Session 2: Life Insurance Product Tax Update: Other Life Topics. Moderator: John Adney, Esq. Davis & Harman LLP

Transcription

1 Session 2: Life Insurance Product Tax Update: Other Life Topics Moderator: John Adney, Esq. Davis & Harman LLP Presenters: Mary Elizabeth Caramagno, FSA, MAAA Prudential Financial John Glover, Esq. Office of Chief Counsel, Internal Revenue Service Craig Springfield, Esq Davis & Harman LLP

2 2016 Product Tax Seminar Session 2 Life Insurance Product Tax Update: Other Topics September 8, 2016

3 Presenters John Adney, Esq., Moderator Davis & Harman LLP Mary Elizabeth Caramagno, FSA, MAAA Prudential Financial John Glover, Esq. Office of Chief Counsel, Internal Revenue Service Craig Springfield, Esq. Davis & Harman LLP 2

4 SOCIETY OF ACTUARIES Antitrust Notice for Meetings Active participation in the Society of Actuaries is an important aspect of membership. However, any Society activity that arguably could be perceived as a restraint of trade exposes the SOA and its members to antitrust risk. Accordingly, meeting participants should refrain from any discussion which may provide the basis for an inference that they agreed to take any action relating to prices, services, production, allocation of markets or any other matter having a market effect. These discussions should be avoided both at official SOA meetings and informal gatherings and activities. In addition, meeting participants should be sensitive to other matters that may raise particular antitrust concern: membership restrictions, codes of ethics or other forms of self-regulation, product standardization or certification. The following are guidelines that should be followed at all SOA meetings, informal gatherings and activities: DON T discuss your own, your firm s, or others prices or fees for service, or anything that might affect prices or fees, such as costs, discounts, terms of sale, or profit margins. DON T stay at a meeting where any such price talk occurs. DON T make public announcements or statements about your own or your firm s prices or fees, or those of competitors, at any SOA meeting or activity. DON T talk about what other entities or their members or employees plan to do in particular geographic or product markets or with particular customers. DON T speak or act on behalf of the SOA or any of its committees unless specifically authorized to do so. DO alert SOA staff or legal counsel about any concerns regarding proposed statements to be made by the association on behalf of a committee or section. DO consult with your own legal counsel or the SOA before raising any matter or making any statement that you think may involve competitively sensitive information. DO be alert to improper activities, and don t participate if you think something is improper. If you have specific questions, seek guidance from your own legal counsel or from the SOA s Executive Director or legal counsel. 3

5 Disclaimer These slides are for educational purposes only and are not intended, and should not be relied upon, as accounting or tax advice. The views and opinions expressed are solely those of the presenters and not those of Prudential Financial, Davis & Harman LLP, or the Internal Revenue Service 4

6 Topics Webber v. Commissioner The Frozen Cash Value Policy Combination Products: Basis and ROPs Treatment of Charges for Benefit Riders Continuing Issues in the Definition of Cash Surrender Value Reasonable Mortality and Expense Charges: Living Outside the Safe Harbor 5

7 Webber v. Commissioner The Frozen Cash Value Policy 6

8 Background Investor control doctrine : the owner of a variable contract is deemed to own the separate account assets for tax purposes if he or she controls them Two related prongs developed in IRS rulings: Actual control over asset acquisition, disposition, management Use of a publicly available pools of assets Facts & circumstances analysis 7

9 Webber v. Commissioner 144 T.C. 324 (June 30, 2015); status of appellate review First investor control case in 31 years Only prior decided case was Christoffersen v. United States, 749 F. 2d 513 (8th Cir. 1984) Tax Court found the policyholder owned the separate account assets for tax purposes, following the investor control doctrine developed in the IRS rulings Section 817(h) and section 7702 issues were presented 8

10 Webber v. Commissioner (cont.) Venture capitalist policyholder purchased private placement variable life contracts from an offshore insurer No question the policyholder controlled the investments: Made recommendations through intermediaries Used Lipkind Protocol to avoid appearance of control 70,000 s directing investments Separate account made investments via special purpose entity (SPE) controlled by the policyholder Many investments were made in the policyholder s companies Frozen cash value life insurance contract was used Contract s surrender value was capped at premiums paid Death benefit was the greater of a minimum stated amount or the value of the separate account 9

11 Webber v. Commissioner (cont.) Frozen cash value life insurance contract Thesis of sale: a contract that is failed under section 7702 still provides tax-free treatment of the death benefit in excess of the net surrender value (NSV), and is taxable on NSV growth (none) plus COIs Alternative thesis: the capped premiums constituted the only cash surrender value (CSV) for purposes of section 7702, thus allowing for compliance with the cash value accumulation test (CVAT) Webber contract may contain no insurance risk (death benefit is the separate account value if greater than the stated minimum amount) What is the contract s NSV and CSV in substance? Merely the premiums paid? Tax Court found that the policyholder extracted earnings through dealings with his SPE 10

