ABA Tax Section Insurance Companies Committee 1 Important Developments Update January 20, 2017

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1 ABA Tax Section Insurance Companies Committee 1 Important Developments Update January 20, 2017 The chairs of the subcommittees of the Insurance Companies Committee have summarized the following important updates from 2016 with respect to life insurance companies, life insurance and annuity products, property and casualty companies, captive insurance companies, and Subchapter C and M&A. The summaries address recent Treasury Regulations, IRS guidance and other determinations, court rulings, and key state developments. The Committee will continue to monitor future developments that are relevant to Committee members. Life Insurance Companies 1. Section 807(f) Change in Basis In Field Attorney Advice (FAA) F (June 7, 2016), the Internal Revenue Service ( IRS or Service ) concluded that if the tax reserve for an annuity rider is limited by the statutory reserves cap under section 807(d)(1), 2 a change in the method of computing statutory reserves is a change in basis. Therefore, according to the IRS, such a change is subject to a ten year spread under section 807(f). In the FAA, the taxpayer is a parent of a life-nonlife consolidated group, one member of which marketed annuities that included a particular rider. Both statutory and tax reserves for the annuities were governed by Actuarial Guideline 33, Determining CARVM Reserves for Annuity Contracts with Elective Benefits (AG 33). The taxpayer misapplied AG 33 resulting in an understatement of both statutory and tax reserves in Years 1-3, which it corrected in Year 4. Specifically, for tax return purposes, the taxpayer filed amended tax returns for Years 2 and 3 claiming there was a change in the basis of computing the Federally-prescribed reserve for those years. However, the amended return reflected no change to the tax liability because the Federally-prescribed reserve was capped by the statutory reserves shown on the originally-filed annual statement. In the fourth year, the statutory reserves cap lifted, and the taxpayer recognized a current year deduction for the full amount. The FAA concludes that the change in statutory reserves in the fourth year was a change in basis subject to section 807(f). Accordingly, the adjustment resulting from that change was required to be recognized ratably over ten years. 1 Many thanks to Mark Smith of PricewaterhousCoopers, Alison Peak of Davis & Harman, Eric Miller of AIG, and Chris Schoen of Sutherland for their summaries of relevant developments. 2 Unless otherwise stated or clear from context, all section references are to the Internal Revenue Code of 1986, as amended, 26 U.S.C.

2 The general tax rule governing a change in method of accounting under Treas. Reg. section (e)(2)(ii)(a) provides that a change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. The regulations further provide that a material item is an item that changes the taxable year in which the taxable income or tax deduction is reported. For purposes of deciding whether there is a change in the basis for determining life insurance reserves, section 807(f) is a more narrow application of the general rule for changes in method of accounting. Revenue Ruling 94-74, C.B. 157, provides that the term basis in section 807(f) is interchangeable with the term method under section 446 when describing a change in basis in computing reserves. The IRS has equated changes in basis for computing reserves with changes in method of accounting in other circumstances as well. The FAA expressed concern that even though the taxpayer claimed to have changed its method of computing the Federally-prescribed tax reserve by filing amended tax returns, the changes were not reflected on the returns because the tax reserves were still limited by the statutory reserves in those years. Until the statutory reserves also were corrected, deductible tax reserves would continue to equal the original statutory reserves on the taxpayer s tax returns. Under this circumstance, the FAA concluded that both the method for computing the Federally-prescribed reserve and the method for computing the statutory reserves are components of the accounting method for reserves. Therefore, changes to either method would constitute a change in basis under section 807(f). Applying this logic to the taxpayer s facts, the FAA concluded that there were two changes in basis over the course of the four years. The first change in basis occurred when the taxpayer changed the method for computing the Federally-prescribed reserve on its amended returns for Years 2 and 3. Because the Federallyprescribed reserve still was capped, the FAA concluded that the section 807(f) adjustment amount was zero for that change. The second change in basis occurred in the fourth year when the new method for computing the statutory reserves was effected and the statutory financial statement reflected the correctly computed