Association of Life Insurance Counsel May 7, 2018 Aditi Banerjee Prudential Bryan Keene Davis & Harman LLP Pete Bautz ACLI
Agenda The Legislative Process Overview and General Tax Reforms Life Insurance Industry Tax Reforms Selected International Tax Reforms Other Implications of Federal Tax Reform State Taxes RBC and Financial Accounting 2
Tax Reform at Lightning Speed Nov. 2 Nov. 9 Nov. 16 Dec. 2 Dec. 20 Dec. 22 Jan. 1 Initial House Bill Initial Senate Bill House Bill Passed Senate Bill Passed Compromise Bill Passed Signed by President Most Provisions Effective 1 3
vs. the 1986 Tax Reform Timeline President Reagan called for reform in State of the Union address Treasury Dept. submitted comprehensive study on reform 30 days of Ways and Means Committee hearings began 36 days of Senate Finance Committee hearings began Administration submitted proposal to Congress Jan. 25 1984 Nov. 27 Feb. 27 1985 May 9 May 29 Ways and Means Committee markup began Ways and Means Committee approved bill House passed bill by voice vote Senate Finance Committee markup began Senate Finance Committee approved bill Senate passed amended bill, 97-3 Conference report filed House approved conference report Senate approved conference report President Reagan signed bill (Public Law 99-514) 1985 Sept. 18 Dec. 3 Dec. 17 1986 March 19 May 6 June 24 Aug. 16 Sept. 25 Sept. 26 Oct. 22 4
What s in a name? 5
Overview of Key Reforms Permanently reduced 35% corporate tax rate to flat 21% Repealed the corporate alternative minimum tax (AMT) Temporarily allows 100% expensing for certain capital assets Fundamentally changed taxation of multinational entities Temporary new deduction for certain income of individuals, trusts, and estates from passthrough entities, sole proprietorships Paid for these business changes through various basebroadening measures and nearly $1.5 trillion of deficit spending Life insurers in particular were targeted with industry-specific revenue raisers 6
Overview of Key Reforms (cont.) Temporarily reduced individual income tax rates, widened tax brackets, and increased and indexed the standard deduction while repealing personal exemptions and limiting certain itemized deductions Temporarily doubled the estate and gift tax exclusion 7
General Corporate Reforms Corporate tax rate lowered to 21% Conforming changes: 70% dividends received deduction (DRD) reduced to 50% and 80% DRD reduced to 65% Corporate AMT repealed Unutilized credits refundable from 2018-2020 at 50% / year Any leftovers in 2021 are refundable that year Sequestration issue: Refundable credits are sequestered: 6.6% reduction for 2018 Balanced Budget and Emergency Deficit Control Act of 1985 8
General Corporate Reforms (cont.) Net Operating Losses (NOLs) Special rules for life insurance companies repealed 3-year carryback and 15-year carryforward eliminated General corporate rules modified (and apply to life companies) No carryback, unlimited carryforward Use of loss carryovers limited to 80% of taxable income P&C company rules unchanged 2-year carryback; 20-year carryforward; no percentage limit Net interest expense deductions Capped at 30% of adjusted taxable income (with special rules) 9
General Corporate Reforms (cont.) Passthrough entities: 20% deduction for qualified business income Financial services and other service businesses: deduction phases out at $315,000 taxable income (joint returns) Limits on executive compensation under section 162(m) Deductions for meals, entertainment expenses further limited Restrictions on fringe benefits Limits on deducting fines, penalties, certain settlements 10
Life Insurance Reserves: Prior Law Tax reserves generally were the greater of a contract s NSV and the federally prescribed reserve The federally prescribed reserve was based on: the tax reserve method applicable to the contract, the greater of the applicable Federal interest rate or the prevailing State assumed interest rate, and the prevailing commissioners standard tables, all determined at issuance of the contract. Reserve determined contract-by-contract Tax reserve capped at the statutory reserve Some types of reserves not deductible 11
Life Insurance Reserves: New Rules New general rule for life insurance tax reserves: The greater of The NSV for the contract, or 92.81% of the reserve computed using the NAIC-prescribed method for the contract The NAIC-prescribed method is determined at the valuation date, not the issue date Rules apply contract-by-contract, like prior law Capped at statutory reserves, like prior law 12
Life Insurance Reserves: New Rules (cont.) New special rule for variable contracts: Tax reserve equals the sum of (a) + (b), where (a) is the greater of (i) the NSV for the contract or (ii) the portion of the reserve that is separately accounted for under Code 817, and (b) is 92.81% of the excess (if any) of (i) the reserve computed using the NAIC-prescribed method for the contract over (ii) the amount in (a) Also subject to statutory reserve cap 13
Life Insurance Reserves: New Rules (cont.) Effective date and transition rule: New rules apply to tax years starting after 12/31/17 Deduct or include differences ratably over 8 years 14
Life Insurance Reserves: New Rules (cont.) Observations: Change to NAIC-prescribed method as of valuation date is generally helpful for principles-based reserving Haircut has greater effect for products without cash values, such as -- Immediate annuities, deferred income annuities, term life insurance, long-term care, disability income Non-deductible reserves: Asset adequacy reserves Deficiency reserves and deferred and uncollected premiums No double counting 15
