SPECIAL REPORT. tax notes. IRS Assumes Away Inconvenient Law in Reinsurance CCA. By William R. Pauls

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1 IRS Assumes Away Inconvenient Law in CCA By William R. Pauls William R. Pauls is a partner in the Washington office of Sutherland Asbill & Brennan LLP. He gratefully acknowledges Michael Miles, a partner in Sutherland s Washington office, for his comments on a prior draft of this report. In this report, Pauls argues that the IRS asserted a William R. Pauls fundamentally incorrect conclusion in ILM and that the conclusion should be rejected because of its blatant disregard of section 848(g) and other applicable provisions of the code and regulations. This report is for informational purposes only and is not intended to constitute legal advice. It does not necessarily represent the views or professional advice of Sutherland Asbill & Brennan LLP. Table of Contents I. Basics of and Retrocessions. 277 II. Analyzing and Retrocessions A. Tax Consequences of Mere B. Impacts of an Applicable Asset Acquisition C. Applicable Asset Acquisition Summary. 284 III. IRS s Flawed Analysis in ILM IV. Parting Thoughts In ILM , 1 the IRS addressed a question that often arises in connection with the acquisition of a life reinsurance business: Is the acquirer entitled to an immediate deduction for the ceding SPECIAL REPORT tax notes commission incurred under an indemnity retrocession agreement undertaken to complete the acquisition? Much to the dismay of many practitioners that work in the reinsurance space, the IRS asserted a fundamentally incorrect conclusion in ILM ; specifically, that the acquirer is required to capitalize and amortize the portion of the ceding commission that exceeds the amount capitalized by the acquirer under section 848 in connection with the indemnity retrocession transaction. As discussed in this report, this misguided conclusion should be rejected because of its blatant disregard of section 848(g) and other applicable provisions of the code and regulations. I. Basics of and Retrocessions is a transaction in which an insurance company (the primary insurer) transfers to another insurance company (the reinsurer) all or part of the risk arising from an insurance or annuity contract (or a group of insurance or annuity contracts) that the primary insurer has issued. Accordingly, reinsurance typically is referred to as insurance for insurance companies, because it covers the primary insurer if funds must be paid under any of the insurance or annuity contracts that the primary insurer previously issued. of life insurance and annuity contracts can be accomplished through either assumption reinsurance or indemnity reinsurance. In an assumption reinsurance transaction, the primary insurer (typically referred to as the ceding company) permanently transfers full liability for a block of insurance business to the reinsurer, along with the investment assets supporting the liabilities associated with the reinsured contracts and the right to receive future premiums generated by the reinsured contracts. 2 Under such an arrangement, the reinsurer becomes directly liable to the insureds, beneficiaries, or holders of the reinsured contracts; sets up reserves for the reinsured contracts; and typically pays the ceding company an upfront fee 1 ILM is dated September 4, 2014, and was released to the public on January 2, This memorandum was prepared by an attorney in branch 4 of the IRS Office of Associate Chief Counsel (Financial Institutions and Products), which often is referred to as the Insurance Branch. 2 See reg. section (a)(7)(ii) ( The term assumption reinsurance means an arrangement whereby another person (the reinsurer) becomes solely liable to the policyholders on the contracts transferred by the taxpayer. Such term does not include indemnity reinsurance or reinsurance ceded (as defined in paragraph (a)(1)(iii) of section ). ). TAX NOTES, April 20,

2 COMMENTARY / SPECIAL REPORT known as a ceding commission. 3 For federal income tax purposes, assumption reinsurance generally is treated as a sale of the reinsured contracts. 4 In an indemnity reinsurance transaction, the reinsurer agrees to indemnify the ceding company for all or part of its insurance or annuity risks or liabilities. 5 Under that arrangement, the ceding company retains its liability to, and its direct contractual relationship with, the insureds, beneficiaries, or holders of the reinsured contracts. 6 The ceding company pays a reinsurance premium to the reinsurer, 7 and the reinsurer sets up its share of reserves and typically pays a ceding commission to the ceding company. 8 For federal income tax purposes, indemnity reinsurance generally is treated as the purchase of insurance protection from a reinsurer. 9 A retrocession is one more step removed from the original insurance or annuity contract. A retrocession occurs when a reinsurer enters into a reinsurance arrangement with another insurance or reinsurance company (the retrocessionaire) to protect the reinsurer if claims must be paid under any of the reinsurance agreements that the reinsurer 3 Because assumption reinsurance constitutes a novation of a valid agreement, the ceding company generally must obtain the consent of the holders of the reinsured contracts in order for the transaction to be effective. 4 See Oxford Life Ins. Co. v. United States, 790 F.2d 1370, 1376 (9th Cir. 1986) ( An assumption reinsurance transaction is treated as a sale of the policies; an indemnity reinsurance transaction is the purchase of insurance protection from the reinsured. ); see also TAM ( For tax purposes, assumption reinsurance is considered a sale of a block of policies (and the related assets), whereas other forms of reinsurance entail a continuing insurance relationship between the ceding company and the reinsurer. ). 5 Indemnity reinsurance can be either proportional or nonproportional in character. Further, proportional indemnity reinsurance can take various forms, including traditional coinsurance, coinsurance on a funds-withheld basis, modified coinsurance, and yearly renewable term. As used herein, and unless the context otherwise requires, the term indemnity reinsurance refers to traditional coinsurance. 6 The ceding company does not need to obtain the consent of the holders of the reinsured contracts in order for an indemnity reinsurance agreement to be effective. 