reserves. The FAA concluded that the increase in statutory reserves based on this change was a change in basis under section 807(f), required to be spread over ten years. In reaching this conclusion, the FAA rejected two arguments presented by the taxpayer. First, the taxpayer looked to the 1984 Act Blue Book, which provides that only a change in the Federally-prescribed reserve, and not a change to net surrender value, is a change in basis because net surrender value is not considered a reserve. Second, the taxpayer argued that a change in the determination of statutory reserves is not a change in basis because the statutory reserves that serve as a cap are not computed or determined the way the Federally-prescribed reserve is computed or determined. Rather they are a limitation, a number lifted from the annual statement. The FAA disagreed. Some taxpayers have taken positions consistent with the analysis of the FAA and some have taken positions inconsistent with its analysis. For this reason, the FAA will likely generate 2

3 controversy among companies and in examination. Regardless of its merits, the FAA will cause companies to consider more carefully whether particular changes in the computation of reserves are changes in basis, and what additional facts might be relevant to that determination. 2. Capitalization of Ceding Commissions in Excess of DAC CCA (June 29, 2016) concluded that a taxpayer was not entitled to a current deduction for ceding commissions in excess of the amount required to be capitalized as deferred acquisition costs (DAC) under section 848. In doing so, the CCA revised the analysis but not the conclusion of CCA (Sept. 4, 2014), which generated significant controversy two years ago. In the CCA, Subsidiary is a life insurance company wholly owned by a parent holding company. As part of a master asset purchase agreement, Subsidiary bought certain assets in Seller s life reinsurance business through a section 1060 applicable asset acquisition and entered into a retrocession agreement with Seller whereby Subsidiary agreed to assume the life reinsurance agreement liabilities on a 100% coinsurance indemnity basis. Both Subsidiary and Seller agreed to use commercially reasonable efforts to obtain executed novation and release agreements. Upon the receipt of these documents, Subsidiary agreed to extinguish Seller s obligations to Subsidiary and assume all the liabilities as the reinsurer under the contracts. The master asset purchase agreement did not specify a completion date for the novation and the release agreements, but all the contracts were eventually novated and release agreements were obtained three years after the transaction. In general, section 848 requires the capitalization of a portion of a company s general deductions equal to a percentage of the net premiums on specified insurance contracts. Amounts capitalized include consideration under reinsurance contracts, and are recovered over a 10-year period. Section 848(g) states that nothing in any provision of law (other than section 848 or section 197) shall require the capitalization of any ceding commission... under any contract which reinsures a specified insurance contract. Section 197 permits a deduction for amortization of certain intangibles. Treas. Reg. section (g)(5)(i) states that section 197 generally applies to insurance and annuity contracts acquired from another person through an assumption reinsurance transaction. The amount taken into account is generally the excess of the amount paid over the amount required to be capitalized under section 848. As a result of the limitation in section 848(g), only amounts in connection with an assumption reinsurance transaction (and NOT amounts in connection with an indemnity reinsurance transaction) are subject to capitalization. The CCA concluded that the transaction at issue was an assumption reinsurance transaction, based on the fact that the transaction anticipated the underlying contracts would be novated to Subsidiary, even though those novations did not in fact take place until a later taxable year. As a result, ceding commissions in excess of the DAC amount were required to be capitalized. 3

4 CCA reached the same conclusion with regard to the same transaction, but based on a different analysis. According to that CCA, the transaction at issue was a section 1060 transaction and, because under regulations such a transaction involves a hypothetical assumption reinsurance transaction, section 848(g) could not prevent ceding commissions in excess of the DAC amount to be capitalized under Treas. Reg. section (c)(5). The 2015 CCA did not explicitly characterize the transaction at issue as an assumption reinsurance transaction, and was criticized for appearing to disregard section 848(g). 