12 Webber v. Commissioner (cont.) Frozen contract (cont.) In litigation, the IRS stipulated section 7702 compliance Strategic approach: Arguments based on investor control were supported by a mass of evidence Arguments based on section 7702 treatment would be complex, unprecedented No implication for future approaches 11

13 Combination Products: Basis and ROPs 12

14 Combination Products A combination life insurance product consists of traditional or universal life with a long-term care rider that accelerates the contract s death benefit Tax treatment of accelerated death benefits (ADBs) is governed by sections 7702B and 101(g) Products often provide return of premium (ROP) benefits ROP may return the cost of the ADB rider ROP may also be provided for the base life contract 13

15 Combination Products (cont.] What is the effect of an ADB payment on the investment in the contract (IIC) under section 72(e)(6)? Section 72(e)(6) defines IIC as premiums paid less untaxed amounts received Important in the event of partial or total surrender This issue is on the IRS Priority Guidance Plan for annuities 14

16 Combination Products (cont.] What is the effect of an ADB payment on premiums paid (section 7702(f)(1))? Section 7702(f)(1) defines premiums paid as premiums paid less amounts subject to section 72(e) not includible in income, excess premiums as to which there is a section 7702(f)(7)(B) or (E) distribution, and other amounts specified in regulations Important for compliance with the guideline premium test 15

17 Combination Products (cont.] What is the effect of an ADB payment on amount paid (section 7702A(e)(1))? Section 7702A(e)(1) defines amount paid as premiums paid less amounts subject to section 72(e) not includible in income (disregarding the treatment of loans under MECs) Important for compliance with the 7-pay test What is the effect of an ADB payment under the section 7702A(c)(3)(i) necessary premium test? 16

18 Combination Products (cont.) What is the effect of ADB payments on the calculation of guideline premiums and 7-pay premiums? When an ADB decreases the death benefit: Does the section 7702(f)(7)(A) adjustment rule apply? If so, how does it apply? Does the reduction-in-benefit rule of section 7702A(c)(2)(A) apply? If not, does the material change rule of section 7702A(c)(3) apply? 17

19 Combination Products (cont.) ROPs provided by a qualified long-term care insurance rider: section 7702B permits a ROP benefit on death or surrender, limited to aggregate premiums paid, and treats the rider as separate from the base contract ROPs provided under a base contract and a rider: proper allocation of benefits between rider and base contract is important, to assure compliance with both section 7702B and section 7702 and for purposes of section 72(e)(11) Chronic illness riders that are not long-term care insurance cannot use the separate contract rule of section 7702B 18

20 Treatment of Charges for Benefit Riders 19

21 Treatment of Benefit Rider Charges Benefits may be provided under life insurance contracts by riders Under sections 7702 and 7702A, rider benefits may be classified as: qualified additional benefits (QABs), additional benefits that are not qualified (non-qabs), and benefits that are integral to a base contract ( integral benefits ) Charges are imposed for most such riders, either as additional premiums or as account value deductions 20

22 Treatment of Rider Charges (cont.) QABs consist of guaranteed insurability, accidental death and disability, family term, and disability waiver benefits (per section 7702(f)(5)(A)) Non-QABs are not defined in the statute, but a typical example is a term rider on a business partner who is not a family member Examples of integral benefits provided via rider are guaranteed minimum withdrawal benefits and no lapse guarantee riders 21

23 Treatment of Rider Charges (cont.) Section 7702(f)(5)(B) treats QAB charges as future benefits included in net single premium and guideline premium calculations; this is carried over to the 7-pay premium calculation by section 7702A(c)(1)(B) Per section 7702(f)(5)(C), non-qabs are not included in the section 7702 calculations and their charges are excluded from premiums paid if not prefunded Integral benefits are not included in the section 7702 calculations unless they constitute death benefits or endowment benefits 22

24 Treatment of Rider Charges (cont.) What is the treatment of QAB rider charges under section 72? In allowing prefunding of such charges in connection with defining the life insurance contract, it seems implicit that such charges would not give rise to distributions A contrary view would produce anomalous results, e.g., a doubling of the effect of QAB rider charges on a contract s investment orientation if such charges were treated as distributions and reduced premiums paid under section 7702 and amount paid under section 7702A Rev. Rul treats premiums paid expressly for additional benefits as if paid for a separate contract, excluding them from IIC of the base contract Still good law? Applicable to charges for QABs? 23