7 To the extent that the reinsurance covers an existing book of business, the ceding company may transfer the investment assets supporting the reinsured contracts directly to the reinsurer or, alternatively, to a grantor trust that the reinsurer establishes for the protection of the ceding company. 8 See reg. section (a)(1)(iii) ( The term reinsurance ceded means an arrangement whereby the taxpayer (the reinsured) remains solely liable to the policyholder, whether all or only a portion of the risk has been transferred to the reinsurer. Such term includes indemnity reinsurance transactions but does not include assumption reinsurance transactions. See paragraph (a)(7)(ii) of section for the definition of assumption reinsurance. ). 9 See supra note 4. previously entered. A retrocession of a life reinsurance agreement can take the form of an assumption by the retrocessionaire of the existing reinsurance agreement (whereby the retrocessionaire effectively steps into the shoes of the reinsurer) or an indemnity reinsurance arrangement involving the reinsurer and the retrocessionaire. As noted above, both assumption and indemnity reinsurers ordinarily pay an upfront fee known as a ceding commission to the ceding company in a reinsurance transaction. A ceding commission represents the price paid by the reinsurer to acquire the right to the future profits generated by the reinsured contracts. 10 When the reinsurer receives a net amount of consideration from the ceding company that is less than the increase in the reinsurer s tax reserves resulting from the reinsurance transaction, the reinsurer generally is treated as having received consideration equal to the net amount of the increase in its tax reserves and as having paid a ceding commission equal to the difference between the increase in the reinsurer s tax reserves and the consideration actually received. 11 II. Analyzing and Retrocessions The portion of the code that sets forth the specific rules concerning the taxation of insurance companies (sections 801 through 848) is referred to as subchapter L. Much of subchapter L was redrafted and reorganized as part of the amendments made to the code by the Tax Reform Act of 1984 (TRA 1984). 12 Importantly, to the extent Treasury regulations issued under the provisions of subchapter L before their amendment by TRA 1984 do not conflict with the current provisions of subchapter L, they generally are considered authoritative guidance regarding the interpretation of the current provisions See Colonial Am. Life Ins. Co. v. Commissioner, 491 U.S. 244, (1989). 11 Cf. reg. section (d)(2)(iii) ( Where the reinsured transfers to the reinsurer in connection with the assumption reinsurance transaction a net amount which is less than the increase in the reinsurer s reserves resulting from the transaction, the reinsurer shall be treated as (A) having received from the reinsured consideration in an amount equal to the net amount of the increase in the reinsurer s reserves resulting from the transaction, and (B) having paid the reinsured an amount for the purchase of the contracts equal to the excess of the amount of such increase in the reinsurer s reserves over the net amount received from the reinsured. ). 12 TRA 1984 was part of the Deficit Reduction Act of 1984 (P.L ). 13 See S. Prt. No (vol. 1), Deficit Reduction Act of 1984 Explanation of Provisions Approved by the Committee on March 21, 1984, at 524 (Apr. 2, 1984) ( Although the bill amends the Internal Revenue Code by repealing the life insurance company taxation provisions of the 1959 Act and replacing (Footnote continued on next page.) 278 TAX NOTES, April 20, 2015

3 In the context of a reinsurance or retrocession transaction, an analysis typically must be performed to determine whether an applicable asset acquisition has occurred and, correspondingly, whether the special basis allocation rules of section 1060 apply to the transaction. The focus of that analysis is whether there has been a transfer of goodwill or going concern value to the reinsurer or retrocessionaire. 14 Significantly, the mere reinsurance of insurance contracts by an insurance company does not necessarily result in an applicable asset acquisition for purposes of section A. Tax Consequences of Mere With the exception discussed below, the principal federal income tax consequences arising from an assumption reinsurance transaction involving life insurance companies (as defined in section 816(a)) largely mirror the consequences associated with an indemnity reinsurance transaction involving life insurance companies. For example, in an assumption reinsurance transaction involving life insurance companies: the ceding company reduces its tax reserves for the reinsured contracts, which gives rise to ordinary income to the ceding company; 16 the ceding company claims a deduction for the amount of consideration it pays to the reinsurer for assuming the liabilities under the reinsured contracts; 17 the reinsurer records the receipt of consideration from the ceding company as an item of income; 18 and the reinsurer claims a deduction for the amount by which its tax reserves are increased as a result of the reinsurance transaction. 19 Correspondingly, in an indemnity reinsurance transaction involving life insurance companies: the ceding company reduces its tax reserves for the reinsured contracts, which gives rise to ordinary income to the ceding company; 20 them with an entire new Part I of subchapter L, the committee intends that the provisions of the new Part I which are based on present law be interpreted in a manner consistent with present law. Thus, where provisions of existing law are incorporated in the bill, the committee expects that, in the absence of contrary guidance in this report; the regulations, rulings, and case law under existing law may serve as interpretative guides to the new provisions. ); see also Rev. Rul , C.B. 144 (containing similar statements). 14 See reg. section (b)(9). 15 See id. 16 See section 803(a)(2). 17 See section 805(a)(6). 18 See section 803(a)(1); see also section 803(b)(1)(E). 19 See section 805(a)(2). 20 See section 803(a)(2). COMMENTARY / SPECIAL REPORT the ceding company reduces its life insurance gross income by the amount of consideration it pays to the reinsurer for agreeing to indemnify the ceding company for the liabilities under the reinsured contracts; 21 the reinsurer records the receipt of consideration from the ceding company as an item of income; 22 and the reinsurer claims a deduction for the amount by which its tax reserves are increased as a result of the reinsurance transaction. 