Reserving Judgment—New proposed regulations issued on computation and reporting of life insurance reserves

The Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) recently published a notice of proposed rulemaking (Proposed Regulations) regarding the computation of life insurance reserves and the process for making a change in the basis of computing life insurance reserves.

Background

The TCJA substantially amended the rules for calculating life insurance reserves under section 807(d)(1).¹ As amended, section 807(d) provides that the amount of life insurance reserves for purposes of calculating taxable income is the greater of the net surrender value of the contract or 92.81 percent of the reserve determined under the method prescribed by the National Association of Insurance Commissioners (NAIC) applicable to such contract. For a variable contract, the amount of the life insurance reserve is the sum of (i) the greater of the net surrender value of the contract or the portion of the reserve that is separately accounted for under section 817 and (ii) 92.81 percent of the excess (if any) of the tax reserve applicable to the contract.

In addition, the TCJA substantially revised the rules related to changes of basis for determining life insurance reserves and certain other items. Instead of a 10-year spread, under new section 807(f), if there is a change in basis for computing life insurance reserves and certain other items listed in section 807(c),

           So much of the difference between—

(A) the amount of the item at the close of the taxable year, computed on the new basis, and

(B) the amount of the item at the close of the taxable year, computed on the old basis,

as is attributable to contracts issued before the taxable year shall be taken into account under section 481 as adjustments attributable to a change in method of accounting initiated by the taxpayer and made with the consent of the Secretary.

Finally, an insurance company, when it files its tax return (Form 1120-L or 1120-PC, as applicable), is required to attach a copy of its NAIC annual statement. Treas. Reg. § 1.6012-2(c)(4) provides that if an insurance company files its tax return electronically, it should not include its annual statement with such return, but should make the statement available at all times to the IRS. Treasury is proposing changes to these filing requirements given the greater significance of statutory reserves in determining taxable income after the TCJA.

The Proposed Regulations in General

A large portion of the Proposed Regulations are administrative in nature, conforming the regulations to the current law. This is an overdue project, because the existing regulations largely are not applicable because they interpret Pre-TCJA reserving rules. Moreover, many of the existing regulations contain references to statutory provisions that have not been in the Internal Revenue Code since the major revisions to the taxation of life insurance companies that occurred in the Deficit Reduction Act of 1984. As part of this project, many of these outdated regulation provisions will be removed or moved so cross-references are correct.

Eversheds Sutherland Observation: The Preamble to the Proposed Regulations indicates that these regulations were not subject to review by the Office of Management and Budget pursuant to the Memorandum of Agreement with the Treasury. The Preamble does not provide any reason why the Proposed Regulations were not subject to review. This approach is in contrast to the approach taken with respect to most other TCJA regulations projects. The treatment of the Proposed Regulations may suggest that Treasury’s view is that these regulations are primarily administrative in nature, rather than a statement of substantive Treasury income tax policy.

Change in the Basis for Computing Reserves

Prop. Treas. Reg. § 1.807-4 provides guidance relating to the change in basis in computing life insurance reserves. The Proposed Regulations provide that a change in the basis of computing life insurance reserves is taken into account under the section 446 regulations as a change in a method of accounting that requires consent of the Secretary. Under prior law, taxpayers amortized adjustments arising out of changes in basis over a 10 year period. Subsequent to the TCJA, a net negative adjustment arising from a change in the computation of reserves is taken into account in the taxable year of the change. A net positive adjustment is generally taken into account over four taxable years, starting with the taxable year when the change occurs. The Preamble to the Proposed Regulations also seemingly adopts the principles of Rev. Proc. 2019-34, which set forth simplifying procedures for an insurance company to change its method of accounting under section 807(f). This revenue procedure granted automatic consent for any change in basis and waived the requirement to file a Form 3115, “Application for Change in Accounting Method.”

Eversheds Sutherland Observation: As revised by the TCJA, section 807(f) requires any adjustment due to a change in basis for computing reserves to be taken into account as an adjustment “attributable to a change in method of accounting initiated by the taxpayer and made with the consent of the Secretary.” Based on the reference in the Proposed Regulations to the regulations under section 446, it appears that Treasury and the IRS have interpreted that language to mean that a change in basis is a change in method. Taxpayers are likely to provide comments on this interpretation of the statutory language.

The Preamble also indicates that, under amendments to the automatic consent procedure, an adjustment for each item listed in section 807(c) (i.e., life insurance reserves, unearned premiums, etc.) will be netted and taken into account as a single section 481 adjustment. However, different section 807(c) items within the taxable year will each be treated individually and be taken into account separately. The Preamble to the Proposed Regulations notes that prior to the TCJA, a life insurance company generally would net all of the positive and negative adjustments for a taxable year into a single adjustment, and spread the net amount of any change, positive or negative, over ten years.