25 Treatment of Rider Charges (cont.) What is the treatment of non-qab rider charges under section 72? Probably treated as distributions, reportable on IRS Form 1099-R if income; otherwise, they reduce IIC see PLR Rev. Rul applies where separate premiums are paid for non-qab riders Recall the treatment of non-qab charges under section 7702(f)(5)(C) if not prefunded, the charges are not counted as premiums (and thus not as IIC) 24

26 Treatment of Rider Charges (cont.) What is the section 72 treatment of charges for integral benefits provided by riders? Charges for COI and other policy expenses are not considered distributions If rider benefits are integral, the same treatment presumably applies 25

27 Continuing Issues in the Definition of Cash Surrender Value 26

28 Definition of Cash Surrender Value The net single premium is compared to the cash surrender value (CSV) of a contract to determine whether the CVAT requirements are met for that contract Section 7702(d) requires a GPT contract s death benefit to be at least a specified multiple of the CSV Per section 7702(f)(2)(A), The cash surrender value of any contract shall be its cash value determined without regard to any surrender charge, policy loan, or reasonable termination dividends 27

29 Definition of Cash Surrender Value (cont.) According to the legislative history of section 7702, the CSV is the amount (disregarding reductions for surrender charges and loans) that is available on surrender and for borrowing Proposed Regulation section issued in 1992 defines the CSV as any amount payable or able to be borrowed under a contract, with exceptions The proposed regulation was controversial; Notice provided assurance it would not be effective before finalized; it remains in proposed form 28

30 Definition of Cash Surrender Value (cont.) Private letter rulings have applied the standard of the proposed regulations to hold that premium refund guarantees under cash value contracts are part of CSV FATCA regulations provided a CSV definition Status of ROP benefits and other amounts payable, but not borrowable, under cash value contracts? CSV definition remains on the Priority Guidance Plan 29

31 Reasonable Mortality and Expense Charges: Living Outside the Safe Harbor 30

32 Reasonable Mortality and Expense Charges TAMRA imposed restrictions on mortality and expense charge assumptions used in the section 7702 and 7702A calculations for contracts issued after 10/20/88 The reasonable mortality requirements imposed on contracts under section 7702(c)(3)(B)(i) can be viewed as having both a permanent rule and an interim rule Permanent rule: mortality assumptions must be reasonable and, absent an exception provided in regulations, cannot exceed the rates in the prevailing commissioners standard tables at the time the contract is issued (as defined in section 807(d)) 31

33 Reasonable Mortality Charges (cont.) Interim rule: for contracts issued before regulations are finalized, mortality charges are treated as reasonable if they do not differ materially from the charges actually expected to be imposed by the company, taking into account any relevant characteristics of the insured of which the company is aware (TAMRA section 5011(c)) Proposed Regulation section (issued in 1991) addresses reasonable mortality charges but was never finalized 32

34 Reasonable Mortality Charges (cont.) Notice provided the first safe harbor rule for reasonable mortality: 100% of the sex distinct 1980 CSO tables (consistent with their specification as the prevailing commissioners tables at the time) Notice provides additional safe harbors: 1980 CSO safe harbor applies to contracts issued before % of 2001 CSO mortality is the safe harbor thereafter, but any lower guarantee in the contract must be used instead 33

35 Reasonable Mortality Charges (cont.) What if mortality charges are outside the Notice safe harbor? Under the permanent rule, what is reasonable absent application of the Notice? The Notice requires the use of any guarantees of lower mortality charges for 2001 CSO contracts, but 100% of 1980 CSO continued to be allowed for 1980 CSO contracts What is the status of 1980 CSO contracts issued in 2008, beyond the 3-year transition rule for the 2001 CSO tables found in section 807(d), if outside the safe harbor? 34

36 Reasonable Mortality Charges (cont.) What if mortality charges are outside the Notice safe harbor (cont.)? The Notice does not expressly address substandard risk, guaranteed issue, and simplified issue contracts Uncertainties in the application of the TAMRA interim rule: materially different and characteristics of the insured 35

37 Reasonable Expense Charges For contracts entered into after 10/20/88, section 7702(c)(3)(B)(ii) requires guideline premiums to be computed assuming 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 be actually paid This reasonable expense charge rule also applies to QABs under the CVAT and the 7-pay test as well as the GPT (Rev. Rul ) 36

38 Reasonable Expense Charges (cont.) No regulations provide guidance on the application of the reasonable expense charge rule No safe harbor is provided Insurers often use current scale charges to comply with the rule What if expense charges depart from a company s current scale? What if a contract undergoes an adjustment or material change? How should uncertainty with respect to future charges be addressed? 37

39 Questions? 38