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American Bar Association – International Insurance Subcommittee

American Bar Association – International Insurance Subcommittee. Subpart F and PFIC Regime, Insurance Rules, and Legislative Activity Phoenix – January 24, 2014. Panel. Moderator Christopher Ocasal – Ernst & Young, LLP Panelists Paul Aronoff – Prudential Financial

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American Bar Association – International Insurance Subcommittee

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  1. American Bar Association –International Insurance Subcommittee Subpart F and PFIC Regime, Insurance Rules, and Legislative Activity Phoenix – January 24, 2014

  2. Panel • Moderator • Christopher Ocasal – Ernst & Young, LLP • Panelists • Paul Aronoff – Prudential Financial • Daniel Kheel – MetLife, Inc. • Jeffrey Maydew – Baker & McKenzie, LLP • Jefferson VanderWolk – Ernst & Young, LLP ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  3. Agenda • Subpart F Insurance Income • History and Summary of Rules • Chairman Baucus’s International Tax Reform Draft • Industry Comments • PFIC Insurance Exception • Summary of Rules • Insurance Exception • Chairman Baucus’s International Tax Reform Draft • PFIC and CFC Overlap • BEPS Overview ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  4. Subpart F Insurance Income ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  5. Revenue Act of 1962 • Subpart F Income included insurance income derived from insuring or reinsuring U.S. risks and applied only if the premiums received on insuring or reinsuring U.S. risks exceeded 5% of the total premiums received during the taxable year • §954(c)(3)(B) excluded from foreign personal holding company income any investment income of a foreign insurance company derived from the unearned premiums or reserves which were ordinary and necessary for the proper conduct of that business, if such income was received from unrelated persons ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  6. Tax Reform Act of 1976 • Congress enacted two new provisions applicable to insurance companies: §§954(c)(3) (C) and 861(a)(7) • Former §954(c)(3)(C) expanded the exclusion from the definition of foreign personal holding company income to include dividends, interest and gain from the sale or exchange of stock or securities received from a person other than a related person and derived from investments made by an insurance company in an amount equal to one-third of its premiums earned during the taxable year, if such income was not attributable, directly or indirectly, to insurance or reinsurance of risks of persons who were related persons ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  7. Tax Reform Act of 1986 • The Act of 1986 completed the broadening application of the anti-deferral rules to §953 insurance income in several ways • First, the scope of §953 was expanded by modifying the definition of insurance income to include not simply U.S. risks but all income derived from insurance or annuity contracts with respect to risks located in a country other than the insurer's country of incorporation • Second, the 5% or more de minimis rule was repealed. However, §953 insurance income became eligible for §954(b)(3)(A)’s general Subpart F income de minimis exception and, except for insurance income taken into account solely by virtue of the related person insurance income (RPII) rule of §953(c), §954(b)(3)(B)’s full-inclusion rule • Third, Congress expanded the definition of a CFC under both the regular “more than 50%” test and the insurance company “more than 25%” test by applying both tests not only on a voting power basis, but also by value • Fourth, a new provision was enacted, §953(c)’s RPII rule, which was specifically geared to combat the burgeoning offshore group captive insurance industry ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  8. Tax Reform Act of 1986 (continued) • Fifth, Congress repealed former §954(c)(3)(B), the exclusion for investment income on reserves, and former §954(c) (3)(C), the exclusion for investment income on one-third of premiums • Sixth, under §952(c)(1)(B), Congress restricted the use of deficits to reduce Subpart F income • Seventh, §904(d) added to the “basketing” rules several other categories of income, including §904(d)(2)(C)’s financial services income including any income received or accrued by any person predominantly engaged in the active conduct of an insurance business and which is §953 insurance income, without regard to the Same-Country Income Exception • Eighth, Congress enacted the passive foreign investment company (PFIC) regime under §1291 through §1297. However, Congress excluded from the definition of passive income under the PFIC rules any income derived in the active conduct of an insurance business by a corporation which is predominantly engaged in an insurance business and which would be subject to tax under Subchapter L of the Code if it were a U.S. corporation ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  9. Taxpayer Relief Act of 1997 and Tax and Trade Relief Extension Act of 1998 Taxpayer Relief Act of 1997 • The 1997 Act added former §954(h) which provided an exception to §954(c) foreign personal holding company income for certain investment income attributable to insurance reserves (Effective