in the U.S. and globally. But the report also states that more insurance companies need to be offering similar services to minimize losses and make the most of business opportunities related to climate change.

Life Insurance and Annuity Contracts During 2006 we saw the issuance of proposed regulations addressing the tax treatment in the case of an exchange of property for an annuity contract. Moreover, the IRS continued its track of providing waivers for insurance contracts that failed to satisfy the requirements of Sections 101(f) and 7702 due to reasonable error.

107 Fleming, Peyton. “Dozens of New Insurance Products Emerging to Tackle Climate Change and Rising Weather Losses,” Ceres, August 22, 2006.


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Exchange of Property for Annuity108

The IRS issued proposed regulations under Sections 72 and 1001 that would address the tax treatment of an exchange of property for an annuity contract (IR-2006-161), and declare obsolete Rev. Rul. 69-74. The rule would apply to exchanges for either private annuities or commercial annuities, but would not affect charitable gift annuities.

Under the proposed amendments, if an annuity contract is received in exchange for property (other than money) (i) the amount realized attribut-able to the annuity contract is the fair market value (as determined under Section 7520) of the annuity contract at the time of the exchange; (ii) the entire amount of the gain or loss, if any, is recognized at the time of the exchange, regardless of the taxpayer’s method of accounting; and (iii) for purposes of determining the initial investment in the annuity contract under Section 72(c)(1), the aggregate amount of premiums or other consideration paid for the annuity contract equals the amount realized attributable to the annuity contract (the fair market value of the annuity contract).

In order to apply the proposed regulations to an exchange of property for an annuity contract, taxpayers will need to determine the fair market value of the annuity contract under Section 7520. For exchanges of property for an annuity contract that is part sale and part gift, the proposed regulations would apply the same rules that apply to any other such exchange under Section 1001. The proposed regulations provide that for purposes of determining the investment in the annuity contract under Section 72(c)(1), the aggregate amount of premiums or other consideration paid for the annuity contract is the portion of the amount realized on the exchange that is attributable to the annuity contract (which is the fair market value of the annuity contract at the time of the exchange).

The proposed regulations provide a single set of rules that leave the transferor and transferee in the same position before tax as if the transferor had sold the property for cash and used the proceeds to purchase an annuity contract. The same rules would apply whether the exchange produces a gain or loss, and whether the property is exchanged for a newly issued annuity contract or for one already in existence.

108 71 F.R. 61441-61445


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The IRS states that it is “aware that property is sometimes exchanged for an annuity contract, including a private annuity contract, for valid, non-tax reasons related to estate planning and succession planning for closely held businesses.” The proposed regulations, the IRS states, “are not intended to frustrate these transactions, but will ensure that income from the transac-tions is accounted for in the appropriate periods.”

PLR 200646002The IRS granted the parent of two stock life insurance companies a waiver under Sections 101(f)(3)(H) and 7702(f)(8) for life insurance contracts that failed to satisfy the requirements of Sections 101(f) and 7702 due to reasonable error.

Companies A and B (Companies) are life insurance companies within the meaning of Section 816(a). Company A is a stock life insurance company organized under the laws of State A and licensed to conduct insurance business in X. Company A is a subsidiary of Parent. Company B is a stock life insurance company organized under the laws of State B. Company B is licensed to engage in the life insurance business in Y. Company B is a wholly-owned subsidiary of Company A. Companies A and B join in the filing of a consolidated federal income tax return with Parent and other eligible affiliates.

The Companies or their predecessors issued Failed Contracts on two different policy forms. The Failed Contracts issued before January 1, 1985 were intended to comply with Section 101(f) by satisfying both the “guide-line premium limitation” of Sections 101(f)(1)(A)(i) and (f)(2) and the “appli-cable percentage” requirements of Sections 101(f)(1)(A)(ii) and (f)(3)(C). The Failed Contracts issued on or after that date were intended to comply with Section 7702 by satisfying both the “guideline premium requirements” of Sections 7702(a)(2)(A) and (c) and by falling within the “cash value corridor” of Sections 7702(a)(2)(B) and (d).

After Parent acquired Companies, the latter undertook a comprehensive review of its compliance systems. As a result, several Contracts were identified as having failed to comply with the guideline premium require-ments of Section 101(f) or 7702. Companies identified five errors that caused the Contracts to fail to comply with Sections 101(f) or 7702. These


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errors occurred because Companies’ employees did not properly follow compliance systems and procedures. Companies propose to remedy the noncompliance of each Failed Contract that is in force on the effective date of this waiver, and under which the sum of the premiums paid as of that date exceeds the guideline premium limitation as of that date.

In general, for flexible premium life insurance contracts entered into before January 1, 1985, Section 101(f) requires the contract to satisfy either of two tests in order for the death benefit to be excludable as the proceeds of a life insurance contract under Section 101(a): a guideline premium limitation set forth in Section 101(f)(1)(A), or a cash value test set forth in Section 101(f)(1)(B). These requirements differ slightly from those applicable to contracts issued after that date, but not materially.

For contracts issued after December 31, 1984, Section 7702 provides a definition of the term “life insurance contract” for all purposes of the Code. Pursuant to Section 7702(a), a contract must also either (1) meet the cash value accumulation test of Section 7702(b), or (2) satisfy the guideline premium requirements of Section 7702(c) and fall within the cash value corridor test of Section 7702(d). Section 7702(b) provides that a contract meets the cash value accumulation test if, by the terms of the contract, the cash surrender value of the contract may not at any time exceed the net single premium which would have to be paid at such time to fund future benefits under the contract. Section 7702(c)(1) provides that a contract meets the guideline premium requirements if the sum of the premiums paid under such contract does not at any time exceed the guideline premium limitation as of such time. Section 7702(c)(2) provides that the term “guideline premium limitation” means, as of any date, the greater of (a) the guideline single premium, or (b) the sum of the guideline level premiums to such date.

The guideline single premium is the single premium at issue that is needed to fund the future benefits under the contract using the mortality and other charges specified in Section 7702(c)(3)(B). Section 7702(c)(3)(B) specifically provides the guideline single premium is based on (i) reasonable mortality charges which meet the requirements (if any) prescribed in regulations and which (except as provided in the regulations) do not exceed the mortality


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charges specified in the commissioners’ standard tables (as defined in Section 807(d)(5)) as of the time the contract is issued; (ii) any reasonable charges (other than mortality charges) which (on the basis of the company’s experience, if any, with respect to similar contracts) are reasonably expected to actually be paid; and (iii) interest at the greater of an annual effective rate of 6 percent or the rate or rates guaranteed on issuance of the contract.

Pursuant to Sections 101(f)(3)(H) and 7702(f)(8), the Secretary of Treasury may waive a failure to satisfy the requirements of Section 101(f) or Section 7702, as applicable. These waivers are granted if a taxpayer establishes that the statutory requirements were not satisfied due to reasonable error and that reasonable steps are being taken to remedy the error.

The IRS concluded that the failure of the Contract to satisfy the requirements of Section 101(f) or 7702, as applicable, was due to reasonable error. Companies’ compliance systems and procedures, if properly followed, would have prevented the errors. Upon discovery of possible errors, Companies timely reviewed their procedures, discovered failures, and requested a waiver of their errors. Finally, Companies’ proposed method of correcting the errors is reasonable.

Death and Disgrace Insurance109

Limiting the fallout when a celebrity’s image gets damaged seems to be an area of growing interest. Many stars insure their images especially because some earn significant amounts from endorsements and sponsors dislike seeing their brands dragged down. However, collecting from these policies can be tricky. Although death is more easy to prove, disgrace is more subjective.

109 “Death and Disgrace Insurance,” The Economist, July 13, 2006.

10Other


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IntroductionFor the first time, for tax years ending on or after December 31, 2005, IRS mandated that certain corporations with assets over $50 million file their corporate tax returns electronically. As of September 15, 2006, over 12,000 large corporations electronically filed their returns. Next year, for tax years ending on or after December 31, 2006, certain corporations with over $10 million in assets will be required to file their returns electronically. According to the IRS Commissioner, electronic filing by large corporations will cut many months off the audit process and will allow the IRS to develop analytical tools to better select areas of audit inquiry. Consequently, those corporations should benefit by having uncertainties on their tax returns resolved sooner, and the government will benefit by more promptly identifying and responding to areas of noncompliance.110

A government accountability office (GAO) report issued in November states that the majority of the IRS filing services improved in 2006. The IRS spent about 38 percent of its $10.8 billion budget on processing returns and providing taxpayer assistance. In its report the GAO suggests that Congress mandate electronic filing for paid preparers. Using the IRS estimates, if 90 percent of returns submitted by paid preparers that are filed on paper were filed electronically, the IRS would save about $68 million per year. The number of returns filed electronically increased by 6.3 percent over the last year, which was less than the 9 percent increase forecasted by the IRS and less than last year’s 11 percent increase, the 12 percent increase in 2004, and the nearly 17 percent increase in 2003. IRS officials noted that since many taxpayers have already converted to electronic filing, it is unlikely that many additional taxpayers will convert.111

The report also recommends that the IRS develop, validate, and implement a plan to consolidate call sites and report to Congress refund timeliness for its modernized processing system compared to its legacy system. In comments, the Commissioner said he agreed with the recommendations and outlined actions the IRS plans to take.112

110 GAO Report, supra at 1.

111 Id.

112 Id.


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In a report by Tax Executive Institute (TEI), 77 percent of companies that responded said they feel the Internal Revenue Service was the only beneficiary of mandated e-filing for large corporations. According to the survey, 88 percent of companies had additional costs in e-filing their tax returns, measured in terms of both money and staffing. This includes 40 percent of respondents who categorized the increase as “substantial” and 48 percent who described it as “modest.”113

On a separate matter, the Tax Court in Byer v. C.I.R., stressed the importance of differentiating between an employee and an independent contractor.114 The Court found the taxpayer liable for self-employment tax because he was deemed an independent contractor, and not an employee. Additionally, the IRS published a tentative determination under Section 809 of the recomputed differential earnings rate for 2004, and issued a number of notices with regard to requirements for insurance company tax exemption under Section 501(c)(15).