23 Both assumption reinsurance and indemnity reinsurance transactions involving life insurance companies are subject to section 848 to the extent that net consideration is transferred between the ceding company and the reinsurer. 24 In general, section 848(a)(1) requires an insurance company to capitalize and amortize specified policy acquisition expenses 25 based on a proxy of the net premiums received on specified insurance contracts. 26 These amounts are intended to serve as a surrogate for an insurance company s actual cost of acquiring insurance contracts. With some exceptions, the amortization is computed on a straight-line basis over 120 months, beginning with the first month in the second half of the tax year in which the premiums are received. 27 For purposes of section 848, a reinsurance agreement that reinsures the risks under a specified insurance contract is treated in the same manner as the reinsured contract. 28 Further, if a reinsurance 21 See section 803(a)(1)(B). 22 See section 803(a)(1). 23 See section 805(a)(2). 24 See reg. section (f)(1); cf. H.R. Rep. No (1990) (describing the background for the addition of section 848 to the code). 25 The specified policy acquisition expenses that must be capitalized and amortized are determined by reference to a company s general deductions for the tax year. See section 848(c)(1). General deductions are the deductions an insurance company claims under sections and sections A for the costs of entering into insurance or reinsurance contracts. See section 848(c)(2); see also reg. section (i). 26 The specified insurance contract categories (and their corresponding capitalization percentages) are as follows: annuity contracts (general deductions equal to 1.75 percent of the net premiums for the tax year on those contracts); group life insurance contracts (general deductions equal to 2.05 percent of the net premiums for the tax year on those contracts); and other life and noncancellable accident and health insurance contracts (general deductions equal to 7.7 percent of the net premiums for the tax year on those contracts). See section 848(c)(1)(A) through (C); see also reg. section (b). 27 See section 848(a)(2). 28 See section 848(e)(5); reg. section (b)(1). TAX NOTES, April 20,

4 COMMENTARY / SPECIAL REPORT agreement includes more than one category of specified insurance contracts (or specified insurance contracts and contracts that are not specified insurance contracts), the portion of the agreement concerning each category of reinsured specified insurance contracts is treated as a separate agreement for section 848 purposes. 29 Similarly, the portion of the agreement concerning reinsured contracts that are not specified insurance contracts is treated as a separate agreement. 30 A company s net premiums subject to capitalization under section 848 are determined by taking into account the premiums and other consideration incurred for reinsurance. 31 If the ceding company has net positive consideration from a reinsurance transaction, 32 that amount is added to its gross premiums in determining net premiums subject to capitalization. 33 However, if the ceding company has net negative consideration from a reinsurance transaction, 34 that amount is subtracted from its gross premiums in determining net premiums subject to capitalization. 35 Importantly, corresponding rules apply to the reinsurer, 36 and to both the reinsurer and the retrocessionaire in a retrocession transaction. 37 As discussed below, the primary difference in the federal income tax consequences of assumption reinsurance transactions involving life insurance companies versus indemnity reinsurance transactions involving life insurance companies concerns the treatment of the ceding commission paid or incurred by the reinsurer. 1. Treatment of ceding commissions in mere reinsurance transactions. From the ceding company s 29 Reg. section (f)(7). 30 Id. 31 See section 848(d)(1), (4); reg. section (a)(1), (b)(1). 32 The ceding company will have net positive consideration from the reinsurance transaction if the gross amount of premiums and other consideration incurred by the ceding company for the reinsurance agreement is less than the gross amount incurred by the reinsurer for the reinsurance agreement, which amount includes any ceding commission. See reg. section (f)(2). 33 See section 848(d)(1); reg. section (b)(1). 34 The ceding company will have net negative consideration from the reinsurance transaction if the gross amount of premiums and other consideration incurred by the ceding company for the reinsurance agreement is greater than the gross amount incurred by the reinsurer for the reinsurance agreement, which amount, as noted above, includes any ceding commission. See reg. section (f)(2). 35 See section 848(f); reg. section (a)(1). But see reg. section (g) (providing rules for reducing the amount of net negative consideration to ensure consistency of capitalization for reinsurance agreements). 36 See reg. section (f)(3). 37 See reg. section (f)(6). perspective, the receipt of a ceding commission from the reinsurer has a similar result in either assumption reinsurance or indemnity reinsurance. In an assumption reinsurance transaction, reg. section (d)(2)(i) requires that the ceding company s deduction under section 805(a)(6) for the consideration it pays to the reinsurer for assuming the liabilities under the reinsured contracts be reduced (but not below zero) by the ceding commission, and if the amount so received exceeds the consideration that the ceding company pays to the reinsurer for assuming the liabilities under the reinsured contracts, the ceding company must take into account the excess as ordinary income under section 803(a)(3). Alternatively, in an indemnity reinsurance transaction, the ceding company generally takes into account the entirety of the ceding commission received from the reinsurer as an item of ordinary income under section 803(a)(3). 