for the taxable years beginning in 1998) Tax and Trade Relief Extension Act of 1998 • The 1998 Act repealed the 1997 version of §954(h) and codified its purpose and rules under §954(i) • Furthermore, the 1998 Act provided for an exception to §953 insurance income under §953(e). The exception to §953(e) substituted the Same-Country Insurance Income Exception to §953(a) for insurance income attributable to exempt insurance income of qualified insurance companies or qualified insurance company branches • Finally, the 1998 Act provide an exception to §954(e) foreign base company services income for service income attributable to exempt insurance income of qualified insurance companies or qualified insurance company branches • Sections 954(i), 953(e) and the 1998 revisions to §954(e) were all one-year temporary provisions, that is, for the taxable year of foreign corporations beginning in 1999. These provisions were extended incrementally to taxable years beginning before January 1, 2014 (sometimes retroactively), and it is expected that they are extended again for 2014 ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  10. Summary of Rules — 953(e) • §953(a)(1)defines Subpart F insurance income. Section 953(a)(2), however, excludes from the definition of Subpart F insurance income any exempt insurance income (EII) as defined under §953(e) • EII is defined as income derived by a qualifying insurance company (QIC) which is: • Attributable to the issuing (or reinsuring) of an “exempt contract” by such company or a qualifying insurance company branch (QIC branch) of such company and • Treated as earned by such company or branch in its home country for purposes of such country's tax laws • EII does not include income attributable to the issuing (or reinsuring) of an exempt contract as the result of any arrangement whereby another corporation receives a substantially equal amount of premiums or other consideration in respect of issuing (or reinsuring) a contract which is not an exempt contract • For purposes of §953(c)’s RPII, EII does not include income derived from exempt contracts which cover risks other than applicable home-country risks ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  11. Summary of Rules — 953(e) Qualifying Insurance Company (QIC) • For foreign corporation to qualify as a QIC, three main requirements must be met: • The CFC must be subject to insurance regulations in its home country; • The corporation must insure a minimum amount of unrelated home-country risks; and • The CFC must be engaged in the insurance business and, if it were a domestic corporation, would be subject to tax under subchapter L of the Code • QIC means any CFC which, in part, derives more than 50% of its net written premiums, on an aggregated basis, from the issuance or reinsurance by such CFC (including all QIC branches) of contracts covering applicable home-country risks of such corporation or branch, as the case may be • A contract shall not be taken into account for purposes of the requirement of more than 50% unrelated home-country risks of §953(e)(3)(B) if: • any policyholder, insured, annuitant or beneficiary is a resident of the United States and such contract was marketed to such resident and was written to cover a risk outside the United States; or • the contract covers risks located within and without the United States and the QIC or QIC branch does not maintain such contemporaneous records, and file such reports, with respect to such contract as the Secretary may require. ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  12. Summary of Rules — 953(e) Qualifying Insurance Company (QIC) – (continued) • Furthermore, premiums from a contract will not be taken into account for purposes of the requirement of more than 50% unrelated home-country risks of §953(e)(3)(B) if such contract reinsures a contract issued or reinsured by a related person (as defined in §954(d)(3) QIC Branch • For a branch to qualify as a QIC branch, three main requirements must be met: • The branch must be a qualified business unit within the meaning of §989(a); • The branch must be subject to insurance regulations in its home country; and • The branch must be a branch of a QIC ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  13. Summary of Rules — 953(e) Exempt Contract • To qualify as an exempt contract such contract must: • Insure only non-U.S. risks; • The QIC or QIC branch mustinsure a minimum amount of unrelated home-country risks; and • If the contract insures risks other than home-country risk, the QIC or QIC branch must conduct substantial home-country activities • No contract of a QIC or of a QIC branch shall be treated as an exempt contract unless such company or branch derives more than 30% of its net written premiums from exempt contracts (1) which cover “applicable home country risks;” and (2) with respect to which no policyholder, insured, annuitant or beneficiary is a related person (as defined in §954(d)(3) • The exempt contract of a QIC or any QIC branch of such company shall be determined separately for such company and each such branch by taking into account: • In the case of the QIC, only items of income, deduction, gain or loss and activities of such company not properly allocable or attributable to any QIC branch of such company; and • In the case of a QIC branch, only items of