Mandate for E-Filing115

On January, 2005, Treasury published temporary regulations requiring certain large corporations to file Forms 1120 and 1120S electronically for taxable years ending on or after December 31, 2005. In order to meet the new electronic filing requirements, taxpayers planned very carefully for conversion to filing electronically. Taxpayers were encouraged to conduct a “GAP Analysis” of how their return was filed in the previous year and what steps would be necessary to enable them to file electronically for calendar 2005.

For taxpayers required to e-file, failure to file an income tax return electroni-cally may be deemed to be a failure to file, subjecting the taxpayer to penalties imposed under Section 6651. A return filed electronically is deemed to be filed on the date of the electronic postmark. The IRS provided special

113 Freda, Diane. “Corporate E-Filing a Success But Carries Costs,” BNA Daily Tax Report, ISSN 1522-8800, (November 29, 2006).

114 Byer v. C.I.R., T.C. Summ. Op. 2006-125 (2006).

115 www.irs.gov. “Tax Year 2005 Directions for Corporations Required to e-file.”


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guidance for situations where a taxpayer attempts to file the return and is rejected. In general, the taxpayer had up to 20 calendar days after the due date of the return to perfect the return for electronic resubmission.

For corporations mandated to e-file with tax years ending after December 31, 2005, and that filed a consolidated Form 1120 which included Life Insurance and/or Property and Casualty Insurance subsidiaries, the return was required to be filed electronically with the exception of the Forms 1120-L and 1120-PC subsidiary returns, which had to be attached as PDF files. The following examples were provided in the regulations:

Example 1116

Form 1120 consolidated return has multiple subsidiaries (Form 1120-L(s), Form 1120 and/or Form 1120- PCs), a Life/non-Life subconsolidation is required and in most cases only lines 30-36 were completed on the top level Form 1120 due to the limitations made to the line items at the subconsolidation levels.

n Required—The top level Form 1120, at a minimum, must have Lines 3–36 completed. All remaining lines on Pages 1, Schedule A, C, L, M-1 and M-2 may be blank. Note: If a corporation is able to insert correct information on all lines of Form 1120 it is preferable.

n Entity information on the top level Form 1120 must be completed through Item D.

n MeF business rules (F 1120–010, 219, 221, 234, and 063) have been modified to allow “mandated” electronic returns to be “accepted” during MeF processing when prepared as directed in above.

n The Form 1120-L and/or PC and their associated attached forms and supporting data will be in PDF. The rest of the return must be in XML including all of the non-1120-L/1120-PC subsidiaries.

116 http://www.irs.gov/businesses/corporations. Click on “e-file for Large and Mid-Size Corporations” then click on “Tax Year 2005 Directions for Corporations Required to e-file.”


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Example 2117

Form 1120 consolidated return has multiple subsidiaries but did not require a Life/non-Life subconsolidation and the top level Form 1120 was completed in its entirely (this was usually the case when there were only Form 1120-PC and/or Form 1120 Subsidiaries).

n The Form 1120-PC and the 1120-PC attached forms and supporting data will be in PDF.

n The rest of the return and all other subsidiary returns must be in XML.

Example 3118

Form 1120-PC and/or Form 1120-L are filed as “stand alone” returns and not as part of a consolidated 1120 return.

n These returns must be filed on paper.

The temporary regulations also provided that the IRS could waive the requirement to file electronically in cases involving “undue hardship.” The IRS indicated that such hardship waivers would be granted only in “exceptional cases.”

Several insurance companies which were required to e-file in 2006 by virtue of having an 1120 C Corp. parent requested and received a waiver. It is unlikely that such waivers will be available for 2006 tax returns.

Changes for Insurers Required to E-file in 2007119

In December the IRS updated the tax year 2006 directions for corporations required to e-file, including significant changes for companies that file “Mixed Returns.” A Mixed Return for e-file purposes is a consolidated Form



119 See www.irs.gov. “ Tax Year 2006 Directions for Corporations Required to e-file.”


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1120 with one or more Form 1120-L or Form 1120-PC subsidiary returns that must be filed electronically. These new rules eliminate the option to file Form 1120L and/or 1120PC returns in PDF. The new rules for Mixed Returns apply only to taxpayers filing a Form 1120 holding company return.

“Tax Year 2006 Directions for Corporations Required to E-File” contains important additional information for taxpayers. For a copy, please see the IRS website at: http://www.irs.gov/businesses/corporations . Click on “e-file for Large and Mid-Size Corporations” then click on “Tax Year 2006 Directions for Corporations Required to e-file”

Insurers filing Form 1120-PC and/or Form 1120-L either as “stand alone” returns (as opposed to a consolidated 1120) or as the parent of a consoli-dated group, will continue to file on paper.

Some other e-file highlights for 2007 include: Fewer documents will be allowed in PDF; Form 85—All parts will be required to be in XML; Compen-sation of Officers—More Detail will be Required; All International forms will be required to be in XML- there will be no PDF and no paper options.

Regulations on Business Electronic FilingOn May 26, 2006, the Treasury Department released proposed regula-tions,120 which either amended or replaced final regulations issued in December 2003. The May 2006 Regulations simplified, clarified or, in some cases, eliminated these reporting burdens. Then in December 2006, the IRS issued TD 9300, final regulations121 that eliminate regulatory impedi-ments to the electronic filing of certain business income tax returns and other forms. The final regulations were adopted without significant changes to the proposed and temporary regulation.

120 71 F.R. 30640-30642

121 71 F.R. 71040-71045


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In general, these regulations simplify, clarify, or eliminate reporting burdens and eliminate regulatory impediments to the electronic filing of certain statements that taxpayers are required to include on or with their federal income tax returns. The rules amend regulations under Sections 279, 302, 331, 332, 338, 351, 355, 368, 381, 382, 1081, 1221, 1502, 1563, and 6012 that require taxpayers to include a statement on or with their federal income tax returns.

The removal of the requirement to file the annual regulatory statement for insurance companies with the federal income tax return should facilitate the e-filing process.

Agent IssuesThe Tax Court tackled questions of: (1) whether, for the year at issue, Petitioner was a statutory employee as a full-time life insurance salesman under Section 3121(d)(3)(B) and Section 3121(d)-1(d)(3)(ii), Employment Tax Regs.; (2) whether Petitioner is entitled to deductions for disallowed trade or business expenses incurred in connection with petitioner’s insurance activity; and (3) whether petitioner is liable for the Section 6662(a) accuracy-related penalty for the year at issue. Consistent with previous rulings, the Court concluded that the taxpayer was liable for self-employment tax.

Byer v. C.I.R.122

The Tax Court ruled Petitioner, a tax attorney and former IRS auditor, was liable for self-employment tax because he was not a statutory employee of an insurance company, but rather an independent contractor subject to self-employment tax.

122 Byer v. C.I.R., T.C. Summ. Op. 2006-125 (2006).


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The Petitioner, for the period January 1999 to April 15, 2005, was engaged in an income-producing activity with Corben Financial Services. Corben was in the trade or business of selling insurance, primarily life insurance. For the year 2000, Petitioner reported gross receipts on Schedule C, Profit or Loss From Business, and deducted related expenses for a net income f approximately $18,000. Petitioner did not include Schedule SE, Self-Employment Tax, for self-employment tax that would ordinarily be due on the $18,000 of net profit. Petitioner claimed he was not required to pay, nor did he owe, self-employment taxes as he was an employee of Corben.

Respondent claimed Petitioner owed a deficiency of approximately $12,000 and an accuracy related penalty under Section 6662(a) in the amount of $2,300. The deficiency was because the Petitioner had not filed Schedule SE as the Petitioner was required to do as an independent contractor of Corben.

Section 3121(d) defines an “employee” as ‘any individual who performs services for remuneration for any person as a full-time life insurance salesman.” Section 3121(d)(3)(B) further defines a “full-time life insurance salesman” as: “an individual whose entire or principal business activity is devoted to the solicitation of life insurance or annuity contracts, or both, primarily for one life insurance company is a full-time life insurance salesman.”

The Tax Court held that the Petitioner’s work with Corben was not devoted to one insurance company and, moreover, Petitioner was required to perform other duties for Corben beyond selling insurance. Additionally, Corben did not view the Petitioner as an employee and therefore deduct any related social security tax or employment taxes from Petitioner’s earnings. Therefore, Petitioner was liable for the self-employment tax deficiency and the related accuracy penalty.


Other

MutualsThe Job Creation and Worker Assistance Act of 2002 amended Section 809 and provided that the differential earnings rate (DER), would be treated as zero for purposes of computing both the differential earnings amount and the recomputed differential earnings amount for a mutual life insurance company’s taxable years beginning in 2001, 2002, or 2003. Subsequently, the Pension Funding Equity Act of 2004 repealed Section 809 for taxable years beginning after December 31, 2004. As a result, this is the last differential earnings adjustment companies will be required to make. So ends the battle of the stocks and the mutuals.

Rev. Rul. 2006-45123

The final determination of the 2004 rates is set forth below. The final differential earnings rate was determined to be zero:

Recomputed differential earnings rate for 2000 0

Imputed earnings rate for 2004 4.449

Base period stock earnings rate 8.221

Current stock earnings rate for 2004 4.913

Stock earnings rate for 2001 2.354

Stock earnings rate for 2002 -1.876

Stock earnings rate for 2003 14.261

Average mutual earnings rate for 2004 10.450

123 Rev. Rul. 2006-45 (September 11, 2006).


10

Section 501(c)(15)The Pension Funding Equity Act of 2004, (the Act) made several changes to Section 501(c)(15). Specifically, the Act amended Section 501(c)(15) to provide that a property and casualty insurance company is eligible to be exempt from federal income tax if (a) its gross receipts for the taxable year do not exceed $600,000, and (b) more than 50 percent of its gross receipts for the taxable year consist of premiums. The Act also clarified that, for purposes of Section 501(c)(15), the term “insurance company” has the same meaning as in Section 816(a) of the Code, which provides that a company is an insurance company if more than half of its business during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.