3. Revocation of Interest Rate Election under Section 807(d)(4) In PLRs (July 1, 2016) and (Aug. 5, 2016), the Service permitted two taxpayers to revoke longstanding elections they had made under section 807(d)(4)(A) to recompute the interest rate used in computing the Federally-prescribed reserve under section 807(d). Under section 807(d), the deductible life insurance reserve with regard to a contract is equal to the Federally-prescribed reserve, subject to a floor (the contract s net surrender value) and a cap (the statutory reserves with regard to the contract). The interest rate used for purposes of computing the Federally-prescribed reserve is the greater of the prevailing state assumed interest rate or the applicable federal rate (AFIR), determined as of the time the contract is issued. Section 807(d)(4)(A) provides an election under which a company may recompute the Federal interest rate every five years for purposes of computing life insurance reserves. Such an election, once made, applies to all contracts issued during the calendar year for which the election is made, and for any subsequent year, unless the election is revoked with the consent of the Secretary. Section 807(d)(4)(A) does not prescribe the mechanics for revoking such an election. In both PLR and PLR , the taxpayers requested permission to revoke the election so that contracts with respect to which there had not yet been a recomputation of the AFIR will not be required to undergo a recomputation of the AFIR. According to both PLRs, the proposed revocations would not affect the computation of reserves with respect to previously-written contracts. Both taxpayers represented they would not make a new election under the provision for at least ten taxable years following the year in which the revocation takes effect. The number of companies with this election in place is small. Persistently low interest rates, however, and the likelihood that rates will eventually rise in future years have drawn attention to the provision. 4. IRS Continues Work on Computation of Tax Reserves under Life PBR The IRS recently published Notice , I.R.B. 683, to address the status of the 2017 CSO mortality tables as prevailing tables under section 7702 by reason of the adoption of those tables as part of the implementation of Life PBR. More tax guidance will be needed in connection with the implementation of Life PBR. Specifically, in addition to issues under section 7702, the industry has requested guidance on transition issues that arise as a result of the implementation of Life PBR, and on substantive 4

5 reserve issues that likewise will arise. Both categories of issues will be discussed in the Life PBR panel at the January 17 meeting of the Insurance Companies Committee. With regard to transition issues, some companies have asked, for example, whether a company that permissibly delays implementation of Life PBR for statutory purposes may consistently delay implementation for tax purposes as well. Other companies have asked about the status of companies that are wholly excused from Life PBR based on their size, and the status of companies that operate in only one state and permissibly are not applying Life PBR for tax purposes. Still others have asked about the treatment of companies that operate only in one or more states that have not adopted Life PBR. It is our understanding that the IRS is aware of these issues and actively studying them. Substantive reserve issues also have been the subject of dialogue between the IRS and industry over the past decade, and the IRS continues to study those. The need for guidance will become more urgent with some companies implementing as early as January 1, 2017 for statutory accounting purposes. One recent development may bear on these issues. A number of companies, together with ACLI, have approached IRS requesting Industry Issue Resolution ( IIR ) for issues that arise under AG 43 and either are not addressed or produce unanticipated results under Notice , I.R.B It is expected that such an IIR process could unavoidably also involve dialogue around Life PBR. There is little to report yet on that effort, as the process is in its very early stages. Life Insurance and Annuity Products 1. Reasonable Mortality Charges Notice provides rules interpreting the reasonable mortality charge requirement of section 7702(c)(3)(B)(i) by providing safe harbors regarding the use of the 1980 CSO, 2001 CSO, and 2017 CSO mortality tables. The Notice makes several modifications to Notice , C.B It provides safe harbors regarding the use by taxpayers of the 2017 CSO tables for purposes of the reasonable mortality charge requirement. In general, the Notice provides that a mortality charge with respect to a life insurance contract will satisfy the requirements of section 7702(c)(3)(B)(i) so long as (1) the mortality charge does not exceed 100 percent of the applicable mortality charge set forth in the 2017 CSO tables; (2) the mortality charge does not exceed the mortality charge specified in the contract at issuance; and (3) either (a) the contract is issued after December 31, 2019, or (b) the contract is issued before January 1, 2020, in a state that permits or requires the use of the 2017 CSO tables at the time the contract is issued. The Notice also provides that if the only change to an existing contract is a reduction or deletion of benefits provided under the contract, such a change will not affect the determination of the issue date of the contract for purposes of the reasonable mortality charge safe harbor. Finally, the Notice provides that changes, modifications, or exercises of contractual provisions include reinstatement of a contract as required under applicable state or foreign law. 5