Proration: Prior Law Life insurance company deductions for dividends received are limited to the company s share of such dividends Company s share was percentage generally equal to: the company s net investment income reduced by policy interest, divided by the company s total net investment income (95% of gross separate account investment income; 90% for general account) Proration also applies to tax-exempt interest and increases in the cash value of life insurance and annuity contracts Reserve decreases and increases are adjusted for the policyholders share of those items These rules applied based on older regulations that caused controversy with the IRS 16
Proration: New Rules Company s share of dividends received is set at 70% Policyholders share of tax-exempt interest and the increase in the cash values of company-owned life insurance and annuity contracts is set at 30% Replaces formulaic approach based on older regulations that caused controversy between the industry and IRS Similar to P&C company tax rules 17
Proration: New Rules (cont.) Base for computing a life insurers general account and separate account DRD also was impacted by a conforming change to the general corporate DRD Reduced the 80% DRD to 65% and the 70% DRD to 50% Adjusts for the benefit of the lower corporate tax rate This means the starting point for the proration calculation is a 50% general DRD The proration percentage of 70% is multiplied by the general DRD percentage of 50% 18
DAC Tax: Prior Law Must capitalize specified policy acquisition expenses A proxy was used that capitalizes a portion of general business expenses based on the percentage of net premiums received for three categories of contracts: 1.75% for annuity contracts, 2.05% for group life insurance contracts, and 7.7% for all other specified insurance contracts (generally nongroup life insurance and non-cancelable A&H insurance) Capitalized expenses deductible ratably over 10 years 5 years for first $5 million, subject to phase-out at $10 million 19
DAC Tax: New Rules Increases the proxy rates by roughly 20% each 2.09% for annuity contracts, 2.45% for group life insurance contracts, and 9.2% for all other specified insurance contracts But: drafting error means only the latter two rate categories were modified; legislative correction may be needed Lengthens amortization period from 10 to 15 years Retains 5-year amortization schedule for smaller balances 20
DAC Tax: New Rules (cont.) New rules apply to net premiums received after 12/31/17 Existing DAC balances continue on their current amortization schedules; not re-amortized 21
Other Life Insurance Reforms Life settlements Reporting is required for any reportable policy sale, which generally means a person acquires, directly or indirectly, a life insurance contract where the acquirer has no substantial family, business, or financial relationship with the insured. The buyer must report information about the purchase to the IRS, to the contract issuer, and to the seller. The issuer must report certain information to the IRS, the purchaser, and the payee of any death benefit. Exceptions to the transfer for value rule do not apply in a reportable policy sale. Rev. Rul. 2009-13 is effectively reversed, regarding COI charges reducing adjusted basis in a life insurance contract. 22
Other Life Insurance Reforms (cont.) Definition of a life insurance contract The reasonable mortality rules are modified to conform to the changes to the reserve rules, which repeal the definition of prevailing commissioners standard tables in the Code Determinations under Code 7702 must be based on reasonable mortality charges which meet the requirements prescribed in regulations to be promulgated by the Secretary or that do not exceed the mortality charges specified in the prevailing commissioners standard tables. The prevailing tables are defined in new Code 7702(f)(10) in the same manner as in current law, except that the definition omits the provisions regarding regulations for contracts for which there is no prevailing table and contracts to which multiple tables may be prevailing. 23
Other Life Insurance Reforms (cont.) Small life insurance company deduction repealed 10-year spread rule for changes in a taxpayer s basis for computing life insurance reserves repealed Policyholder surplus account provisions repealed Any PSA balances in existence as of December 31, 2017, will be taxed ratably over the next 8 years 24
Issues Unresolved Life / non-life consolidation Ordinary / capital mismatch Others? 25
International Reforms Moves to a quasi-territorial system with a 100% dividends received deduction Replaces the current worldwide system of taxation with a dividend-exemption system Exempts from U.S. taxation 100% of the foreign-source portion of dividends paid by a foreign corporation to a U.S. corporate shareholder owning at least 10% of the foreign corporation 26
International Reforms (cont.) One-time tax on previously un-repatriated earnings Generally requires a 10% U.S. shareholder of a CFC to include in income its pro rata share of the CFC s pre-2018 accumulated E&P that has not previously been subject to U.S. tax The portion of the E&P comprising cash and cash equivalents is taxed at 15.5% and the remainder at 8% There is an election to pay the tax over eight years 27
International Reforms (cont.) Base Erosion and Anti-Abuse (BEAT) Tax Earnings stripping by certain foreign-headquartered multinationals was long recognized as a problem by the U.S., with deductible royalty payments, interest payments, and service payments to a foreign parent reducing U.S. tax liabilities H.R. 1 potentially subjects businesses with more than $500 million in annual gross receipts and more than a de minimis amount of certain related-party payments to a new 10% minimum tax (5% for 2018 and 12.5% for tax years beginning after 12/31/2025), called the BEAT 28