Tax exemptions under Section 501(c)(15) continued to receive special attention in 2006, as the IRS evaluated whether or not companies claiming insurance company status had the requisite risk shifting and risk distribution for insurance company status, which is a requirement to obtaining exempt status.

Notice 2006-42In May 2006, the IRS clarified the definition of “gross receipts” as it pertains to the requirements for insurance companies to be tax exempt. The Notice provides that amounts received from the following sources during the taxable year will be included in “gross receipts” for the applicable Code Section.

n Premiums (including deposits and assessments), without reduction for return premiums or premiums paid for reinsurance;

n Items described in Section 834(b) (gross investment income of a non-life insurance company); and

n Other items that are properly included in the taxpayer’s gross income under subchapter B of chapter 1, subtitle A, of the Code.


Other

Thus, gross receipts include both tax-free interest and the gain (but not the entire amount realized) from the sale or exchange of capital assets, because those items are described in Section 834(b). Gross receipts do not, however, include amounts other than premium income or gross investment income unless those amounts are otherwise included in gross income. Accordingly, the term gross receipts does not include contributions to capital excluded from gross income under Section 118, or salvage or reinsurance recovered accounted for as offsets to losses incurred under Section 832(b)(5)(A)(i).

Companies assessing whether or not they are eligible for tax-exempt status under the Code should determine whether or not they meet the gross receipts test as provided under the Notice. The definition of gross receipts differs from the prior definition of Net Written Premiums in that no reduction is provided for reinsurance ceded.

PLR 200644047In keeping with its promise to take a hard look at exemptions under Section 501(c)(15), the IRS ruled that an organization did not qualify for tax-exempt status under Section 501(c)(15) because its insurance arrangement had no risk distribution and therefore did not qualify as an insurance arrangement for federal income tax purposes.

Taxpayer’s sole shareholder is X, a corporation that contracts with physi-cians and other medical service providers, as independent contractors. Taxpayer has no employees and issued one purported insurance contract each in 2002 and 2003. Each contract identifies X as the “Name Insured” and several other parties as “Insureds.” The contracts’ insureds include approximately 30 physicians with respect to amounts they may have to pay as damages for bodily injury arising out of medical services provided. For each relevant policy year, the premium was paid by X on behalf of all the insureds. Taxpayer applied for exemption under Section 501(c)(15).


10

For years at issue, an organization will be eligible for the benefit of Section 501(c)(15) if it qualifies as an insurance company. For federal income tax purposes an insurance company is a company whose primary and predominant business activity during the year was the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. In addition, a non-life insurance company is exempt under Section 501(c)(15) if the written premiums for the taxable year do not exceed $350,000. Treas. Regs. Section 1.801-3(a) provides that “it is the character of the business actually done in the taxable year which deter-mines whether a company is taxable as an insurance company under the Internal Revenue Code.” This language resulted from a series of cases, including Bowers v. Lawyers Mortgage Co., 285 U.S. 182, 188 (1932) in which the Court established the test that later became incorporated as Treas. Regs. Section 1.801-3(a), as follows: “While name, charter powers and subjection to state insurance laws have significance as to the business which a corporation is authorized and intends to carry on, the character of the business actually done in the tax years determines whether it is taxable as an insurance company.”

Each contract named X as the “Named Insured” and additional parties as “Insureds.” Rev. Rul. 2002-89, 2002-2 C.B. 984, explains that a parent/wholly-owned subsidiary arrangement does not constitute insurance if the parent accounts for 90 percent of the risk, but does qualify if other insureds constitute more than 50 percent of the risk. Additionally, Rev. Rul. 2005-40, 2005-27 I.R.B. 4 explains that a parent/subsidiary arrangement does not qualify as insurance if the issuer of an “insurance” contract enters the contract with one policyholder or if one insured accounts for 90 percent of the risks.

Citing well-established captive insurance case law, for example, Helvering v. LeGierse, 312 U.S. 531, 539 (1941), which ruled that “insurance involves risk shifting and risk distributing,” the IRS concluded that taxpayer does not qualify for exemption under Section 501(c)(15) of the Code. The IRS reasoned that even though there were purportedly multiple insureds under the policy, the only risks insured were those that arose in connection with providing medical services to Named Insureds’ own clients. As such, it appeared likely that a claim against any Insured would necessarily entail a claim against the Named Insured as well.


Other

PLR 200603030Once again, the IRS challenged the exemption of an organization and ruled that it did not qualify for exemption from federal income tax under Section 501(a) as an organization described in Section 501(c)(15).

The ruling states that the IRS made the determination because the insur-ance arrangement involved only one type of insurance contract, and the arrangement did not qualify as an insurance arrangement for federal income tax purposes because there was no risk distribution. Since the arrangement did not qualify as insurance, the company did not qualify as an insurance company for the time period in question. The IRS required the company to file federal income tax returns for the years at issue within 30 days of the letter, unless the taxpayer requested an extension of time to file. The IRS has routinely denied exempt status for companies that did not have the requisite risk shifting and risk distribution.

Extension of Time to FileIR-2006-29The process for businesses filing an automatic extension of time to file was significantly modified in 2006. Business taxpayers that previously filed extension Forms 8800, 8736, 7004, and 2758 must now file only the revised Form 7004, Application for Automatic 6-Month Extension of Time to File Certain Business Income Tax, Information, and Other Returns, to request an automatic six-month extension.

Business taxpayers must file Form 7004 by the due date of the return in order to receive an automatic six-month extension of time to file. The IRS notes that new regulations make this option available to most noncorporate business taxpayers, including partnerships and trusts. Previously, only corporations could request an automatic six-month tax-filing extension.


10

Individuals: A similar change was recently made for individual taxpayers. Individuals who need additional time to file their tax returns may request an automatic six-month extension by filing Form 4868 (see IR-2005-131, published Nov. 4, 2005).

United States v. Monumental Life Ins. Co.124

On March 3, 2006, the Sixth Circuit reversed the district court’s enforcement of an IRS administrative summons on Monumental Life Insurance Company. Acknowledging that the Court would normally remand with instructions to limit enforcement to relevant documents not already in the government’s possession, the Court found that after years of proceedings during which compromise could not be reached, the best course was to deny enforcement of the summons in full and permit the IRS, if it wishes, to redraft a more narrowly tailored summons. The decision in this case underscores the breadth of the IRS summons power, the low relevance threshold required of the IRS, and the determination of the IRS to use its summons power to ascertain more general policy and operational information, which may be used against multiple taxpayers.

Information ReportingThe requirement to file Information Returns is mandated by the Internal Revenue Service and associated regulations.125 In 2006, the IRS released final regulations on the information reporting requirements under Section 6045(f) for payments of gross proceeds to attorneys, adopting with revisions, the proposed regulations published in May 2002.

Final Regulations for Information Reporting126

Section 6045(f) generally requires information reporting for payments of gross proceeds made in the course of a trade or business to attorneys in connection with legal services. The final regulations adopt certain exceptions to the information reporting requirement. Some of the final regulations exceptions include:

124 U.S. v. Monumental Life Ins. Co., 440 F.3d 729 (2006).

125 Internal Revenue Service, “A Guide to Information Returns.”

126 71 F.R. 39548-39553


Other

n Payment that is required to be reported under Section 6041(a), relating to payments made in the course of a trade or business.

n Payment that is required to be reported under Section 6051, relating to receipts for employees.

n Payments made to attorneys in connection with the financing of real estate. The exception now covers payments made to attorneys in connection with refinancing and mortgages, not limited to purchase-money mortgages.

n Payments made to trustees and other fiduciaries such as administrators of estates and settlement funds. If an estate or fund were the payee, information reporting under Section 6045(f) would not be required.

n Payments to attorneys acting in the capacity of bankruptcy trustees.

The final regulations address the question as to whether or not an attorney is the payee of a check where the check is made out to the attorney’s client, but “in care of” the attorney or to the attorney’s client trust account. The final regulations define, generally, an attorney as the payee on a check written to the attorney’s client trust fund, but not on a check which the attorney may not negotiate.

The gross proceeds reporting requirement under Section 6045(f) is intended to be broad and has a different purpose than information reporting under Section 6041 for payments for services.

The final regulations include several examples. The examples include more cross-references to other information reporting rules, and some examples illustrate the correct reporting under sections other than Section 6045(f). The final regulations apply to payments made on or after January 1, 2007.

11Multistate


Multistate

IntroductionIn most states premium taxes imposed on both domestic and foreign companies, continue to be a major source of revenue.127 In 2005, insurers paid more than $14.8 billion in state premium taxes, which represents 2.3 percent of all state tax revenue.128 In addition to state-level taxes, the property-casualty industry alone paid out $11.2 billion in federal income taxes in 2006.129

During the year a number of states issued notable decisions. One area worth special mention is the discernible trend among state and local tax jurisdictions toward varying forms of alternative tax structures.130 New Jersey’s Alternative Minimum Assessment (AMA) is one such tax that has become a lighting rod of criticism.131

Other substantive changes this year included: Arizona’s establishment of a new daily penalty rates for delinquent Arizona surplus lines insurance tax payments; California’s franchise tax liability developments as they relate to insurance company subsidiaries; Florida’s salary tax calculations; New York City’s insurance agent Issues, and Texas retaliatory tax issues. Finally, New Jersey Supreme Court affirmed the Appellate Division’s judgment regarding the method of calculating New Jersey’s retaliatory tax.

127 �“Property-Casualty�Insurance�and�the�U.S.�Economy,” American Insurance Association, Advocate, October 9. 2006.

128 American Insurance Institute. “Property-Casualty Insurance and the U.S. Economy,” October 9, 2006.

129 Id.

130 Ertmer, Brian ; Sash, Robert. “ Unfriendly aspects of the growing trend among states opting for the “un-income” tax regime,” Journal of State Taxation, September 1, 2006.