6 2. Annuity Guidance under Section 72 The IRS issued Revenue Procedure , I.R.B. 1160, and Notice , I.R.B. 1068, which provide guidance on amounts received as an annuity under section 72. The Notice provides guidance on the treatment under section 72 of payments made under a defined benefit plan during phased retirement and in particular whether the payments are amounts received as an annuity. Revenue Procedure provides that the manner in which the terms annuity starting date and amounts received as an annuity are applied in Notice does not apply to nonqualified annuities. It also provides that the possibility of further contributions to the contract or a subsequent election under the contract to receive the benefit payable under the contract in a different manner generally will not affect the determination of whether payments are amounts received as an annuity. 3. Diversification Rules Allow Government Money Market Funds Notice , I.R.B. 1, provides guidance under the section 817(h) diversification rules for segregated asset accounts that invest in government money market funds ( MMFs ). The Notice states that variable contracts should be able to offer government MMFs as an investment option and that Treasury and the IRS intend to amend Treas. Reg. section In the meantime, taxpayers may rely on an alternative diversification requirement under Treas. Reg. section for a segregated asset account that invests in a government MMF. In this regard, a segregated asset account within the meaning of Treas. Reg. section (e) is adequately diversified for purposes of section 817(h) if (1) no policyholder has investor control; and (2) either (a) the account itself is a government MMF under SEC Rule 2a 7(a)(14); or (b) the account invests all of its assets in an investment company, partnership, or trust as defined in Treas. Reg. section (f)(1) that satisfies the criteria of Treas. Reg. section (f)(2) and qualifies as a government MMF under SEC Rule 2a 7(a)(14). 4. Partial Annuitization PLR (May 3, 2016) addresses the partial annuitization rules of section 72(a)(2) in the context of a deferred income annuity rider that will be added to a non-qualified deferred variable annuity contract. The owner will transfer some or all of the contract s value to the rider, which will result in life annuity payments commencing on a specified future date. The payments may commence from the rider while the contract otherwise remains in a deferred status. The IRS concluded that section 72(a)(2) will apply each time a partial annuitization is made. Such partial annuitization will give rise to a separate contract for purposes of section 72. Each separate contract will be allocated a pro rata portion of the investment in the contract based on the percentage of account value transferred and will have its own annuity starting date for purposes of section 72. 6

7 5. Tax-deferred Exchanges of Annuities under Section 1035 PLR (Mar. 16, 2016) addresses an attempted section 1035 exchange of annuity contracts. The taxpayer was a beneficiary under an inherited non-qualified annuity contract who wanted to exchange the contract for a new one. The taxpayer mistakenly submitted a withdrawal request form rather than an exchange request form, causing the total cash value to be deposited into his checking account. Attempting to correct the mistake, the taxpayer applied the amount towards the purchase of a new annuity contract. Under these facts, the IRS concluded that the transaction did not qualify for non-recognition treatment under section In addition, the lump sum payment from the original annuity contract was taxable under section 72(e) in the year received. In reaching its conclusions, the IRS cited Revenue Ruling , C.B. 1282, which involved a taxpayer endorsing a check representing a surrender of an old non-qualified annuity policy to a second insurance company as consideration for a new non-qualified insurance contract. The IRS noted that, unlike the rollover rules that apply to qualified retirement plans, neither section 1035 nor the regulations thereunder provide for the purchase of a non-qualified annuity contract with amounts distributed from another non-qualified annuity contract. Property and Casualty Companies 1. Self-insurance Risk Pools In Non Profit Insurance Program v. United States, 2016 WL (E.D. Wa. 2016) (Apr. 28, 2016), a self-insurance risk pool consisting of Washington State non-profit organizations (the Pool ) was denied federal tax exempt status in a summary judgment