38 The reinsurer s treatment of the ceding commission initially will depend on whether specified insurance contracts are reinsured under the reinsurance agreement. In this regard, section 848(g) provides: Nothing in any provision of law (other than this section or section 197) shall require the capitalization of any ceding commission incurred on or after September 30, 1990, under any contract which reinsures a specified insurance contract. If specified insurance contracts are reinsured under the reinsurance agreement, section 848(g) directs that the ceding commission attributable to those contracts is potentially subject to the capitalization rules of sections 848 and 197 but not any other provision of law. By providing this result, section 848(g) effectively nullified the application of reg. section (d)(2)(ii)(B) to the reinsurer in an assumption reinsurance transaction involving specified insurance contracts, as well as Colonial American 39 in an indemnity reinsurance transaction involving specified insurance contracts. 40 Conversely, if the reinsured contracts are not specified 38 See, e.g., LTR (Ruling (1)); cf. Rev. Rul , C.B. 141 (concluding that, in a proportional indemnity reinsurance transaction involving nonlife insurance companies, the primary insurer, under principles of accrual accounting, must take into account the ceding commission due from the taxpayer on the reinsured business under section 832(b)(1)(C) in the tax year in which the reinsurance coverage becomes effective) U.S Both reg. section (d)(2)(ii)(B) and Colonial American otherwise required the reinsurer to capitalize the entire ceding commission and amortize that amount over the life of the reinsured contracts. 280 TAX NOTES, April 20, 2015

5 insurance contracts, section 848(g) (and, for that matter, the rest of section 848) does not come into play for those contracts, 41 but section 197 and other authorities (including Colonial American) still apply to determine the reinsurer s federal income tax treatment of the ceding commission attributable to those contracts. For purposes of these rules, a specified insurance contract generally is any life insurance, annuity, or noncancellable accident and health insurance contract (or any combination thereof). 42 As discussed above, section 848(a)(1) requires an insurance company to capitalize and amortize specified policy acquisition expenses based on a proxy of the net premiums received on specified insurance contracts. The specified policy acquisition expenses that must be capitalized and amortized are determined by reference to a company s general deductions (as defined in section 848(c)(2)) for the tax year. 43 As relevant to the application of section 848 to the ceding commission paid by the reinsurer, that amount constitutes a general deduction subject to capitalization under section 848(a)(1). 44 Because the ceding commission is reflected in the specified policy acquisition expenses capitalized under section 848(a)(1) in connection with the reinsurance transaction, the reinsurer may deduct currently the portion of the ceding commission equal to the amount capitalized under section 848(a)(1). 45 To the extent the ceding commission exceeds the amount capitalized by the reinsurer under section 848(a)(1) in connection with the reinsurance transaction, the reinsurer s ability to claim a current deduction for that excess portion (the Excess Amount) depends on whether the reinsurance transaction constitutes an assumption or indemnity 41 See reg. section (j). 42 See supra note See section 848(c)(1). 44 See ILM ( Congress intended that expenses associated with the acquisition of a stream of income from premiums are to be capitalized as specified policy acquisition expenses....ceding commissions are essentially the cost paid by a reinsurer for its right to receive the amount of premiums agreed to between the insurer and the reinsurer, i.e., a stream of future income from the premiums paid by the insureds for the ceded policies. ); cf. reg. section (i) ( An insurance company determines its general deductions for the taxable year without regard to amounts capitalized or amortized under section 848(a). The amount of a company s general deductions is also determined without regard to the rules of section (f), which apply only for purposes of determining net consideration for reinsurance agreements. ). 45 Cf. reg. section (c)(4), Example 1 ( New T deducts the $2.62 of the ceding commission that is not amortizable under section 197 because it is reflected in the amount capitalized under section 848 and also deducts the remaining $17.38 of its general deductions. ). COMMENTARY / SPECIAL REPORT reinsurance arrangement and also on the types of contracts reinsured. In an assumption reinsurance arrangement involving specified insurance contracts, the reinsurer generally is required to capitalize the Excess Amount and amortize that amount ratably over 15 years beginning with the month of the acquisition. 46 In contrast, in an indemnity reinsurance arrangement involving specified insurance contracts, the Excess Amount is immediately deductible by the reinsurer under section 848(g). 47 For purposes of these rules: an assumption reinsurance transaction is defined by reference to reg. section (a)(7)(ii), 48 which explicitly excludes indemnity reinsurance from that definition; and the transfer of a reinsurance contract by one reinsurer to another reinsurer is treated as an assumption reinsurance transaction only if the transferor s obligations are extinguished Summary. Table 1 below offers a summary of the federal income tax consequences of mere reinsurance transactions involving life insurance companies and specified insurance contracts. B. Impacts of an Applicable Asset Acquisition In the case of an applicable asset acquisition, section 1060 generally requires the seller and the purchaser to allocate the consideration paid or received in the transaction among the assets transferred in the same manner that amounts are allocated under section 338(b)(5) (governing the allocation of adjusted grossed-up basis among the assets of the target corporation when a section 338 election is made). An applicable asset acquisition is defined as any direct or indirect transfer of a group of assets that constitutes a trade or business in the hands of either the purchaser or the seller, and the purchaser s basis in the assets is determined wholly by reference to the consideration paid. 50 A reinsurance or retrocession transaction will be deemed to be part of an applicable asset acquisition when the purchaser acquires significant business assets, in 46 See section 197(a), (f)(5); reg. section (a)(1), (g)(5)(i), (g)(5)(ii)(a); see, e.g., reg. section (g)(5)(ii)(D), Example Cf. H.R. Rep. No , at 688 (1993) (Conf. Rep.) (stating that section 197(f)(5) applies to any insurance contract that is acquired from another person through an assumption reinsurance transaction (but not through an indemnity reinsurance transaction) (emphasis added)). 48 See supra note 2; see also supra note See reg. section (g)(5)(i); see also H.R. Rep. No , at 688, n.25 (1993) (Conf. Rep.) ( An assumption reinsurance transaction is an arrangement whereby one insurance company (the reinsurer) becomes solely liable to policyholders on contracts transferred by another insurance company (the ceding company). ). 50 See section 1060(c); reg. section (b)(1). TAX NOTES, April 20,