131 Id.


11

State-by-State DevelopmentsArizona Arizona Department of Insurance released an announcement establishing new daily penalty rates for delinquent Arizona surplus lines insurance tax payments. The new penalty rate is 20 cents per $100 per day of late tax payment for delinquent payments of $12,499.99 or less. The penalty rate is unchanged for delinquent payments of $12,500 or more—$25 per day. Previously, a $25 daily penalty was levied on all delinquent payments, regardless of the amount of tax due.

Healthcare insurers in Arizona can take advantage of a new insurance premium tax credit. To qualify for the credit insurers must be providing coverage for a Department of Revenue certified individual or a small business without insurance. Additionally, the insurance must be obtained within 90 days of being approved as an eligible recipient by the Department of Revenue. The aggregate amount of the credits is limited to $5 million per year and can be carried forward up to five tax years.

California In a Letter Decision released this year, the state of California concluded that insurance company subsidiaries could not be included in a combined report “by proxy” for purposes of determining the parent’s corporation’s California corporation franchise tax liability. The State Board of Equalization has previously ruled that insurance companies cannot be included in a combined report. Insurance companies are subject to California insurance premiums tax in lieu of the California franchise and income tax. The taxpayer, in the Letter Decision, failed to distinguish how their facts differed from the facts in previous rulings. Furthermore, because Insurance gross premiums tax is calculated on an insurance company’s gross premiums, the Letter Decision noted there would be no way in which to determine an insurance company’s net income for inclusion on the combined report.


Multistate

The California State Board of Equalization issued a memorandum opinion in the Matter�of�the�Petitions�for�Redetermination�Under�Tax�on�Insurers�Law�of�California�Automobile�Insurance�Company, holding that gross premiums taxpayers should be determining their tax obligation based on gross premiums received rather than gross premiums written.

Florida Technical Assistance Advisement 06B8-001 provided that salaries paid by a management general agent to its employees should be included in the salary tax calculations of the insurer’s for which the managing agent s licensed provided the managing general agent’s employees are located or based in Florida and are covered by the Florida law’s unemployment compensation provisions. Any eligible salaries should be apportioned to each of the insurers, for purposes of the salary tax credit, using a consistent methodology based on the amount of time the agent’s employees per-formed services for each company. The amount of the managing general agent salaries allocated to a specific insurance company may not exceed the amount paid by that insurer for services received from the agent.

Special Session on Property and Casualty Insurance Reform132

Members of the Florida legislative body announced that they will call a Special Session of the Florida Legislature starting January 16, 2007 to begin an effort to restructure Florida’s property insurance market and provide relief to Florida residents and businesses.

The Senate, House, and Governor-elect will work with Governor Bush and Chief Financial Officer-elect Alex Sink to develop a comprehensive reform plan with the goal of increasing competition, lowering rates, providing incentives for preparedness, and creating greater transparency for consumers. In January 2007, Gov. Charlie Crist signed legislation that promises to provide insurance reform, including rate reductions, and provisions that require insurers to pay claims within 90 days and disallow the dropping of policyholders during hurricane season.

132 Florida Property & Casualty Insurance Reform Committee. “ Governor-elect Crist and Legislative Leaders Announce Special Session on Property and Casualty Insurance Reform,” November 29, 2006.


11

Iowa The Senate revised the method by which to determine the basis of tax on the “gross amount of premiums,” or “gross receipts from premiums, assessments, fees, and promissory obligations,” imposed upon any fire or casualty insurance company. Senate File 2364 provides that gross amount or receipts consist of the gross written premiums, in addition to receipts for direct insurance. This is without including or deducting amounts received for direct insurance, or amounts received or paid for reinsurance. Companies reinsuring windstorm or hail risks written by county mutual insurance associations will be required to pay a tax calculated upon the gross amount of reinsurance premiums received upon such risks. The gross amount will be reduced by other deductions, and in addition deducting any so-called dividend or return of savings or gains to policyholders; provided that as to any deposits or deposit premiums received by any such company, the taxable premiums will be the portion of such deposits or deposit premiums which are earned during the year.

LouisianaThe law was expanded to allow insurance companies to reduce state premiums tax if they make a qualified Louisiana investment in a certificate of deposit issued by a bank, savings and loan association, or savings bank with a main office or one or more branches in Louisiana. The tax reduction may also be obtained if the insurance company deposits funds into a trust company with a main office or one or more branches in the state and the trust company subsequently invests those funds in a certificate of deposit issued by either a bank, savings and loan association, or savings bank with a main office or one or more branches in Louisiana.

Prior to the revised definitional change, a deposit into a savings bank or a trust company did not constitute a qualified investment. Therefore an insurance company was required to deposit funds into a financial institution domiciled in Louisiana in order to qualify for the state insurance premiums tax reduction. That domiciliary limitation has been removed.


Multistate

Changes, Costs in Other States133

Like Florida, other hurricane-prone states on the Gulf of Mexico and the East Coast have begun to experience higher insurance costs and limited availability of homeowners insurance.

n In Louisiana, many insurers have raised deductibles to 5% of property value and have raised rates 10% to 49% in the past year, depending on the company.

n In Mississippi, the state insurance pool increased rates for homes by 90%—after initially requesting a 397% increase.

n In the Carolinas and Massachusetts, major insurance companies are cutting back on coverage and sales to limit their risk.

n In New York, Allstate, the state’s largest insurer, announced it would drop 28,000 policies in New York City and eight counties.

Minnesota The Court of Appeals affirmed a District Court ruling that stop-loss insurance is accident-and-health insurance for purposes of calculating the annual assessment for the Minnesota Comprehensive Health Association (MCHA). In the decision, Blue Cross Blue Shield of Minnesota (BCBSM) claimed that stop-loss insurance was not within the statutory definition of accident-and-health insurance for purposes of calculating the MCHA assessment, and that the stop-loss insurance should be excluded from the calculation. The Court of Appeals ruled, however, that the statute authorizing the MCHA assessment intended to include stop-loss insurance premiums. The stop-loss insurance, which included benefits for the expenses of hospital, surgical, or medical care, is therefore included in the definition of accident-and-health insurance for purposes of calculating the MCHA assessment.

133 Reed, Matt. “Insurance rates pummel Fla. Homeowners; Companies say increases tied to risk,“ USA Today, P4A, October 26, 2006.


11

New Hampshire Governor John Lynch signed into law H.B. 678, cutting the state’s insurance premium tax in half, from 2 percent to 1 percent, by 2011. The gradual reduction in the insurance premium tax rate for insurance companies applies to all insurance companies, except those issuing accidental death and dismemberment policies. In addition, although quarterly tax payments are required through 2006, tax payments are on an annual basis beginning in 2007. The annual tax payments are due March 15. The premium tax reduction is part of a plan calling for the New Hampshire insurance commissioner and the commissioner of the department of resources and economic development to mutually develop and implement a comprehensive plan to retain domestic insurers and recruit foreign insurers to redomesticate in New Hampshire with the goal of retaining and creating jobs and spurring economic activity in the state.

New Jersey The Supreme Court affirmed the Appellate Division’s judgment that the Director of the Division of Taxation’s method of calculating New Jersey’s retaliatory tax by including the tax benefits of the premium tax cap failed to give effect to both N.J. Stat. Ann. Sec. 54:18A-6 and N.J. Stat. Ann. Sec. 17:32-15. The New Jersey retaliatory tax is computed prior to the benefit of the “premium tax cap” provisions, which limits an insurer’s New Jersey premium tax liability to a percentage of total worldwide premiums, the Court held. Accordingly, where a foreign insurance company’s home state imposes a premium tax rate higher than the New Jersey rate, the insurer must compute the difference between the New Jersey premiums tax liability before application of cap and the premiums tax liability that would be imposed on New Jersey taxable premiums by the domicile state, and add the difference to the taxes otherwise due in New Jersey after applica-tion of the premium tax cap provisions. The ruling may provide refund opportunities for taxpayers subject to the New Jersey premium tax, who computed their retaliatory tax liability in accordance with the Division’s guidelines. These developments could also be the beginning of a trend in state insurance premium taxes across the nation.


Multistate

New York On February 24, 2006, the Technical Services Bureau of New York Department of Taxation and Finance issued new guidance for filing for a transfer of CAPCO credits. Under a New York insurance franchise tax amendment enacted in 2005, insurance corporations that are certified investors in certified capital companies (CAPCO) may transfer unused CAPCO tax credits, in whole or in part, to any affiliate within an affiliated group of taxpayers that is subject to the insurance franchise tax. Insurance corporations making the transfer must notify the New York Department of Taxation and Finance and the Insurance Department within 45 days of the transfer date.

The New York City Tax Appeals Tribunal ruled Petitioner, as an agent for an insurance company, was an independent contractor whose income was subject to Unincorporated Business Tax (“UBT”) computed against income from the unincorporated business of the sale of Company life insurance. (TAT(H) 03-21(UB); Matter of Friedman (8 Jun 2006)). Taxpayers with agents either serving through an apprenticeship or as an independent contractor should familiarize themselves with the facts and circumstances on which this case was concluded.

North Carolina Session Law 2006-196, House Bill 1891, amended the application of the additional gross premium tax on fire and lightning coverage, to apply the tax to a percentage of the gross premiums from the respective contracts. The Bill adds language to the additional statewide fire and lightning rate and the additional local fire and lightning rate and provides the tax will be a percentage of the gross premiums from the contracts, The Bill also amended the requirements for installment payments. Taxpayers subject to the fire and lightening coverage tax and also have a premium tax liability of $10,000 or more for business done in North Carolina will remit three equal quarterly installments.


11

OregonThe Tax Court held in Stonebridge�Life�Insurance�Co.�v.�Department134 of Revenue that use of the statutory three-factor apportionment formula to determine an out-of-state insurance company’s Oregon insurance excise tax liability was unconstitutional because use of the property factor distort-ed the company’s taxable income. The court noted that a taxpayer faces a heavy burden to prove that application of a standard three-factor formula is unconstitutional, but agreed with Stonebridge that application of the three-factor formula did, in fact, lead to a grossly distorted result, and the three factors do not fairly reflect its Oregon business activity. Instead, the court found that the high property factor “grossly distorted” the value generated by Stonebridge’s Oregon operations. In so ruling, the court rejected the department’s argument that the inclusion in the formula of a zero percent payroll factor and a low sales factor balances Stonebridge’s relatively high property factor, such that the three factors together achieve a constitution-ally acceptable apportionment. Stonebridge asked the court to adopt an alternate formula to determine its Oregon income. However, the court did not find any statutory authority allowing it to adjust the formula. As a result, based on the conclusion that the taxes paid by Stonebridge were paid under an unconstitutional application of the statutory formula, it awarded Stonebridge a full refund of the insurance excise tax it paid.