motion granted by the U.S. District Court to the IRS. The Pool had argued that it should be treated as a tax-exempt entity either as an integral part or a section 115 instrumentality of Washington State. The Pool s key argument was that it was regulated the same as local government insurance pools in the state which were instrumentalities under Revenue Ruling 90-74, C.B. 34. The District Court dismissed that argument because the Pool was not managed by the state and its income did not benefit any state entities only private non-profit entities. Similarly, arguments that non-profit entities provide services similar to governmental entities were not seen as sufficient to fulfil the technical requirements of the statute and case law. The District Court also held that the Pool was not an integral part because it was financially independent and there was no state control except for routine oversight by the state s insurance regulator. The plaintiffs were apparently seeking either to expand the case law under section 115 to encompass non-profit organizations or to avoid a failure to pay an estimated tax penalty under section 6654(a). They lost on both grounds as the District Court did not regard the Plaintiffs as having any persuasive authority that could mitigate the penalty. 2. Uncollectible Re The IRS released a legal memorandum, ILM (July 1, 2016), discussing the deductibility of losses arising from the lack of collectability of deductible layer reimbursements. The memorandum concludes that the proper treatment is to take a bad debt deduction under 7

8 sections 166 and 832(c)(10) at the point when the insurer actually pays the claim based on the assumption that a liability for the deductible only arises at that point. The issue arises in high deductible policies such as worker s compensation where the insurer is required by state law to pay claimants on a first dollar basis but the actual policy includes a large deductible layer. When an insured goes into financial distress such that the deductible may not be collectible, statutory accounting generally requires a supplemental reserve be established for the amount that may be uncollectible. The memorandum stated that where the deductible layer amount was not included in gross premium written, the taxpayer is not permitted to include in losses incurred the supplemental reserve for federal income tax purposes. Instead the deduction would be timed at the actual claims payment because prior to Taxpayer s payment of a claim, Taxpayer does not have an enforceable claim to reimbursement. It is not clear from the memorandum what position the IRS would take if the terms of the insurance contract made reimbursement (or collateral increases) mandatory at a point prior to claims payment. 3. Surplus Lines Insurers The New York State Department of Taxation and Finance issued two advisory opinions, TSB-A- 16(4)C and TSB-A-16(5)C (June 10, 2016), stating that surplus lines insurers are subject to state insurance franchise (corporate) tax rather than premiums tax. This conflicts with authorized P&C companies in New York which are subject only to premium tax. Surplus lines or nonadmitted insurance in New York is subject to a 3.6% premiums tax imposed on brokers or insureds. The advisory opinions would also require surplus lines insurers to subject an allocable portion of their net income or capital bases to New York State franchise tax. The opinions are based on a New York Tax Appeals Tribunal ruling which is currently under appeal so it is not yet known how these opinions will hold up to court challenge. For example, there is some question of whether or not New York State s position conflicts with the federal Nonadmitted and Reinsurance Reform Act which limits out of state premium taxation. It is also unclear the extent to which surplus lines insurers in New York could argue that they do not have sufficient nexus or presence in New York to subject themselves to corporate taxation in that state as that fact is assumed in the rulings and the underlying tax case. Captive Insurance Companies 1. Notice , modified by Notice In Notice , I.R.B. 745, issued November 1, 2016, the Treasury and IRS designated certain insurance transactions as Transactions of Interest, which triggers filing requirements on both participants and material advisors under sections 6111 and See Treas. Reg. section (b)(6). Failure to file carries substantial penalties. The details are more complex, but generally the Transaction of Interest is one that is the same, or substantially similar to: 8

