Tax Hedging Policies for Insurance Companies How to Avoid an Expensive Foot Fault

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1 Tax Alert Tax Hedging Policies for Insurance Companies How to Avoid an Expensive Foot Fault August 2015 Insurance companies are in the business of assuming risk for a fee. Fire, casualty, medical expenses, catastrophic weather events, interest rate fluctuations, portfolio crashes all of these may be insured. In order to insulate themselves from the risks that they assume, insurers buy protection at wholesale prices, by entering into economic hedges. Most insurers have an accounting policy in place that describes the proper method of treating these transactions for financial accounting purposes. However, many insurance companies do not have a tax hedging policy in place. Lack of a proper policy for the identification of tax hedging transactions raises risks of increased tax expense through deferred loss recognition, character and timing mismatches, and phantom income inclusions from foreign subsidiaries. These risks can be mitigated through the implementation of an effective policy for the identification and/or integration of tax hedging transactions. 1) Tax Hedging Transactions and Economic Hedges All tax hedging transactions are economic hedges, but not all economic hedges are tax hedging transactions. In order to be a general business tax hedging transaction, a transaction must have the following three features: > The transaction must be entered into in the ordinary course of the taxpayer s trade or business; > The transaction must be entered into to manage risk with respect to ordinary property or an ordinary obligation. For these purposes, ordinary property is property the disposition of which gives rise to ordinary income or loss. A hedge of a capital asset (say, a portfolio of stock purchased by a life insurer to hedge against pay-out risks) cannot qualify as a tax hedging transaction. However, a hedge of an instrument entered into to hedge the potential gap between the value of an insurer s portfolio and policy liabilities may qualify as a tax hedging transaction; and, > The transaction, the hedged risk, and the hedged item must all be identified. The transaction must be identified GREENBERG TRAURIG, LLP ATTORNEYS AT LAW 1

2 as a hedging transaction on the day on which it is entered into, and the hedged risk and the hedged item must be identified no later than 30 days thereafter. This may be done through the use of an over-arching tax hedging policy. Failure to identify will generally result in capital treatment, although there may be an exemption for inadvertent failures to identify. In addition to the general business tax hedging rules, certain transactions may be integrated with other instruments in order to be treated as a single instrument (so called micro hedges ). The most common instances of these transactions include swaps or forwards entered into by issuers or holders of debt instruments in order to hedge interest rate or FX risk. 2) Timing and Character Mismatches The rules for timing and character of income from the types of transactions typically used to manage risk are often different from the rules for the timing and character of risk-creating transactions. This creates a significant risk of both timing and character mismatches. Instruments used to hedge risk often give rise to capital gain or loss, which cannot be used to offset taxable ordinary gain or loss from business transactions. Similarly, the timing of gain or loss from hedging transactions is determined under the rules applicable to the relevant instrument, which may or may not be consistent with the rules for the timing of the recognition of items from hedged transactions. The effect of the general business tax hedging rules is to recognize a hedged transaction and a hedge as separate transactions, but to match the timing and character of the recognition of income, deduction, gain, and loss on the two transactions with each other. Example 1: A life insurance company issues an equity-linked variable annuity. The customer pays $105 upon entry, and receives the right to the greater of (i) the value of an equity index or (ii) $100 in five years. The insurer hedges its liability under the annuity by entering into a long position in an index futures contract, and by purchasing a put option on the index future with a strike price of $100. Absent proper tax hedging identification, the foregoing would give rise to a timing and character mismatch. The equity-linked annuity would give rise to ordinary income or deduction, and would be accounted for using the method that the taxpayer generally uses to account for liabilities. Gain or loss on the futures contract, and gain or loss on the futures option, would be capital, and would be taken into account using a mark-to-mark accounting. Capital gain on the hedge could not be offset by ordinary loss on the annuity, and vice versa. By contrast, if the futures contract and the put are identified as tax hedging transactions, gain or loss on the hedges will be ordinary, and their recognition will be timed to match offsetting items recognized on the insurance liability. The micro hedging rules operate differently from the general business hedging rules, but they also have the effect of preventing timing and character mismatches. Generally, under these rules, if a qualifying debt instrument and an applicable hedge are identified as two legs of an integrated transaction, they are treated as a single debt instrument for United States federal income tax purposes. Because the two legs are treated as a single transaction, there is no risk of timing or character whipsaws. Example 2: An insurance company purchases a GBP-denominated zero-coupon bond with a five year maturity and a principal amount of 1,000 for In order to hedge the risk of currency fluctuations between the purchase date and the maturity date, the insurance company enters into a forward contract to sell 1,000 for $1,415 on the maturity date of the bond. If the taxpayer does not integrate the forward contract and the debt instrument, the two transactions will give rise to a timing mismatch. 1 Income on the debt instrument will be accrued as OID using a yield-to-maturity method, but gain or loss on the forward contract will be marked to market. However, if the bond and the forward contract are identified as two legs of an integrated transaction, the taxpayer will be treated as having purchased a single USD-denominated zero coupon bond with an issue price of $1, (assuming a spot rate of 1 = $1.415 at inception) and a principal amount of $1, Because the forward contract is a Section 988 transaction, it should give rise to ordinary gain or loss. Section 988(a)(1)(A). GREENBERG TRAURIG, LLP ATTORNEYS AT LAW 2