International Reforms (cont.) BEAT (continued ) The alternative tax base is similar to the regular tax base except otherwise deductible payments to a foreign related party (base erosion payments and any NOLs attributed to such payments) are added back in arriving at the alternative tax base. Base erosion payments include deductible payments to related foreign persons for certain reinsurance arrangements, but not for costs of goods sold or for services provided at cost. BEAT is not applicable to deductible payments to a foreign corporation treated as a U.S. corporation pursuant to an election under section 953(d). 29
International Reforms (cont.) Global Intangible Low-Taxed Income (GILTI) H.R. 1 taxes U.S. corporate shareholders currently on their portion of a CFC s GILTI. GILTI generally is income that is low-taxed roughly, less than a 10.5% effective tax rate (ETR), grading up to a 13.125% ETR for tax years beginning after 12/31/25 and generates a high rate of return. 30
International Reforms (cont.) Foreign-Derived Intangible Income (FDII) H.R. 1 effectively creates a new preferential tax rate for income derived by domestic corporations from serving foreign markets. This is accomplished via a new deduction for FDII A lower effective tax rate of 13.125% on routine income arising from foreign markets provides a new benefit for owning intangible property and conducting business operations in the United States. 31
International Reforms (cont.) FDII (continued ) The FDII deduction is available to domestic corporations that are taxed as C corporations, including U.S. corporate subsidiaries of foreign-based multinationals. Foreign corporations with income effectively connected with a U.S. trade or business, S corporations, regulated investment companies, real estate investment trusts, partnerships, and individuals are not eligible. 32
International Reforms (cont.) Passive Foreign Investment Companies (PFICs) H.R. 1 amends the PFIC exception for insurance companies to apply only if the foreign insurance company has insurance liabilities that constitute more than 25% of its total assets. Insurance liabilities includes loss and loss adjustment expenses and life and P&C reserves, but would exclude unearned premium, deficiency, and contingency reserves as reported on the insurer s applicable financial statement. If the foreign insurer s reserve percentage falls below 25% solely due to run-off or rating-related circumstances, an alternate test would be available for a company whose insurance liabilities constitute at least 10% of its assets. 33
Implications for State Taxes? The dramatic changes in the federal tax base (for both individuals and businesses) impact states Many states conform their tax codes to the federal code In opening state tax codes to address the federal changes, states may contemplate broader actions that more directly impact the taxation of life companies or their policyholders Tax credits, premium taxation, etc. 34
Risk-Based Capital Tax reform significantly impacts life insurers risk-based capital (RBC) ratios due primarily to the drop in the corporate tax rate from 35% to 21% In simplistic terms, RBC = available capital/required capital Required capital, which is based on loss contingencies, is determined on an after-tax basis In a loss event, a lower corporate tax rate means the Federal government s share of the loss is reduced The drop in the corporate tax rate also decreases the value of deferred tax assets (DTAs) included in available capital Elimination of the carryback period for life operating losses also can lead to lower admitted DTAs 35
Risk-Based Capital (cont.) Both of these factors drive RBC ratios down Overall, life company RBC ratios could decline in the range of 20% The industry is advocating that the effect of tax rate changes on required capital be recognized in 2019 along with some other, perhaps offsetting, changes the NAIC is considering 36
Financial Reporting (SEC) SAB 118 (issued 12.22.17, the same day President Trump signed H.R. 1) addresses reporting effects of the new tax law for public companies Provides important relief to companies filing 12.31.17 financial statements: Allows them to take a reasonable period to determine and recognize the effects of the new tax bill Addresses the challenges entities may face in accounting for and reporting on the effects of the new tax bill because of incomplete information and accounting 37
Financial Reporting (FASB) On 1.10.18, FASB held a public board meeting and indicated they would adopt the SEC reporting approach for U.S. GAAP reporting purposes FASB also gave more specific guidance on financial reporting issues related to tax reform, including how to properly restate deferred taxes on unrealized gains and losses on securities recorded through accumulated other comprehensive income, as requested by ACLI on 12.21.17 FASB subsequently issued guidance on the financial accounting treatment of repatriation tax liabilities, AMT tax credit refund receivables, the BEAT and GILTI 38
Financial Reporting (NAIC) On 1.11.18, the NAIC exposed revisions to statutory accounting principles to reflect the effects of tax reform On 1.30.18, the NAIC Statutory Accounting Principles Working Group released an interpretation that would allow for relief similar to SAB 118 for 2017 statutory annual statement filings 39
Questions 40