Pennsylvania Pennsylvania Commonwealth Court ruled in Northbrook�Life�Insurance�Co.�v.�Pennsylvania135 that Northbrook was entitled to include amounts assessed on nontaxable as well as taxable annuities in its calculation of the Life and Health Insurance Guaranty Association credit against the Pennsylvania gross premiums tax on insurance companies. This case marks the first case decided with regards to the annuity guaranty fund credit issue which has plagued annuities writers for at least 10 years. While this was a victory for taxpayers, the Court’s ruling regarding the “proportionate part” may make the victory hollow for some.

134 Or. Tax Ct., No. TC 4705, February 22. 2006

135 Pennsylvania Commonwealth Court, No. 1120 F.R. 1996, January 26, 2006.


Multistate

The Court also denied exceptions filed by both the Commonwealth and a taxpayer to a decision addressing offsets for annuity assessments. In that case, the Court held that an insurer may offset a proportionate part of annuity assessments imposed by the Pennsylvania Life and Health Insurance Guaranty Association against insurance premium tax. The Commonwealth’s claim that a separate fraction should be used for each type of assessment was rejected. The taxpayer’s argument was also refused because it was based on the assumption that the term “life” referred to both life insurance and annuities.

Tennessee The Court of Appeals affirmed a trial court’s judgment that the credit against franchise and excise taxes did not apply to a taxpayer that was self-insured for purposes of workers’ compensation insurance. The Court of Appeals, however, ruled that the legislative intent was to restrict the credit to “insurance companies,” as defined in the Tennessee Code, and that this definition did not include companies that were self-insured for workers’ compensation. The credit is allowed only for insurance companies defined as, primarily, being in the business of selling insurance. The court held that the taxpayer automobile manufacturer, which was self-insured for workers’ compensation, did not qualify for the credit.

Texas Authorities announced that Pennsylvania insurance fraud prevention assessments are required to be included in calculations for Texas retalia-tory tax. The ruling was based on the conclusion that the fraud prevention assessment was a tax, and not a special purpose assessment that could be excluded from the retaliatory tax calculation.

In a Policy Letter Ruling, the State declared that if an insurer used an excessive or unfairly discriminatory rate to determine premiums for personal automobile or residential property insurance, the excessive portion must be either refunded or credited against future premiums.


11

Additionally, once the Commissioner of Insurance makes such a determination, the insurer is not eligible to claim any premium tax credits until it has refunded or credited the excessive premiums.

A Public Accounts Letter released this year clarified that fees paid in-lieu of commissions and charged by insurance agents/brokers to their clients for the procurement of insurance coverage which is subject to the gross premiums tax under the Texas Insurance code are exempt from Texas sales and use tax. Accordingly, such fees are subject to sales and use tax only if they are not subject to the premiums tax.

Utah The Legislature passed, and the governor signed, Utah Senate Bill 136. The bill decreases the rate of tax on Utah variable life insurance premiums, retrospective to January 1, 2006. The bill decreases the rate to 2.25% of the first $100,000 of Utah variable life insurance premiums paid and received by an admitted insurer in the preceding calendar year, and .08% of such premiums in excess of $100,000. Previously, such premiums were subject to the general 2.25% insurance premiums tax rate.

On March 17, 2006, a new bill was enacted which significantly impacts insurers in Utah. Highlighted provisions of the bill, which was made effective May 1, 2006, makes several modifications with regard to the state’s insurance law. Specifically, the bill: (1) Clarifies the definition of accident and health insurance, bail bond insurance, business insurance, casualty insurance, captive insurance, continuing care insurance, automobile insurance, and credit insurance; (2) Defines “insurance”; (3) Stipulates what insurance includes; (4) makes certain clarifications regarding the annual fee imposed on captive insurance companies to obtain or renew their certificates of authority; (5) Provides that the Utah Life and Health Insurance Guaranty Association is not a state agency.


Multistate

Washington The House and Senate passed, and the Governor signed, H.B. 2880 clarifying that insurance companies are liable for the Washington state and local excise taxes imposed on the sale of services and extended warranties. Prior law provided that the insurance premiums tax was in lieu of any other tax imposed on insurers, except that insurers were not exempt from taxes on real and tangible personal property, or excise taxes on the sale, purchase, or use of such property. The act applies both prospectively and retrospectively.

12Tax Accounting


Tax Accounting

IntroductionIn the normal course of business, companies often seek to reduce their overall tax burden and minimize or delay cash outflows for income taxes. For example, they may enter into tax-advantaged transactions, structure their businesses in a tax-efficient manner, or seek tax-optimized methods of transacting with affiliates and others. Yet even without these tax-motivated activities, the average corporate tax return will include numerous positions—inherent to the normal course of business—that are subject to significant and varied interpretation (e.g., common leasing and financing arrangements). This often results in uncertainty about whether a particular position taken on a tax return will ultimately withstand the scrutiny of the relevant taxing authority.

Further, because income taxes are self-assessed in most jurisdictions and tax returns may not be examined for a number of years, companies must evaluate for financial reporting purposes the likelihood that the benefits of tax positions will be sustained upon review by the taxing authority. Owing to a widely perceived lack of explicit, authoritative accounting guidance in this area, substantial diversity in the accounting for tax uncertainties has developed.

In July 2006, the Financial Accounting Standards Board (the FASB or Board) released an Interpretation that is intended to reduce diversity: Accounting for Uncertainty in Income Taxes (FIN 48 or the Interpretation). Under the Interpretation, companies’ financial statements will reflect expected future tax consequences of uncertain tax positions.136

While the FASB provided guidance to reduce diversity, the new focus of lawmakers and policy writers on better reconciling book income with tax income raises broad and complex questions with no clear answers as yet, and carries enormous implications in the international context.137 In related state developments, the State of Texas enacted substantial changes to its tax system that significantly affected franchise tax in the state.

136 PricewaterhouseCoopers. “Lifting the Fog: Accounting for Uncertainty in Income Taxes,” 2006.

137 Bennett, Alison. “Book-Tax Accounting Conformity Presents Big Questions for Multinational Companies,” BNA Daily Tax Report, ISSN 1522-8800 (December 7, 2006).


12

FIN 48The release of FASB Interpretation Number 48 (FIN 48) was the result of a more than two-year process of study and deliberations on the part of the FASB, inclusive of extensive public comments. Prior to the release of FIN 48, the FASB issued an Exposure Draft which represented the pro-posed rules to clarify the accounting for uncertain income tax positions. Release of the Exposure Draft was followed by a comment period which ended on September 12, 2005, and a roundtable discussion held on October 10, 2005 to further discuss the proposal with tax practitioners and other interested parties. After much deliberation, the process ultimately culminated in the release of FIN 48 in July 2006.138

Requests to Delay Effective Date of FIN 48Two proposals, one dated December 11, 2006 from the Investment Company Institute (ICI), and another dated December 12, 2006 from the Tax Executives Institute (TEI), were sent to the FASB asking that the effective date of FIN 48 be delayed. TEI is the preeminent association of corporate tax executives in the world. In their proposal, they implored the FASB to allow companies and their independent auditors sufficient time to address the substantive, procedural, and documentation challenges posed by the new interpretation. Specifically, they recommend that the effective date of FIN 48 be extended to fiscal years beginning after December 15, 2007.139 In ICI’s request, it expressed distinctively the unique ways in which FIN 48 affects investment companies and why the FASB should delay its effective date.140 However, in January 2007, the FASB decided it would not delay the effective date of Fin 48. Accordingly, companies must adopt the adoption date is January 1, 2007 for calendar year companies

138 Staley, Daniel J. “A move to bring consistency to uncertain income tax positions,” October 20, 2005.

139 Tax Executives Institute. “Proposal to Delay Effective Date of FIN 48,” December 12, 2006.

140 Investment Company Institute. “Effect of FASB’s FIN 48 on Mutual Funds,” December 11, 2006.


Tax Accounting

Application of the Interpretation141

The Interpretation applies to all U.S. GAAP financial statements for public and private enterprises alike and provides a definitive, comprehensive accounting model with prescriptive disclosure requirements related to income tax uncertainties. The adoption of FIN 48 will likely result in the need for significant changes to an enterprise’s accounting policies, financial statement disclosures, data gathering processes, and internal controls—especially for multinational enterprises. FIN 48 will likely also impact existing corporate tax planning and management processes.

The Interpretation is effective for annual periods beginning after December 15, 2006.

We believe that a multidisciplinary approach to implementation is required to “get it right the first time.” The key points in the Interpretation are:

n A tax benefit may be reflected in the financial statements only if it is “more likely than not” that the company will be able to sustain the tax return position, based on its technical merits.

n A tax benefit should be measured as the largest amount of benefit that is cumulatively greater than 50 percent likely to be realized.

While promoting increased standardization of current practice, the Interpretation could have significant consequences for a large number of companies. Among those consequences, we expect:

n Less flexibility for management in determining reserves for tax exposures as compared to existing practices

n Increased transparency of tax exposures, which may trigger inquiries by analysts and could affect the behavior of taxing authorities; it may also lead to larger cash outlays for taxes, due to a diminished appetite for taking aggressive tax positions

n Greater income statement volatility and increased risk of nonrecurring financial statement effects from income taxes as management’s assess-ments of uncertain tax positions change over time.

141 PwC. “Lifting the Fog.”


12

IRS Early Resolution Offer142

As corporate taxpayers scrambled to comply with new accounting rules for uncertain tax positions, and in a move that took many by surprise, the IRS announced an initiative offering expedited resolution for uncertain tax positions. After the first few weeks, it was IRS officials’ turn to express surprise, because taxpayers were not rushing in to take advantage of the offer.