income, deduction, gain or loss and activities properly allocable or attributable to such branch. The Secretary of the Treasury is granted the authority to prescribe rules for the allocation of contracts, income from contracts and activities among two or more QIC branches of a QIC in order to clearly reflect the income of such branches ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  14. Summary of Rules — 953(e) Earned by QIC or QIC Branch in Its Home Country for Purposes of Such Country's Tax Laws • EII is defined as income derived by a QIC which, in part, is treated as earned by such company or branch in its home country for purposes of such country's tax laws • An example illustrating the 2006 §954(i) temporary regulations highlights that in order for the investment income earned by a partnership to qualify for the exception under §954(i), it must first qualify as EII under §953. Accordingly, such investment income earned by a partnership, inter alia, must be subject to tax in the CFC partner's country of organization Anti-Abuse Rules • Section 953(e)(7) provides a series of anti-abuse rules intended to limit the availability of §§953(e) and 954(i) to certain transactions. Section 953(e)(7)(A) cross references in part to the anti-abuse rules of §954(h)(7) (other than the rule under §954(h)(7)(B) and applies these rules to §§953(e) and 954(i) ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  15. Summary of Rules — Section 954(i) • §954(i) provides that foreign personal holding company income does not include qualified insurance income of a QIC. This exception provides for the exclusion of two amounts under the definition of qualified insurance income Qualified Insurance Income • Qualified insurance income means income of a QIC equal to the sum of two amounts: • The unrelated ordinary and necessary investment income attributable to exempt contracts; and • The unrelated investment income attributable to exempt contracts from required surplus Other Definitions • For purposes of §954(i), any term used in §954(i) which is also used in §953(e) has the meaning given such term by §953 ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  16. Summary of Rules — Section 954(i) Insurance Reserves • For purposes of life insurance business, the amount of reserves of a QIC or QIC branch for any life insurance or annuity contact (life reserve amount) will be equal to the greater of the net surrender value of such contract (as defined in §807(e)(1) (A), including the balance in the policyholder's fund in the case of pension plan contracts; or the §954(i)(5) reserve on such contract) • Generally, provided some exceptions, the §954(i)(5) reserve on a life or annuity contract is the amount of the reserve on such contract determined in the same manner as it would be determined if the QIC or QIC branch were subject to tax under Subchapter L • For taxable years beginning after December 31, 2001, the life reserve amount is the foreign statement reserve for the contract (less any catastrophe, deficiency, equalization or similar reserves), if, pursuant to a ruling request submitted by the taxpayer or as provided in published guidance, the Secretary determines that the factors taken into account in determining the foreign statement reserve provide an appropriate means of measuring income ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  17. Summary of Rules — Section 954(i) Insurance Reserves– (continued) • The IRS has issued several private letter rulings under §954(i)(4)(B)(ii), which provide: • CFC must establish, maintain and calculate their underwriting reserves in accordance with the insurance laws and regulations of its country of organization and guidance prescribed by the government in such country • Local insurance government agency generally must require a life insurance company to determine the amount of its underwriting reserves under the net level premium method (however the Zillmer method may also be permissible under certain circumstances) • CFC must set forth their underwriting reserves on the annual reports, which must be filed annually with the local insurance government agency • Local insurance government agency requires that the CFC hold their underwriting reserves to enable them to fulfill claims owed to contract holders and their beneficiaries • Underwriting and risk reserves must not be catastrophe, deficiency, equalization or similar reserves • Regarding P&C insurance business, the unearned premiums and loss reserves of a QIC or a QIC branch with respect to property, casualty or health insurance contracts (P&C reserve amount) is determined using the same methods and interest rates that would be used if such company or branch were subject to tax under Subchapter L, except that • The interest rate determined for the functional currency of the company or branch, and which, except as provided by the Secretary, is calculated in the same manner as the federal mid-term rate under §1274(d), is substituted for the applicable federal interest rate; and • Such company or branch must use the appropriate foreign loss payment pattern ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  18. Subpart F – Chairman Baucus’s International Tax Reform Draft General comment • Expands the U.S. Shareholder definition of §951(b) to include any United States person who owns, or is considered as owning, 10 