6 COMMENTARY / SPECIAL REPORT Table 1. Tax Consequences of Mere of Specified Insurance Contracts Ceding Company Reinsurer Assumption Indemnity Assumption Indemnity Premium Deduction Reduces life insurance Ordinary income Ordinary income gross income Tax Reserves Ordinary income equal to amount of reduction Ordinary income equal to amount of reduction Deduction in an amount equal to increase Deduction in an amount equal to increase Ceding Commission Reduces deduction for reinsurance premium, with any excess treated as ordinary income addition to insurance contracts, to which goodwill and going concern value could attach. 51 For purposes of these rules: goodwill generally is defined as the value of a trade or business attributable to a party s expectancy of continued customer patronage; and going concern value generally is defined as the additional value that attaches to property because it is an integral part of an ongoing business activity. 52 The determination of whether assets have goodwill or going concern value is based on the facts and circumstances of each particular transaction. 53 Factors to consider in this analysis include the presence of intangible assets; the existence of an excess of total consideration paid over the book value of the tangible and intangible assets purchased; and certain transactions related to the transfer, including a lease, license, covenant not to compete, or other related transactions between the buyer and the seller. 54 When it is determined that a reinsurance or retrocession transaction is part of an applicable asset acquisition, the rules of reg. section (c) direct the allocation of consideration among the assets transferred using the residual method. In this regard, reg. section (c)(5) incorporates the applicable principles of reg. section (a) through (d) into the allocation rules of reg. section (c)(1) through (4) for purposes of the analysis. Reg. section (c)(5) provides, in pertinent part, as follows: 51 Reg. section (b)(9). 52 See reg. section (b)(2)(ii). 53 See reg. section (b)(2)(iii). 54 See reg. section (b)(2)(iii)(A) through (C). Ordinary income (1) Current deduction for portion equal to specified policy acquisition expenses capitalized under section 848(a)(1) (2) Excess Amount capitalized and amortized over 15 years (1) Current deduction for portion equal to specified policy acquisition expenses capitalized under section 848(a)(1) (2) Current deduction for Excess Amount If the trade or business transferred is an insurance business, the rules of this paragraph (c) are modified by the principles of section (a) through (d). However, in transactions governed by section 1060, such principles apply even if the transfer of the trade or business is effected in whole or in part through indemnity reinsurance rather than assumption reinsurance, and, for the insurer or reinsurer, an insurance contract (including an annuity or reinsurance contract) is a Class VI asset regardless of whether it is a section 197 intangible. As provided by reg. section (c)(5), the hybrid rules that result from the incorporation of the applicable principles of reg. section (a) through (d) into the allocation rules of reg. section (c)(1) through (4) apply equally to assumption reinsurance and indemnity reinsurance transactions. Accordingly, the derivation of these rules is key to the determination of the federal income tax consequences arising from an applicable asset acquisition involving a reinsurance or retrocession transaction. Under reg. section (c)(1), the seller s consideration is the aggregate amount realized under section 1001(b) from selling the assets in the applicable asset acquisition, and the purchaser s consideration is the aggregate amount of its cost of purchasing the assets in the applicable asset acquisition that is properly taken into account in basis. Thus, in a reinsurance or retrocession transaction, the consideration contemplated by reg. section (c)(1) is the actual ceding commission paid to the ceding company by the reinsurer, plus the amount of tax reserves taken into account by the 282 TAX NOTES, April 20, 2015

7 reinsurer with respect to the reinsured contracts, because tax reserves constitute a liability under reg. section (b)(1). 55 Reg. section (c)(2) provides that, for purposes of determining the seller s amount realized for each of the assets sold in an applicable asset acquisition, the seller allocates consideration to all of the assets sold by using the residual method under reg. section , substituting consideration for aggregate deemed sale price. Reg. section (c)(2) also provides that, in determining the purchaser s basis in each of the assets purchased in an applicable asset acquisition, the purchaser allocates consideration to all of the assets purchased by using the residual method under reg. section , substituting consideration for adjusted grossed-up basis. Under reg. section , the consideration is allocated among seven asset classes in priority order. 56 Those seven asset classes are: Class I: cash and cash equivalents; Class II: actively traded personal property as defined in section 1092(d), certificates of deposit, and foreign currency; Class III: accounts receivable, mortgages, and credit card receivables that arise in the ordinary course of business; Class IV: stock in trade of the taxpayer or other property of the kind that properly would be included in the taxpayer s inventory if on hand at the close of the tax year, or property held by the taxpayer primarily for sale to customers in the ordinary course of business; Class V: all assets not in class I, II, III, IV, VI, or VII; Class VI: all section 197 intangibles, as defined in section 197, except goodwill and going concern value; and Class VII: goodwill and going concern value Cf. reg. section (a)(1) ( the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition ); reg. section (a)(4)(ii) ( The sale or other disposition of property that secures a recourse liability discharges the transferor from the liability if another person agrees to pay the liability (whether or not the transferor is in fact released from liability). ). 