On November 15, the last day for taxpayers to apply to participate in the initiative, an IRS spokesman said that the agency had received “several” applications at IRS headquarters and that more applications are expected to be reported in this week by IRS field teams. One day later on November 16 the IRS spokesman said that the IRS “will consider requests that are received slightly beyond the 45-day deadline. Our intention is to work with taxpayers to resolve these issues, and if we believe we are able to do so in the time remaining, we will.” With the emphasis on complete transparency on the taxpayer’s part, it appears that most practitioners view the agency’s program less as a customer service and more as a Trojan horse.

Identifying Uncertain Tax Positions143

As one of the first steps in identifying uncertain tax positions, a company must determine the appropriate “unit of account” or level of disaggregation of its tax positions and comprehensively analyze each disaggregated position. A common example is the uncertain sustainability of the eligibility for a tax credit of particular costs associated with research and experimen-tation activities. Should a tax position be identified and analyzed in the aggregate or should it be disaggregated e.g., all research projects collec-tively or each project separately? Should the type of costs incurred for a particular project constitute the appropriate level of analysis or should every identifiable expense item be independently evaluated? Deciding not to provide definitive application guidance on these questions, the Board maintains that the specific facts and circumstances accompanying each position should be considered.

142 Stratton, Sheryl. “With FIN 48 Deadline Looming, Few Opt for IRS Early Resolution Offer,” Tax Notes Today, 2006 TNT 222-2, November 17, 2006.



Tax Accounting

Recognizing Uncertain Tax Positions144

After uncertain tax positions are identified, the question becomes one of recognition: when, if ever, should the benefit of a tax position that reduces current or expected corporate tax burdens be recognized for financial reporting purposes? The new model prescribed by the Board answers this question in two steps. The first involves a recognition threshold that must be satisfied before any potential benefit can be recognized; the second focuses on measurement, a critical issue to be addressed in the next section.

Before it can qualify for benefit recognition, a position needs to have a “more likely than not” chance of being accepted on its technical merits by the relevant taxing authorities. Assuming that the taxing authorities have full knowledge of all relevant facts, management must be able to reasonably conclude that tax law, case law, regulations, and other relevant information provide sufficient evidence that the sustainability of the position is more than 50 percent likely. If that is not the case, the entire tax benefit provided by the position must be reserved in the financial statements.

Recognizing a reserve for an entire tax benefit could result in a recorded liability that is substantially greater than the eventual cash payment to taxing authorities. This, in turn, could adversely impact debt ratios and increase reported interest expense. It may also cause increased periodic effective tax rates because certain structures and recurring transactions may be deemed insufficiently sustainable and could affect reported income in future periods as the dispute resolution process unfolds.

The new recognition threshold also represents a significant change in current taxpayers’ accounting policies, which provide for notably lower or higher recognition thresholds in many circumstances. One of these policies allows a tax benefit to be recognized as long as it is not probable that it would be disallowed, while a second, at the other end of the spectrum, allows benefits to be recognized only if the sustainability of the benefit is considered probable. Depending on its historical policy and profile of positions, upon adoption a company may need to record substantially higher reserves or release significant amounts of currently existing tax reserves. Further,



12

management should consider the expected effects of the Interpretation on the company’s system of internal control, as well as on budgeting processes, setting financial targets, communicating with capital markets, and negotiat-ing the terms of any applicable contracts such as debt covenants.

Measuring the Tax Benefit145

After concluding that a particular filing position has a “more likely than not” chance of being sustained, a company should address step two in the FASB’s model by measuring the amount of benefit to be recognized. To avoid potentially aberrant results and to create definitive guidance, the Board introduced a new methodology based on “cumulative probability,” a measurement approach under which companies will record in the financial statements the largest benefit that cumulatively is greate than 50 percent likely to be sustained.

Disclosures146

While management may be concerned about providing taxing authorities with information that is helpful for their enforcement activities, other stakeholders—for example, investors and regulators—use the same set of financial statements for their own purposes. Accordingly, there can be substantial divergence in expectations among concerned parties regarding the depth of disclosure relative to tax exposures.

The Interpretation addresses this issue by requiring a discussion of positions expected by management to change significantly within the next 12 months and a quantitative rollforward of the worldwide, aggregated amount of unrecognized tax benefits. The tabular reconciliation of the beginning and ending balance of unrecognized tax benefits from uncertain positions will include line items such as the effects of new positions taken during the year, changes in assessments of prior-period positions, and the impact of settlements with taxing authorities (see example below). The FASB believes that this aggregated level of information will not provide the taxing authorities with new or additional meaningful information for their enforcement efforts, but will allow users of the financial statements


146 Id.


Tax Accounting

to make judgments about management’s risk appetite, as well as possible future cash outflows of resources, and identify significant changes in management’s estimates. Companies will want to consider the need to communicate with analysts and other interested parties about specific adjustments in the rollforward disclosure.

Companies should also be cognizant of the possible impact of the new accounting model and the related disclosure requirements on their relation-ships with the taxing authorities. For example, disclosing the expected release of a significant tax reserve within the next 12 months may affect the company’s negotiating position with the taxing authorities or result in increased attention by taxing authorities during an ongoing or future tax examination. Notwithstanding those concerns, disclosure is required under FIN 48 when the change is expected to be significant. Accordingly, compa-nies will want to consider how best to satisfy the disclosure requirements of FIN 48, while at the same time balancing such concerns.

SEC Does Not Expect Full FIN 48 Disclosure in Interim Period147

According to Carol Stacey, chief accountant for the SEC’s Corporation Finance Division, speaking Nov. 17 in New York at the Financial Executives International financial reporting conference, companies should use their judgment on what to disclose in interim periods under FASB’s FIN 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109.

A panel of the American Institute of Certified Public Accountants, November 21, 2006, issued a discussion document on implementation issues under FIN 48 that also reflects that SEC perspective.

InsightsThe Interpretation represents a significant shift in the accounting and report-ing model for income taxes, yet its effects are likely to go well beyond merely changing reported balances in financial statements. Further, it introduces a

147 “Stacey Confirms SEC Does Not Expect Full FIN 48 Disclosures in Interim Periods,” BNA Daily Tax Report, ISSN 1522-8800 (November 30, 2006).


12

more defined, rigorous accounting model while requiring significant judgment by management. The level of implementation effort and need for process changes should not be underestimated, particularly for multinational compa-nies. Senior management and the board will want to consider:

n Whether the company has the necessary resources, such as sufficient personnel with adequate experience and training, as well as information collection and management processes, to implement and comply with FIN 48 in a timely manner.

n The strength of the company’s tax-related internal controls and what modifications may have to be developed and implemented.

n Current tax-related policies and disclosure practices, and the extent to which they may have to change upon adoption.

n How adoption of FIN 48 will likely affect the company’s key financial measures and what communications with other parties may be necessary (e.g., shareholders, analysts, others).

The many difficult assessments required in evaluating uncertain tax positions and their potential material impact on financial statements and other corporate communications will require a more profound interaction among finance, tax, legal, and operational units of a company, several of which may have diverging views and business objectives and may require mediation and guidance from senior management or the board of directors itself. To minimize unnecessary time spent on resolving disputes, manage-ment will want to ensure that the right mix of personnel is devoted to this effort from the outset.

Undeniably, uncertain tax positions create risk for companies. To minimize that risk, management and the company’s board should ensure that their values and risk tolerance are properly communicated and understood by all corporate employees, including those who determine the level of risk the company will assume in tax return filings. Companies should allow their conscientiously formulated risk policy to guide complex decisions regarding which tax positions will be pursued to minimize taxes, how tax positions will be evaluated for financial reporting, and the quality of disclosures in financial statements.


Tax Accounting

PwC Client Action Plan148

PwC has released an illustrative Client Action Plan (CAP). The plan has nine phases, each consisting of steps and actions necessary to address FIN 48. Certain steps may be mission critical, while others may be more or less relevant to a particular enterprise based on its overall business, tax, and financial reporting profile. The CAP Summary and Timeline highlights the key implementation considerations, as well as illustrative estimates of time-to-completion. While the CAP involves certain steps that are primarily sequential, some of the steps are interconnected. Accordingly, it is important to view any such plan dynamically, rather than as having separately completed or isolated steps.

We expect that an enterprise’s timing and effort to implement its plan will vary based on a number of factors. For example, if an enterprise is subject to tax in very few jurisdictions and has not engaged in many nonrecurring or tax planning transactions, we would expect that the time and effort to implement a plan to address FIN 48 would be at the low end of the range. For enterprises that have tax uncertainties in a number of different jurisdictions, which may involve a significant amount of complicated tax structures, we would expect them to fall within the high end of the range. Further, the incremental time required will also be influenced by the enterprise’s historic practices, methodologies, and controls with respect to income tax uncertainties. We would expect in many instances that the bulk of the effort would be achieved toward the early end of the range, but may require follow-up that could extend closer to the back-end of the range.

Given the potential time involved in appropriately implementing FIN 48 for a calendar year-end enterprise, we believe it is critical to initiate the first and second phases as soon as possible to accommodate potential resource constraints (particularly if an enterprise is heavily relying on outside resources) as well as to effectively roll out a comprehensive action plan with relevant employees and coordinate efforts with an enterprise’s external auditors. For a copy of the Client Action Plan please contact your local PwC tax advisor.

148 PricewaterhouseCoopers. Client Action Plan, 2006.


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Financial Reporting Implications of Changes in Texas Franchise Tax149

On May 18, 2006, the State of Texas enacted substantial changes to its tax system, which included the replacement of the taxable capital and earned surplus components of its franchise tax with a new franchise tax based upon modified gross revenue. This new franchise tax is referred to as the “Margin Tax.”

Accounting for the Texas “Margin Tax” The newly enacted “Margin Tax” will significantly affect the financial reporting of a wide range of enterprises operating within Texas. Significant resources may be required to properly analyze and timely reflect the financial statement impact of these changes in the period of enactment. While the tax will capture significantly more entities as taxpayers (i.e., partnerships not owned by natural persons), insurance companies and related entities that are subject to the Texas premium tax are generally nontaxable entities and thus should not be subject to the margin tax.