9 (a) A, or a related person, owns 20% of the insured and a Captive insurance company electing to be taxed under section 831(b). (b) The Captive has less than a 70% loss ratio over a 5-year period, or Captive has loaned, pledged, etc. its assets to A or a related person within the last five years in a non-taxable transaction. The Notice states that the Treasury and IRS recognize that related parties can use insurance companies that elect section 831(b) that do not involve tax avoidance, but believe that some arrangements are improper. The IRS believes it lacks sufficient information to identify those transactions used for tax avoidance, or define the characteristics to distinguish tax avoidance transactions from others. The IRS is concerned about policies that: cover implausible risk, do not match a risk of the Insured, are vague, or duplicate commercial coverage. It is also concerned about payments designed for a deduction of a particular amount, that don t have proper actuarial or underwriting support, are not made timely, are accepted without comparison to the market, exceed the market and/or are improperly allocated among insureds. The IRS is also concerned with a Captive that does not meet regulatory requirements, doesn t timely issue policies or binders, or has inadequate claims administration; it is also concerned if the insured doesn t file a claim for each covered loss. Finally, the IRS is concerned if the Captive has inadequate capital for the risks assumed, invests in illiquid or speculative assets not usually held by insurance companies, or loans or transfers capital to affiliates. Persons entering into a Transaction of Interest, and material advisors that make a tax statement and exceed the threshold, after November 2, 2006, must disclose the transaction (material advisors must also keep a list). The Captive, Insured(s), Pass-Through Owners and Fronting Company, if any, must report on Form 8886 by May 1, 2017, (originally January 30, 2017). Material Advisors must also report by May 1, All participants must describe the transaction in sufficient detail to understand the structure and the parties involved, including when and how the taxpayers became aware of the transaction. The Captive must also identify (1) whether it is reporting because of a less than a 70% loss ratio, (2) a loan, pledge, non-taxable transfer, etc. to an affiliate, or (3) both; (2) its domicile; (3) all coverage provided during the year(s) of participation; (4) how premiums were determined, including the name and contact information of any actuary or underwriter; (5) the claims paid and reserves; and (6) Captive s assets, including securities, loans, real estate, partnerships or joint ventures, and identify of related parties transactions with respect to those assets. The IRS also invited comments on how the transaction might be addressed in published guidance by January 30, PLR In PLR (Dec. 23, 2016), the IRS determined that two insurance companies did not qualify for tax exemption under section 501(c)(15). In PLR , the IRS found that the following were not insurance risks, nor insurance in the commonly accepted sense: (1) tax 9

10 liability insurance, (2) punitive wrap lability insurance, (3) regulatory changes, (4) expense reimbursement of crisis management public relations expenses, (5) involuntary loss of services from two employees, (6) excess intellectual property package policy, (7) general liability gap insurance policy, (8) loss of major client insurance, and (9) legal expense insurance policy. The IRS also did not know what risks were reinsured in a reinsurance program, but suspected they were not insurance risks. A coinsurance program reinsured risks on vehicle service contracts, but the IRS did not know the risks being insured and reinsured. The IRS believed the policies were not based on actuarial calculation and factors, and were overpriced. The IRS concluded there was no risk distribution and the risks were too heavily concentrated on a simply policyholder. PLR (Nov.; 4, 2016) was similar. Subchapter C and M&A 1. Proposed and Final Section 385 Regulations On April 4, 2016, Treasury and the IRS released proposed regulations (the Proposed Regulations ) under section 385, which concerns the treatment of corporate interests as stock or indebtedness. According to the preamble to the regulations, the rules were intended to combat Treasury s perceived concerns associated with what Treasury refers to as excessive indebtedness between related entities within a corporate group. The Proposed Regulations encompassed three discrete sets of rules. The first set of rules, (the Bifurcation Rules ), provided that the Service could treat certain debt instruments between related parties within large corporate groups as part indebtedness and part stock. The second set of rules (the Documentation Rules ) required large corporate groups to produce and retain certain documentary evidence for a related party instrument to be treated as debt. The third set of rules (the General and Funding Rules ), which received the most attention, automatically recharacterized debt that was used in certain types of transactions as equity. Such transactions included (1) a distribution of a debt instrument to a related-party shareholder, (2) the use of a debt instrument to purchase stock of a related entity, and (3) the use of a debt instrument in an internal asset reorganization under the Code. The rule provided that if a related-party