56 Specifically, after being reduced by the amount of Class I assets (if any) transferred to the reinsurer in the applicable asset acquisition, the consideration is allocated among the Class II assets transferred in proportion to the fair market values of those assets, then among the Class III assets transferred in that proportion, then among the Class IV assets transferred in that proportion, then among the Class V assets transferred in that proportion, then among the Class VI assets transferred in that proportion, and finally to Class VII assets. See reg. section (b)(2)(i). 57 See reg. section (b)(1); reg. section (b)(2)(ii) through (vii). COMMENTARY / SPECIAL REPORT As mandated by reg. section (c)(5), an insurance contract (including an annuity or reinsurance contract) is a Class VI asset regardless of whether it is a section 197 intangible. Thus, reg. section (c)(5) follows the design of the regulations under sections 197 and 338 and implicitly recognizes that indemnity reinsurance does not give rise to amortizable section 197 intangibles. 58 However, by treating the reinsured contracts as Class VI assets, reg. section (c)(5) provides the mechanism through which the deemed ceding commission for the indemnity reinsurance transaction can be determined under the residual method of reg. section For purposes of allocating consideration under reg. section (b), reg. section (b)(2) provides that the fair market value of the reinsured contracts is the amount of the ceding commission that 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 was equal to the ceding company s tax reserves for the contracts. Thus, in a situation in which the actual reinsurance premium paid to the reinsurer is $200x, the amount of tax reserves associated with the reinsured contracts is $195x, and the actual ceding commission is $10x, reg. section (b)(2) directs that the FMV of the reinsured contracts for purposes of reg. section (b) is $5x that is, $10x - ($200x - $195x). If some portion of the consideration ultimately is allocated to Class VI assets, reg. section (c)(3) provides that the ceding company is deemed to receive, and the reinsurer is deemed to pay, a ceding commission in an amount equal to the consideration allocated to the reinsured contracts. 59 As discussed below, the federal income tax treatment of this deemed ceding commission in an indemnity reinsurance transaction is the subject of ILM See, e.g., reg. section (c)(2) (providing an exception from the definition of the term section 197 intangible for interests under some financial contracts and directing that the carveout from this exception applies only to an interest under an assumption reinsurance contract ); reg. section (c)(2) (recognizing that section 197(f)(5) only applies in determining the amount of consideration allocated to an amortizable section 197 intangible resulting from an assumption-reinsurance transaction ); see also reg. section (b)(6) (describing customer-based intangibles that constitute section 197 intangibles; listing an amount paid or incurred for insurance in force through an assumption reinsurance transaction as a customer-based intangible). 59 The amount of the consideration allocated to a transferred asset (other than the Class VII assets) cannot exceed the FMV of the asset as of the beginning of the day after the acquisition date. See reg. section (c)(1). TAX NOTES, April 20,

8 COMMENTARY / SPECIAL REPORT Table 2. Tax Consequences of Applicable Asset Acquisition Involving Specified Insurance Contracts Ceding Company Reinsurer Assumption Indemnity Assumption Indemnity Premium (1) Deduction (2) Equal to tax reserves (1) Reduces life insurance gross income (2) Equal to tax reserves (1) Ordinary income (2) Equal to tax reserves (1) Ordinary income (2) Equal to tax reserves Tax Reserves Ceding Commission Ordinary income equal to amount of reduction (1) Determined under residual method (2) Reduces deduction for reinsurance premium, with any excess treated as ordinary income 60 Reg. section (d) describes the consequences resulting from an increase in the tax reserves for the reinsured contracts following the reinsurance or retrocession transaction. Ordinary income equal to amount of reduction (1) Determined under residual method (2) Ordinary income Deduction in an amount equal to increase (1) Determined under residual method (2) Current deduction for portion equal to specified policy acquisition expenses capitalized under section 848(a)(1) (3) Excess Amount capitalized and amortized over 15 years Deduction in an amount equal to increase (1) Determined under residual method (2) Current deduction for portion equal to specified policy acquisition expenses capitalized under section 848(a)(1) (3) Current deduction for Excess Amount Lastly, reg. section (c)(2) deems the gross amount of premium paid by the ceding company to the reinsurer to be equal to the ceding company s tax reserves for the reinsured contracts. C. Applicable Asset Acquisition Summary By incorporating the applicable principles of reg. section (a) through (d) 60 into the allocation rules of reg. section (c)(1) through (4) for an applicable asset acquisition involving a reinsurance or retrocession transaction, reg. section (c)(5) modifies the analysis under subchapter L in several meaningful ways. First, it eliminates the possibility of a net deduction to the ceding company, and, correspondingly, precludes net income to the reinsurer, as a result of the actual reinsurance premium for the transaction exceeding the tax reserves for the reinsured contracts. Second, although that provision takes into account the actual ceding commission paid by the reinsurer to the ceding company in determining the consideration to be allocated under reg. section (b), the amount given effect for purposes of subchapter L is the deemed ceding commission determined under the residual method specifically, the amount of consideration allocated to the reinsured contracts as Class VI assets. Under this approach, there may be little or no consideration allocated to the ceding commission. Third, in a reinsurance or retrocession transaction involving specified insurance