One question that had arisen under the TCJA revisions was the treatment of the section 481(a) adjustment when a life insurance company or non-life insurance company ceases to qualify as such. Consistent with the post-TCJA version of section 807(f), the rules provide that if a taxpayer loses its insurance company status altogether, then any remaining balance of the section 481(a) adjustment is taken into account in the last taxable year the company qualified as an insurance company. The Proposed Regulations do not, however, accelerate the section 481(a) adjustment if the company changes from a life insurance company to a nonlife insurance company or vice versa.

Finally, the Proposed Regulations propose to “obsolete” an extensive list of revenue rulings that applied to section 807(f) prior to the implementation of the TCJA. These rulings had generally applied a broad definition to the term “change in basis” for calculating reserves and narrowed the scope of changes that did not qualify as a basis change, e.g., a mathematical or posting error.² The rulings are proposed to be obsoleted effective with the date of the regulations are finalized.

Eversheds Sutherland Observation: It is noteworthy that Treasury and the IRS have proposed to obsolete these rulings on a prospective basis. The Preamble states that these rules “are inconsistent with section 807(f)” after the TCJA, and the IRS regularly obsoletes rulings that are inconsistent after a change in tax law without proposing their obsolescence in a Proposed Regulations project. In fact, in some cases the IRS will do so on the effective date of the new law. There may have been some disagreement at Treasury and the IRS regarding whether some or all of these ruling truly are inconsistent with section 807(f), as amended. Of importance to taxpayers, however, is the clear implication that Treasury and the IRS are interested in comments from the industry on this point.

Treatment of Foreign-Issued Contracts

Under current U.S federal income tax law, a contract does not qualify as a “life insurance” contract unless it meets the requirements of section 7702, among other tax requirements. Likewise, a contract does not qualify as an annuity contract unless it meets section 72(s), among other tax requirements. As a result, it is unlikely that many life and annuity contracts issued to non-US persons by non-US companies would qualify for treatment as life insurance contracts or annuity contracts, as relevant.

The Preamble to the Proposed Regulations states that Treasury and the IRS received a request to promulgate regulations under section 807 that would provide that the determination of whether a contract issued by a non-US insurance company and reinsured by a US insurance company is a life insurance or annuity contract is made without regard to these statutory requirements, if no policyholder or beneficiary is a US person and the contract is regulated as a life insurance contract or annuity contract in its home country. This change would allow a US insurance company that reinsures such contracts to establish additional life insurance reserves. The preamble indicates that Treasury and the IRS are evaluating this approach and may address it in the final regulations. The Preamble, therefore, requests comments on this issue.

Other Clean-Up Changes

Several other “clean up” changes are proposed under the Proposed Regulations:

• Prop. Treas. Reg. § 1.338-11(d) removes the section 807(f) exception from the general rule requiring the capitalization of reserves in certain circumstances where a section 338(h)(10) election is made
• Prop. Treas. § 1.807-1(a) provides, consistent both with prior law and with the legislative history to the TCJA, that no asset adequacy reserve may be included in the amount of deductible reserves under section 807(d)
• Prop. Treas. Reg. § 1.807-3 provides that the IRS may require information necessary for the proper reporting of life insurance reserves, unearned premium reserves, advance premiums, and other items listed in section 807(c)
• Prop. Treas. Reg. § 1.817A-1 removes the requirement from the currently applicable regulations requiring the current market rate of interest be used to determine both the life insurance reserve and the interest during the temporary guarantee period of a non-equity indexed modified guaranteed contract
• Prop. Treas. Reg. § 1.6012-2(c) is amended to require an insurance company to file a copy of its NAIC annual statement with its tax return even when the company files its tax return electronically
• The following regulations are revoked/obsoleted as no longer applicable after the 2017 Act: Treas. Reg. § 1.381(c)(22)-1(b)(6), Treas. Reg. § 1.801-5(c), Treas. Reg. § 1.801-7, Treas. Reg. § 1.801-8(e), Treas. Reg. § 1.806-4, Treas. Reg. § 1.809-2, Treas. Reg. § 1.810-3, Treas. Reg. § 1.818-2(c), 1.818-4

Effective Date

The Proposed Regulations will generally apply to taxable years beginning on or after they are published as final regulations, but taxpayers may choose to apply them to all taxable years beginning after December 31, 2017, until the regulations are finalized.

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