percent or more of the total valueof shares of all classes of stock of a foreign corporation • Therefore, you can be a US shareholder even if you do not have voting rights Qualified Entities • Retains current law provision that requires a qualifying insurance company (“QIC”) (a) be subject to home country insurance regulations, (b) be licensed to engage in insurance activity with unrelated persons in its home country and (c) be subject to tax under Subchapter L if it were a domestic corporation • The requirement that the company derive more than 50 percent of aggregate net written premiums from unrelated persons is also retained, but the requirement that these premiums cover home country risk would be deleted ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  19. Subpart F – Chairman Baucus’s International Tax Reform Draft Qualified Entities – (continued) • Adds two new requirements to the definition of a QIC: • More than 50 percent of the CFC’s gross receipts for a taxable year must consist of premiums for insurance or reinsurance in connection with property, liability, or the lives or health of individuals, that are treated as earned by such CFC in its home country for purposes of tax laws in the home country of the CFC • The CFC’s applicable insurance liabilities must amount to more than 35 percent of the CFC’s total assets as reported on the company’s applicable financial statement for the year with or within which the taxable year ends Qualified Income • Retains provision that requires a QBU to derive more than 30% of aggregate net written premiums from unrelated persons that are not U.S. persons. However, repeals requirement that the premiums meeting this 30% threshold cover only home country risks ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  20. Subpart F – Chairman Baucus’s International Tax Reform Draft Qualified Income – (continued) • Substantial activity requirement would be expanded to require that any exempt insurance contract is an exempt contract only if the CFC conducts substantial activities with respect to the contract and that substantially all of the activities necessary to give rise to the income generated by the contract are performed by the CFC in its home country • An activity would be considered directly conducted by a QIC in its home country if the activity is performed in such home country by the employees of a related person and (1) the related person is subject to tax in the home country of the qualifying insurance company, (2) the related person is compensated at arm’s length for the activities of its employees, and (3) such compensation is treated as earned in such home country for purposes of the home country’s income tax laws ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  21. Industry Comments Qualified Income • Elimination of the home country risk requirement is a positive and constructive change. All foreign risk should be treated as producing active income • Many active life insurance companies would have difficulty meeting the requirement that 50 percent of the CFC’s gross receipts consist of premiums for insurance or reinsurance, particularly if interest rates rise. This is especially the case if single premium type products. Also presents difficulty for start-up and run-off companies • The requirement that a certain percentage of net written premiums come from unrelated party risk is overly strict when the premiums relate to home country risk • The statute should not continue to have an overlapping 50% net written premium test for a qualifying insurance company and a 30% net written premium test for a qualifying insurance company or a qualifying insurance company branch (tests are duplicative) ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  22. Industry Comments Qualified Income • For purposes of the 35 percent test, the term “assets” should not include non-income producing assets, such as shares in a related-party subsidiary, goodwill or going concern intangibles, deferred acquisition costs or other similar non-income producing assets, as this assets would have a distortive effect on this test • Adding a new entity requirement for asset capitalization – combined with the retention of the section 954(i) investment income reserve rules -- results in duplicative tests, all aimed at identifying overcapitalized insurance companies. It is not clear why this test should be used to determine if the insurance activity of the entity is active • To the extent that the liability ratio test relies on financial statements, all CFCs should be treated in a similar manner. There should not be a different test for companies that may prepare financial statements based on GAAP or IFRS for global purposes, such as to be included in a parent company’s financial reporting ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  23. Industry Comments Qualified Income • Newly proposed requirement that substantially all of the activities necessary to give rise to the income generated by the contract be performed by the CFC in its home country (or a service company in a very narrow set of circumstances) is overly restrictive and does not reflect common industry practices • A broader related party should be considered. Many insurance companies have non de-minimis portions of their work performed in regional (or global) service companies/centers. Further, the