instrument is issued with a principal purpose to fund a distribution or acquisition that would have been a Covered Transaction if debt were used, the instrument will be recharacterized as equity to the extent of the funding. The Funding Rule also provided a non-rebuttable presumption that a debt instrument is issued with a principal purpose of funding a distribution or acquisition if it is issued by the funded member during the period beginning three years before that entity makes a distribution or acquisition and ending three years after the issuance of the distribution or acquisition (the Presumption Period ). The proposed regulations led to hundreds of responses, among which was a major comment paper from the ABA Tax Section with substantial contributions from the Insurance Companies Committee. The final and temporary regulations, which were issued on October 13, 2016, greatly narrowed the scope of these rules. The Bifurcation Rules were removed in their entirety from the Final Regulations, although the preamble to the regulations indicated that Treasury continues to study the issue. The Documentation Rules generally survived with modifications, but their effective 10

11 date was postponed until January 1, The General and Funding Rules became subject to significant exceptions, most notably by excluding foreign borrowers, which greatly narrowed the scope of the section 385 regulations. In response to comments from the insurance sector (including from the Insurance Companies Committee), the regulations include an exclusion for Regulated Insurance Companies. A Regulated Insurance Company is a corporation that (1) is subject to tax under subchapter L; (2) is domiciled in a state or the District of Columbia; (3) is licensed to sell insurance, reinsurance or annuity contracts to persons other than related persons; and (4) is engaged in regular issuances (or subject to liability with respect to) insurance, reinsurance, or annuity contracts with persons that are not related persons. The preamble indicates that the definition of Regulated Insurance Company was designed to exclude most captives. 2. Section 355 Developments In July 2016, Treasury and the IRS issued proposed regulations on the active business and device elements of section 355. The IRS indicated that it was necessary to provide objective guidance on these requirements. To this end, the proposed regulations set up per se tests on active business and device. With respect to active business, an active business does not satisfy the active trade or business ( ATB ) test unless the active business represents five percent in total of the assets of the corporation. With respect to device, if either Distributing or Controlled has a nonbusiness asset percentage above certain levels and the other party to the transaction had a significantly lower nonbusiness asset percentage, then the distribution is automatically a device, unless it meets a safe harbor for a distribution not considered to be a device (e.g., no earnings & profits, distributions would be entitled to dividends-received deduction, etc.). The regulation s emphasis on business versus nonbusiness assets could raise questions with respect to insurance company assets, which are largely marketable securities. On December 19, 2016, Treasury and the IRS issued temporary regulations regarding whether a distributing or controlled corporation is a predecessor or successor for purposes of section 355(e). The temporary regulations differ in marked ways from proposed regulations that had been issued in Most critically, a corporation will only be a predecessor of the distributing corporation if the transaction that occurred that raised the predecessor issue was part of a plan with the subsequent section 355 transaction. 3. Temporary and Proposed Section 901(m) Regulations On December 6, 2016, the Treasury and the IRS issued temporary and proposed regulations under section 901(m). Section 901(m) denies a foreign tax credit that arises from basis differences in certain covered asset acquisitions. The disqualified portion of any foreign income tax attributable to such basis differences are not creditable; instead, they are permitted as a deduction. The statute includes three categories of transactions that are covered asset acquisitions; the most relevant being a transaction where a section 338 election is made for a foreign target. The proposed regulations add three categories to the definition of covered asset acquisition. The proposed regulations also provide rules for determining the disqualified tax 11

12 amounts and the amount of basis differences, and set out anti-abuse rules. The effective dates for the temporary regulations are complex, but in general the new regulations apply retroactively to the date of the issuance of Notices , I.R.B. 270, and , I.R.B. 388, which was July 21, The regulations will have significant impact on acquisitions of controlled foreign corporations in situations where the parties make section 338 elections. 12