contracts, the two preceding points will affect the net consideration taken into account for purposes of the capitalization rules of section 848. Importantly, as discussed below, reg. section (c)(5) does not operate to convert an applicable asset acquisition involving indemnity reinsurance into one involving assumption reinsurance. Rather, it merely directs that the hybrid rules resulting from the incorporation of the applicable principles of reg. section (a) through (d) into the allocation rules of reg. section (c)(1) through (4) be applied equally to applicable asset acquisitions involving assumption reinsurance or indemnity reinsurance. Table 2 above offers a summary of the federal income tax consequences of an applicable asset acquisition involving the reinsurance or retrocession of specified insurance contracts between life insurance companies. III. IRS s Flawed Analysis in ILM ILM describes a transaction in which the taxpayer acquired a life reinsurance business by purchasing the workforce and other assets associated with that business and entering into a retrocession agreement that passed to the taxpayer 100 percent of the liabilities, as well as premiums and other payments, associated with several reinsurance agreements involving what appear to be specified insurance contracts. The acquisition was structured as an indemnity retrocession transaction under which the selling company remained directly liable to the underlying ceding companies for the retroceded reinsurance agreements, rather than an assumption reinsurance transaction in which the taxpayer would have become directly liable to the 284 TAX NOTES, April 20, 2015

9 underlying ceding companies. The indemnity retrocession agreement included a covenant by the seller to use commercially reasonable efforts to novate the retroceded reinsurance agreements to the taxpayer after the closing. While the exact facts of the transaction at issue in ILM are unknown, it appears that all the retroceded reinsurance agreements eventually were novated to the taxpayer at various points following the closing and, correspondingly, the taxpayer did become directly liable to the underlying ceding companies. 61 The taxpayer treated the acquisition transaction as an applicable asset acquisition under section Because the retrocession transaction took the form of indemnity reinsurance, the taxpayer immediately deducted the entire ceding commission that it was deemed to receive under the residual method offered by reg. section (c)(5). On audit, the IRS exam team challenged the current deduction claimed by the taxpayer for the Excess Amount (that is, the portion of the deemed ceding commission exceeding the amount capitalized by the taxpayer under section 848(a)(1) in connection with the retrocession transaction). In so doing, the IRS exam team asserted that, because the retrocession transaction occurred in an applicable asset acquisition, the taxpayer should be required to capitalize the Excess Amount and amortize that amount over 15 years under section 197 regardless of the fact that the retrocession transaction did not take the form of assumption reinsurance. In its analysis of the IRS exam team s position, ILM asserts that, because reg. section (c)(5) incorporates the applicable principles of reg. section (a) through (d) into the allocation rules of reg. section (c)(1) through (4) for an applicable asset acquisition involving a reinsurance or retrocession transaction, section 1060 acquisitions are hypothetical assumption reinsurance transactions. ILM further asserts that the rules describing the residual method are clear that an indemnity reinsurance contract is a Class VI, section 197 intangible. In view of these assertions, ILM ultimately upholds the IRS exam team s position that the taxpayer should be required to capitalize the Excess Amount and amortize that amount over 15 years using section 197 even though the retrocession transaction did not take the form of assumption 61 In view of these facts, ILM hints at the prospect of treating the indemnity retrocession transaction at issue as a constructive assumption reinsurance transaction for federal income tax purposes. However, ILM ultimately bases its conclusion on the analysis described below. COMMENTARY / SPECIAL REPORT reinsurance. This misguided conclusion should be rejected for the reasons discussed below. Despite the assertion of ILM , reg. section (c)(5) does not operate to convert an applicable asset acquisition involving indemnity reinsurance into one involving assumption reinsurance. 62 Keep in mind that reg. section provides rules that apply when an election under section 338 is made for an insurance company target. 63 In that situation, there is no actual reinsurance transaction that occurs; rather, there simply is an acquisition of the stock of the target insurance company. Consequently, a mechanism is needed to account for the deemed asset sale that results from the section 338 election. To fill this gap, reg. section (c)(1) provides that (1) the deemed sale of insurance contracts is treated as an assumption reinsurance transaction for federal income tax purposes, and (2) the relevant provisions of subchapter L apply in determining the federal income tax consequences resulting from that deemed assumption reinsurance transaction. Reg. section (a) reinforces this construct by providing that the rules of reg. section trump any other conflicting provisions of the code or Treasury regulations when a section 338 election is made for an insurance company target. In contrast, in an applicable asset acquisition involving a reinsurance or retrocession transaction, it is unnecessary to overlay any artificial mechanism on the asset transfer that actually takes place. Rather, as the IRS recognized in FSA , Other commentators have reached similar conclusions. See, e.g., Cliff Gross and Jessica Hough, Certain Tax Issues in M&A Transactions Involving Insurance Companies, in Strategies for Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings, ch. 184, at , n.13 (2014) ( Treas. Reg. section (c)(5) provides a cross-reference to Treas. Reg. sections (a)-(d). However, this crossreference should not automatically convert an indemnity reinsurance transaction that is part of a Section 1060 applicable asset transaction into an assumption reinsurance agreement for U.S. federal income tax purposes...we believe the better view is that the cross-reference in the Section 1060 Treasury Regulations to the Section 338 Treasury Regulations should be read as providing for a purchase price allocation under the Section 338 Treasury Regulations and not requiring an indemnity reinsurance that is part of an applicable asset acquisition to be treated as assumption reinsurance for Section 197 purposes. ); see also Seth L. Rosen et al., IRS Counsel s Memorandum Challenges Deductibility of Ceding Commission for Indemnity Transaction, at 4 (Jan. 6, 2015), available at ology.com ( The regulations under section 1060 do not support the view that the section 1060 rules governing allocation of consideration transform an indemnity reinsurance contract into assumption reinsurance for purposes of section 197. ). 63 Reg. section (a). 64 FSA is dated September 20, 2001, and was released to the public on November 2, Like ILM (Footnote continued on next page.) TAX NOTES, April 20,