Texas’s new “Margin Tax” is assessed on an enterprise’s Texas-sourced “taxable margin.” “Taxable margin” equals the lesser of: 1) 70 percent of an enterprise’s total revenue, or 2) 100 percent of its total revenue less, at the annual election of the taxpayer: a) cost of goods sold, or b) compensation, as those terms are defined in the law. The current Texas franchise tax structure remains in existence until the end of an enterprise’s 2006 tax year with a switch to the “Margin Tax” required in 2007. Another unique compo-nent of this tax is that it will require unitary taxpayers to file as part of a combined group. Texas was strictly a separate entity reporting state under the earned surplus/taxable capital tax regime.

149 “The Financial Reporting Implications of Changes in The Texas Franchise Tax System” Dataline 2006-15, PricewaterhouseCoopers, May 30, 2006.


Tax Accounting

In order to lessen the effects of the transition from the current franchise tax to the new “Margin Tax,” lawmakers established a “Temporary Credit on Taxable Margin.” As enacted, the computation of the credit contains numerous operational complexities as well as apparent drafting inconsis-tencies that are expected to be addressed by the Texas Legislature when they return to session in January.

Because each of the measures of “taxable margin” have their own subset of applicable temporary differences, scheduling may be required if an enter-prise expects to be subject to more than one measure of taxable margin in future years when existing book versus tax basis differences are expected to reverse under FAS 109. To the extent an enterprise expects to be subject to the “70 percent of total revenue” measure of “taxable margin,” we believe that the applicable rate applied to those revenue related temporary differ-ences (e.g., differences in recognition between book and tax for bad debts, deferred revenue, etc.) should be 70 percent of the Texas-apportioned enacted tax rate (reflecting the fact that 30 percent of the reversing revenue related temporary differences would not impact taxes payable).

The Texas “Margin Tax” is significantly different from the federal tax structure and from tax structures in place in most other states. Because of the unique structure of the Texas “Margin Tax,” we expect that many companies may not be able to aggregate Texas’s “Margin Tax” calculation with the calculations of other taxing jurisdictions.


12

Approaches to Book-Tax Accounting Conformity150

Michelle Hanlon of the University of Michigan and Edward Maydew of the University of North Carolina presented a paper with extensive research on the possible outcomes of four different approaches to book-tax conformity for companies with overseas operations. The four approaches presented include the following:

n To adopt U.S. generally accepted accounting principles, thus maintaining the United States’ current worldwide taxation system but eliminating foreign income deferral for foreign subsidiaries.

n To maintain the worldwide tax system and require book-tax conformity, but also allow deferral of foreign subsidiary income.

n To adopt book-tax conformity along with territorial taxation. Under such a system, they said, the conformity would stem from the idea that U.S. taxes would be based on U.S. domestic source financial accounting income. At the same time, foreign source earnings would not be taxed by the United States.

n To combine worldwide book-tax conformity with the use of a formulary apportionment system. This would employ the same apportionment employed by U.S. states. One benefit would be that income sourcing would become less of an issue, but complications would arise with calculating sales, locating payroll and property, and other issues.

150 Bennett, Alison. “Book-Tax Accounting Conformity Presents Big Questions for Multinational Companies,” BNA Daily Tax Report, ISSN 1522-8800, (December 7, 2006).

13Appendix A Appendix B


13

Appendix A

CasesByer v. C.I.R., T.C. Summ. Op. 2006-125 (2006)The Tax Court ruled Petitioner, a tax attorney and former IRS auditor, was liable for self-employment tax because he was not a statutory employee of an insurance company, but rather an independent contractor subject to self-employment tax.

Dow Chemical Co. v. U.S., 435 F.3d 594 (2006).In a split decision the Sixth Circuit Court of Appeals reversed the District Court‘s decision in Dow Chemical v. U.S. and held that Dow’s COLI plans were economic shams and its interest deductions associated with the plans were properly disallowed.

Eugene A. Fisher et al. v. United States, 69 Fed.Cl. 193 (2006).The Claims Court denied the Trust’s motion for class action status, finding that (1) the Trust failed to demonstrate that the class would be so numerous that it would be impracticable to settle each case individually and (2) the Trust failed to establish that it could provide adequate representation for itself and others in a class-action lawsuit.

The Travelers Insurance Company v. United States, 72 Fed.Cl. 316, 317 (2006).The Court of Federal Claims granted summary judgment in this case remanded from the U.S. Court of Appeals for the Federal Circuit, on issues of excess gain from operations and its ruling that the policyholders’ share should be excluded from an insurance company’s taxable income for foreign tax credit purposes.


Appendix A

IRS Rulings/Procedures/ Notices/FAAsFFA 20062201FThe IRS issued Field Attorney Advice 20062201F addressing questions for controlled foreign corporations (CFCs) previously classified as insurance companies.

IR-2005-80An update of the Priority Guidance Plan for the plan year July 1, 2005 to June 30, 2006. The updated Plan details projects original to the 2005-2006 Priority Guidance Plan issued in August 2005, as well as several new projects.

IR-2006-18Pub. 4492 contains information for taxpayers affected by hurricanes Katrina, Rita, and Wilma. The new publication highlights changes to the tax law and relief provisions available to those affected by Hurricanes Katrina, Rita, and Wilma.

IR-2006-20Update of the tax year 2006 directions for corporations required to e-file. These new rules eliminate the option to file certain attachments in PDF and require a separate Schedules M-3 for members of the group.

IR-2006-29The process for business taxpayers filing for an automatic extension of time to file was modified. Taxpayers must now file revised Form 7004, Application for Automatic 6-Month Extension of Time to File Certain Business Income Tax, Information, and Other Returns.


13

IR-2006-51Updated drafts of Schedules M-3 for the 2006 tax year for Forms 1120, 1120-L, 1120-PC, 1120S, and 1065. Also released was a new Form 8916, Reconciliation of Schedule M-3 Taxable Income with Tax Return Taxable Income for Mixed Groups, that will be filed by certain insurance-related corporations.

IR-2006-114Final draft forms and instructions for Schedules M-3 and Form 8916 for the 2006 tax year, and a new Form 8916-A, Reconciliation of Cost of Goods Sold Reported on Schedule M-3.

71 F.R, 47158-01Temporary and proposed regulations under Section 7874. The regulations expand the scope of Section 7874 to cover certain transactions involving publicly traded foreign partnerships, create a significant safe harbor exception from the inversion rules, and provide guidance on several basic issues under Section 7874.

71 F.R. 61441-61445Proposed regulations under Sections 72 and 1001 that address the tax treatment of an exchange of property for an annuity contract (IR-2006-161), and declare obsolete Rev. Rul. 69-74.

71 F.R. 64488-64496 Contains proposed and temporary regulations to revise the existing final regulations relating to reportable transactions under Sections 6011, 6111, and 6112 for both taxpayers and material advisors.

71 F.R. 64496-64500On December 4, 2006, the IRS published proposed regulations which provided the rules relating to disclosure of reportable transactions by material advisors under Section 6111. Under the proposed regulations, each material advisor with respect to any reportable transaction (as defined in Section 1.6011-4(b)(1)) must file a return by the date prescribed in the regulations.


Appendix A

71 F.R. 64501-64504The IRS eliminated the book-tax difference category of reportable transactions stating that is no longer necessary because the new Schedule M-3 provides detailed information on transactions with significant book-tax differences.

Notice 2006-18The IRS released Notice 2006-18, IRB 2006-8, publishing a tentative determination under Section 809 of the recomputed differential earnings rate for 2004.

Notice 2006-35Correction of an error in Rev. Rul. 2006-25 which supplemented the schedules of prevailing state assumed interest rates set forth in Rev. Rul. 92-19, for purposes of Section 807(d)(4). Rev. Rul. 2006-25 gave incorrect interest rates for the life insurance valuation rates.

Notice 2006-42Claried the definition of “gross receipts” as it pertains to the requirements for insurance companies to be tax-exempt. The Notice provides that amounts received from the following sources during the taxable year will be included in “gross receipts” for the applicable Code Section.

Notice 2006-95 Provides rules interpreting the reasonable mortality charge requirement contained in Section 7702(c)(3)(B)(i) of the Internal Revenue Code. This notice supplements Notice 88-128, 1988-2 C.B. 540, and modifies and supersedes Notice 2004-61, 2004-2 C.B. 596, by providing safe harbors regarding the use of either the 1980 Commissioners’ Standard Ordinary mortality and morbidity tables (CSO tables) or 2001 CSO tables to determine whether mortality charges are reasonable.


13

Rev. Rul. 2006-25Contains the prevailing state assumed and applicable federal interest rates (AFR) for tax years beginning after December 31, 2004, supplementing Rev. Rul. 92-19. Provides the new rates for calculating reserves for life insurance and supplementary total and permanent disability benefits, individual annuities and pure endowments, and group annuities and pure endowments.

Rev. Rul. 2006-45Determination under Section 809 of the “recomputed differential earnings rate” for 2004, used by mutual life insurance companies to calculate their federal income tax liability for taxable years beginning in 2005. Notice 2006-18 contained a tentative determination of this rate.

Rev. Proc. 2006-39Provides the domestic asset/liability percentages and domestic investment yields needed by foreign life insurance companies and foreign property and liability companies to compute their minimum effectively connected net investment income under section 842(b) of the internal Revenue Code, for taxable years beginning after December 31, 2004.

Rev. Proc. 2007-9 and Rev. Proc. 2007-10Loss payment patterns/discount factors and the salvage discount factors, for the 2006 accident year. These factors are for use in computing discounted unpaid losses and estimated salvage recoverable under Section 846 and Section 832 of the Internal Revenue Code.


Appendix A

Private Letter Rulings and Technical AdvicePLR 200601006Sub-account assets will be treated as owned by Taxpayer and not by the contact-owner. So long as the contracts continue to satisfy the diversifica-tion requirements, the contract-owner will not be required to include the earnings on the sub-account assets in income.