3 3) The Straddle rules Identification of two transactions as a tax hedging transaction and a hedged item, or as two halves of an integrated debt instrument, also has the effect of turning off the loss deferral rules of Section Under Section 1092, realized loss on one leg of a straddle is deferred to the extent of unrealized built-in gain on the other leg. For these purposes, a straddle consists of offsetting positions in personal property. Since economic hedges are entered into in order to offset risk associated with ordinary property or liabilities, most economic hedges will qualify as straddles, absent proper identification. Example 3: An insurance company holds a portfolio of bonds with varying maturities and coupon rates to finance policy liabilities. In order to hedge portfolio duration, the company enters into a series of interest rate swaptions. The swaptions are terminated at a loss. Policy liabilities are marked to market for United States income tax purposes. Absent identification of the swaptions as tax hedging transactions and the policies as hedged items, the swaptions and the portfolio will be treated as two legs of a straddle. So long as the taxpayer holds the bond portfolio, loss on the swaptions will not be taken into account to the extent of built-in gain on the bond portfolio. This means that there will be taxable gain on the policy liabilities, but no offsetting taxable loss. By contrast, if the swaptions are identified as tax hedging transactions, they will not be treated as a leg of a straddle. This will have the effect of allowing the taxpayer to take gain or loss from the swaptions into account as ordinary gain or loss in a manner that matches the recognition of loss or gain on the policies. 4) The Specter of Subpart F United States shareholders of a so-called controlled foreign corporation (a CFC) are required to include their ratable share of subpart F income of the CFC currently, regardless of whether the CFC distributes this income to its shareholders. Inter alia, subpart F income includes foreign personal holding company income (FPHC). FPHC consists of eight discrete buckets of income, gain, or loss from which cannot offset non-subpart F income or subpart F income or loss from other buckets. One of these buckets is net gain or loss from foreign exchange transactions. However, foreign exchange gain from a qualified business transaction or a qualified hedging transaction does not constitute subpart F income. In order to be a qualified hedging transaction, the following must apply to a transaction: > The transaction must be reasonably necessary to the conduct of regular business operations in a manner in which the business operations are customarily and usually conducted by others; > The transaction must be entered into primarily to reduce the risk of currency fluctuations with respect to property or services sold or to be sold or expenses incurred or to be incurred in transactions that are qualified business transactions; and, > The hedging transaction and the property or expense (or category of property or expense) to which it relates must be clearly identified on the records of the CFC before the close of the fifth day after the day during which the hedging transaction is entered into. Example 4: A domestic insurance company has a foreign subsidiary whose functional currency is the Pound Sterling. The subsidiary issues certain policies that are denominated in euros. To hedge against the risk of currency fluctuations, the subsidiary enters into forward contracts to buy euros. The euro increases in price; there is a gain on the forward contract and an offsetting loss on the policy liability. Absent identification of the forwards as qualified hedging transactions, gain from the forward contracts will be subpart F loss in the foreign exchange bucket. Loss on the policy will be ordinary business loss, which is not subpart F income, and which cannot offset subpart F income. Unless the subsidiary has realized offsetting foreign exchange loss from unrelated transactions during the tax year, the domestic insurance company will be required to include gain from the forward contracts in income for the tax year as subpart F income, even if a corresponding GREENBERG TRAURIG, LLP ATTORNEYS AT LAW 3

4 cash amount is not distributed. By contrast, if the forward contracts are identified as qualified hedging transactions, gain thereon will be treated as non-subpart F business income of the subsidiary, which is not currently includible to the parent, and which may be offset by business losses. 5) Creating An Effective Tax Hedging Policy The one-time cost of putting a tax hedging policy in place is not substantial but the penalty for not doing so can be punitive. Taxpayers who do not have an up-to-date tax hedging policy in place are advised to do so. The process of creating an effective tax hedging policy generally follows the steps described below: > Review the client s business. Which entities are incurring which risks? Which entities are hedging which risks? Is there a central hedging entity, or does each entity hedge its own risks? > Review the accounting hedge policy. This is the best source for information about economic hedges and hedged risks. > Prepare a tax hedging policy. The most user-friendly-way to identify transactions as tax hedging transactions is to put a global identification document in place. This reduces the administrative burden of individual identifications. > Write an M-1 adjustment map. Except in rare instances, the tax and financial accounting treatments of certain hedging transactions will differ. A process for translating from the book treatment of hedging transactions to the correct tax treatment thereof is an essential part of a tax hedging policy. The goal in all cases is to minimize operational risk by reducing the numbers of steps that need to be taken after the initial policy is put in place, and by routinizing the process of book-tax adjustments. This GT Alert was prepared by John Kaufmann. Questions about this information can be directed to: > John Kaufmann kaufmannj@gtlaw.com > Or your Greenberg Traurig attorney GREENBERG TRAURIG, LLP ATTORNEYS AT LAW 4

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