10 COMMENTARY / SPECIAL REPORT the actual form of the transaction, whether it be assumption reinsurance or indemnity reinsurance, should be given effect in that situation for purposes of determining its federal income tax consequences, including those afforded by subchapter L. In FSA , the IRS considered a situation involving the purchase by a life insurance company of the business of another life insurance company through an applicable asset acquisition. As part of the transaction, the taxpayer reinsured a block of the selling company s existing insurance policies through an indemnity reinsurance agreement. At issue in the memorandum is how the taxpayer should determine its basis in the ceding commission it paid to the seller as part of the total cash consideration for the seller s business. In its analysis, the IRS acknowledged and accepted the taxpayer s immediate deduction of the ceding commission in accordance with section 848(g). As previously noted, section 848(g) provides: Nothing in any provision of law (other than this section or section 197) shall require the capitalization of any ceding commission incurred on or after September 30, 1990, under any contract which reinsures a specified insurance contract. [Emphasis added.] Although section 848(g) does not draw an explicit distinction between indemnity reinsurance and assumption reinsurance, it does so by its inclusion of a cross-reference to section 197, which does include that distinction. As discussed above, section 197(f)(5) requires a reinsurer to take into account, under section 197(a), any amortizable section 197 intangible resulting from an assumption reinsurance transaction, to the extent that the amount paid or incurred by the reinsurer under the assumption reinsurance transaction exceeds the amount required to be capitalized under section 848(a)(1) in connection with that transaction. Significantly, the legislative history to section 197(f)(5) emphasizes that the provision does not apply to indemnity reinsurance transactions: The bill applies to any insurance contract that is acquired from another person through an assumption reinsurance transaction (but not through an indemnity reinsurance transaction). 65 [Emphasis added.] Consistent with this legislative history, reg. section (g)(5)(i) provides that, for purposes of section 197(f)(5): , this memorandum was prepared by an attorney in branch 4 of the IRS Office of Associate Chief Counsel (Financial Institutions and Products). 65 H.R. Rep. No , at 688 (1993) (Conf. Rep.). an assumption reinsurance transaction is defined by reference to reg. section (a)(7)(ii), 66 which explicitly excludes indemnity reinsurance from that definition; and the transfer of a reinsurance contract by one reinsurer to another reinsurer is treated as an assumption reinsurance transaction only if the transferor s obligations are extinguished. 67 As a result of the enactment of sections 848(g) and 197(f)(5) in 1990 and 1993, respectively, and the corresponding amendment to section 848(g) in 1993, the code itself establishes that, when a ceding commission is incurred by the reinsurer in an applicable asset acquisition involving indemnity reinsurance of specified insurance contracts, the reinsurer may deduct the entire amount of that ceding commission currently. 68 Reg. section (c)(5) buttresses this conclusion by recognizing that amortizable section 197 intangibles do not arise from an indemnity reinsurance transaction that is part of an applicable asset acquisition. 69 That section provides, in a transaction governed by section 1060, an insurance contract is a Class VI asset regardless of whether it is a section 197 intangible. This quoted language would be unnecessary if, as ILM claims, all insurance (and reinsurance) contracts involved in an indemnity reinsurance transaction constitute section 197 intangibles. Thus, contrary to the assertion 66 See supra note 2; see also supra note Cf. H.R. Rep. No , at 688, n.25 (1993) (Conf. Rep.) ( An assumption reinsurance transaction is an arrangement whereby one insurance company (the reinsurer) becomes solely liable to policyholders on contracts transferred by another insurance company (the ceding company). ). 68 Cf. ILM ( Congress intended that expenses associated with the acquisition of a stream of income from premiums are to be capitalized as specified policy acquisition expenses. In section 848(g), Congress specified that section 848 controls the treatment of ceding commissions on reinsurance (emphasis added).). Like ILM and FSA , ILM was prepared by an attorney in branch 4 of the IRS Office of Associate Chief Counsel (Financial Institutions and Products). Other commentators have reached similar conclusions. See, e.g., Gregory L. Stephenson et al., Mapping the Code: FSA Successfully Orders Subchapter L and Tax Provisions of General Applicability, 22 Ins. Tax Rev. 47, 55 (2002) ( Current law...mandates that ceding commissions paid in a transaction under 1060, and which are incurred under an indemnity reinsurance arrangement, are currently deductible ); see also Rosen et al., supra note 62, at 1 ( The CCA s conclusion contradicts section 848(g), which says explicitly that nothing in any provision of law other than section 848 and section 197 (which does not apply to indemnity reinsurance transactions) shall require the capitalization of a ceding commission paid in connection with a reinsurance agreement that reinsures life, annuity and noncancellable accident and health insurance contracts. ). 69 See supra text accompanying note TAX NOTES, April 20, 2015