PLR 200601007A Taxpayer whose foreign subsidiary issues variable contracts containing segregated accounts backed by publicly available funds contracts will not be considered the owner of the underlying investment assets.

PLR 200602016Trusts established by liquidators to satisfy claims brought against former officers and directors of life insurance companies are qualified settlement funds which are not subject to reporting or backup withholding requirements on amounts held for missing claimants until those funds are distributed.

PLR 200603030An organization did not qualify for exemption from Federal income tax under Section 501(a) as an organization described in Code Section 501(c)(15), because the insurance arrangement in question involved only one type of insurance contract, and there was no risk distribution.

PLR 200613011A mutual insurance company’s conversion to stock form, and the re-domestication of a foreign target, involved a series of tax-free reorganizations under Section 368.


13

PLR 200613028Beneficial interests held by a variable-annuity pension plan will not prevent the regulated investment companies from meeting the requirements of Treas. Reg. Section 1.817- 5(f)(2)(i), as long as the contracts meet certain terms and conditions.

PLR 200614004The IRS determined that Taxpayer satisfied Treas. Reg. Section 301.9100-3(a), and accordingly, granted Taxpayer an extension of time to make the election provided by Section 953(d).

PLR 200617024The liquidation of an insolvent insurance company subsidiary into the parent company was deemed to be tax-free under Section 332.

PLR 200617033The IRS granted an extension of time under Treas. Reg. Section 301.9100 to elect to be treated as a domestic corporation under Section 953(d) for the tax year ending on December 31, 2003, and thereafter.

PLR 200618025This ruling provides that a trust created for premium stabilization reserves is owned by the insurer.

PLR 200622017 The IRS granted an insurers’ request for an extension to make an election under Section 953(d) to be taxed as a domestic corporation.

PLR 200622003 The IRS granted an insurers’ request for an extension to make an election under Section 953(d) to be taxed as a domestic corporation.


Appendix A

PLR 200628018Express limited warranties are not insurable risks for federal income tax purposes.

PLR 200636085Amounts paid for product liability and other risk coverage by a Foreign Parent’s wholly-owned subsidiary and its operating subsidiaries to an insurance affiliate are insurance premiums for purposes of determining business expense deduction under Section 162.

PLR 200644047The IRS ruled that an organization did not qualify for tax-exempt status under Section 501(c)(15) because its insurance arrangement had no risk distribution and therefore did not qualify as an insurance arrangement for federal income tax purposes.

PLR 200646001A Taxpayer making payments from the foreign branch of a U.S. life insur-ance company to a nonresident taxpayer, was advised that such payments would result in U.S.-source income subject to applicable withholding taxes.

PLR 200646002The parent of two stock life insurance companies was granted a waiver under Sections 101(f)(3)(H) and 7702(f)(8) for life insurance contracts that failed to satisfy the requirements of Sections 101(f) and 7702 due to reasonable error.

TAM 200607020The conversion of a Blue Cross Blue Shield organization from a not-for-profit mutual insurance company to a for-profit stock insurance company constitutes a material change in its structure under Section 833(c)(2)(C).


13

TAM 200610016A Taxpayer cannot use the safe harbor method of accounting for premium acquisition expenses provided in Rev. Proc. 2002-46 to deduct the liability shown on its annual statement with respect to a deferred compensation plan for independent contractor insurance agents.

71 F.R. 2496-2497 Temporary and proposed regulations under Section 954(i) providing guidance under subpart F relating to partnerships. The temporary regulations will affect CFCs that are qualified insurance companies, as defined in Section 953(e)(3), that have an interest in a partnership and U.S. shareholders of such CFCs.

71 F.R. 13003-13008Final regulations relating to the withholding of tax under sections 1441 and 1442 on certain U.S. source income paid to foreign persons and related requirements governing collection, deposit, refunds, and credits of withheld amounts under Sections 1461 through 1463.

71 F.R. 26826Proposed regulations issued under Section 338 that treats a deemed asset sale by an insurance company or an acquisition of an insurance business as an assumption reinsurance transaction.

71 F.R. 23856-23857IRS provided temporary and proposed regulations under Section 1502, eliminating the separate condition of the tacking rule in Reg. Sec. 1.1502-47(d)(12).

Appendix A


Appendix A

71 F.R. 17990-18007Final and temporary regulations relating to an actual or deemed acquisition of an insurance company’s assets were released by the IRS. The final regulations under Sections 338 and 1060 apply to: an actual or deemed acquisition of an insurance company’s assets pursuant to an election under Section 338; a sale or acquisition of an insurance trade or business subject to Section 1060; and an acquisition of insurance contracts through assumption reinsurance.

71 F.R. 30640-30642These regulations contained numerous temporary regulations amending or replacing final regulations issued in December 2003.

71 F.R. 39548-39553Final regulations on the information reporting requirements under Section 6045(f) for payments of gross proceeds to attorneys. The regulations adopt, with revisions, the proposed regulations published in May 2002.

71 F.R. 53967-53971A significant ruling announcing the final regulations on how to determine the attained age of an insured for purposes of testing whether a contract qualifies as life insurance for federal tax purposes, was released by the IRS this year. After consideration of one written comment, the final rules adopt several modifications to the proposed version of the rules (REG-168892-03) which were issued in 2005.

71 F.R. 71040-71045These final regulations eliminate regulatory impediments to the electronic filing of certain business income tax returns and other forms and were adopt-ed without significant changes to the proposed and temporary regulation.


13

Appendix B

Insurance Tax Leaders

Atlanta, GeorgiaClinton N. McGrath 678.419.2024 [email protected]

Julie V. Goosman 678.419.1003 [email protected]

Sherrie Winokur 678.419.1172 [email protected]

BermudaBill Bellew 441.299.7107 [email protected]

Laurie Bailey 441.299.7104 [email protected]

Richard Irvine 441.299.7136 [email protected]

Birmingham, AlabamaKurt W. Hopper 205.250.8525 [email protected]

Karen R. Miller 205.250.8550 [email protected]

Ross Irwin 205.250.8595 [email protected]

Boston, MassachusettsDave Rudicel 617.530.7721 [email protected]

John Farina† 617.530.7391 [email protected]

Irving H. Plotkin 617 530 5332 [email protected]

Kevin Johnston 617.530.7542 [email protected]

Maura Sullivan 617.530.7822 [email protected]

Peter Sproul 617 530.7370 [email protected]

† Insurance Tax Leader, Americas


Appendix B

Chicago, IllinoisCraig B. Larsen 312. 298.5524 [email protected]

Rob Finnegan 312.298.3557 [email protected]

Sanjeev Gupta 312.298.5740 [email protected]

Yolanda Torres 312.298.4081 [email protected]

Fort Worth, TexasChris A. Baraks 817.870.5570 [email protected]

Chuck Lambert 817.870.5521 [email protected]

Florham Park, New JerseyDavid Wiseman 973.236.4656 [email protected]

Los Angeles, CaliforniaMichael F. Callan 213.356.6039 [email protected]

Nancy T. Wei 213.356.6441. [email protected]

Patricia A. Gergen 213.356.6421 [email protected]

Susan Leonard 213.830.8248 [email protected]

New York, New YorkAddison Shuster 646.471.3880 [email protected]

Arthur Scherbel 646.471.2276 [email protected]

Elizabeth Lotito 646.471.8233 [email protected]

Gayle Kraden 646.471.3263 [email protected]

Isaac Malul 646.471.3704 [email protected]

Joseph Foy † 646.471.8628 [email protected]

Kevin P. Crowe 646.471.0117 [email protected]

Lisa Miller 646.471.8199 [email protected]

Mark L. Lynch 646.471.3000 [email protected]

Michele Scala 646.471.7084 [email protected]

† Global Insurance Tax Leader


13

New York, New York (continued)

Thomas Groenen 646.471.7026 [email protected]

Timothy Kelly† 646.471.8184 [email protected]

Randall Becky 646.471.7514 [email protected]

Aaron McClain 646.471.4531 [email protected]

Nicole Classi 646.471.4665 [email protected]

Ted Nicholes 646.471.0005 [email protected]

Arash BarkHorder 646.471.2118 [email protected]

Philadelphia, PennsylvaniaJohn J. Peel 267.330.1530 [email protected]

Joseph B. Waldecker 267.330.6210 [email protected]

Richard A. Ashley 267.330.6040 [email protected]

Helen Sotirakoglou 267.330.1719 [email protected]

St. Louis, MissouriByron A. Crawford 314.206.8131 [email protected]

David R. Monday 314.206.8174 [email protected]

Jeffrey J. Kohler 314.206.8159 [email protected]

Matthew J. Lodes 314.206.8194 [email protected]

Thomas F. Wheeland 314.206.8166 [email protected]

Washington, D.C.Elaine Church 202.414.1461 [email protected]

Tony DiGilio 202.414.1702 [email protected]

Christopher Ocasal 202 414.1398 [email protected]

† Financial Services Tax Leader, Americas

Appendix B

MC-NY-07-0607 © 2007 PricewaterhouseCoopers LLP. All rights reserved. "PricewaterhouseCoopers" refers to PricewaterhouseCoopers LLP (a Delaware limited liability partnership) or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP (US).

AcknowledgementsThis analysis represents the efforts and ideas of many individuals within PricewaterhouseCoopers’ National Insurance Tax Services Group. The text was prepared by a team of professionals, including:

Yasmin Noel, Anthony DiGilio, Clinton McGrath, Julie Goosman, Rick Irvine, Corina Trainer, Andrew Prior, Byron Crawford, Rob Finnegan, Tom Wheeland, Barbara Reeder, Joseph Foy, Elaine Church, and Chris Ocasal.

We also would like to thank Alison Gilmore, Meredith Wright, and Raquella Kagan.

Continuing D

evelopm

ents in the Taxation of Insurance Com

panies

2006 The Year in R

eview

Continuing Developments in the Taxation of Insurance Companies*

2006 The Year in Review

www.pwc.com

Continuing Developments in the Taxation of Insurance Companies*

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