requirement that the related person be compensated at arm’s length will often conflict with local regulatory requirements Treatment of Investment Income • The discussion draft does not include any changes to the current-law treatment of investment income • The industry has made several sets of proposals aimed at more closely aligning the definition of qualifying capital and reserves from which qualified investment income is derived to the capital and reserve levels that are required by local regulators and that are necessary to do business in local markets ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  24. PFIC Insurance Exception ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  25. PFIC – Summary of Rules • Policy Considerations • Prevent deferral of US federal income tax to the extent such income was earned through offshore mutual funds or other investment funds • Prevent ability to convert ordinary income into capital gains by deferring distributions and selling stock of such foreign investment fund • Definition of a PFIC Under Sec. 1297(a) • A passive foreign investment corporation (PFIC) is any foreign corporation if, for any taxable year - • 75% or more of its gross income is passive income or • At least 50% of its assets are held for the production of passive income • Three Alternative PFIC Tax Regimes • Excess distribution regime • Qualified electing fund regime • Mark to market (MTM) regime ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  26. PFIC – Summary of Rules • Excess Distribution Regime of Sec. 1291 • Tax and, where applicable, an interest charge on “excess distributions” to US persons who own stock in a PFIC • Includes actual or deemed distributions or gain recognized on sale of PFIC stock • Also includes indirect distributions or dispositions on indirectly owned PFIC stock (see sec. 1298(b)(5) and Prop. Reg. 1.1291-2(e)(iv) and (f)) • Qualified Electing Fund Regime • US shareholder can, for any taxable year, make a sec. 1295 election (which is nonrevocable without IRS consent) to treat PFIC as a qualified electing fund (QEF) • For each taxable year of fund, US shareholder must include in gross income (i) as ordinary income the pro rata share of ordinary earnings of fund and (ii) as long term capital gain the pro rata share of net capital gain of fund • US shareholder does not take into account losses ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  27. PFIC – Summary of Rules • Mark to Market Regime • US shareholder can elect to mark its stock in PFIC to market under sec. 1296 if the stock is marketable stock, e.g. exchange-traded stock • Must mark to market any PFIC stock owned at end of taxable year • US shareholder includes in gross income excess of FMV over basis • If basis exceeds FMV, US shareholder allowed deduction equal to lesser of (i) amount of excess or (ii) unreversed inclusions with respect to PFIC stock ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  28. PFIC – Insurance Exception • Active Insurance Exception under Sec. 1297(b)(2)(B) • Passive income does not include income derived in active conduct of an insurance business by a corporation predominantly engaged in an insurance business and which would be subject to tax under subchapter L if it were a domestic corporation • Requirements for Active Insurance Exception • Foreign corporation would be subject to subchapter L if it were a US corporation • Foreign corporation is an entity “predominantly engaged in the active conduct of an insurance business” if - • Entity is engaged in active conduct of an insurance business • Active insurance business is the entity’s predominant business • Income earned by the foreign corporation must be “derived” in the active conduct of an insurance business ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  29. PFIC – Insurance Exception • Foreign Corporation Subject to Subchapter L if a US Corporation • Unclear if “predominantly” and “active conduct” are subsumed into this requirement • Note that, under a Closing Agreement between Lloyd's of London and the IRS and for purposes of sec. 1297(b)(2)(B), corporate underwriters were “treated as companies predominantly engaged in an insurance business, the income of which would be taxable under Subchapter L of the Code.” • Potential scrutiny of captive insurance activities (Notice 2003-34) • Regarding arrangements involving purported insurance company organized offshore • Some of insurance company’s contracts do not cover insurance risks. Other contracts significantly limit the risks assumed by insurance company through the use of retrospective rating arrangements, unrealistically low policy limits, finite risk transactions, or other similar devices • Insurance company’s insurance activities are small compared to investment activities • Insurance company invests capital and premiums in hedge funds or investments in which hedge funds typically invest and generates investment returns that substantially exceed the needs of insurance business • IRS indicated that if the insurance company would not be subject to tax under subchapter L (e.g., less than half of its business is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies), then the Active Insurance Exception will not apply • Even if the company would be subject to tax under subchapter L if it were a domestic corporation, the IRS stated that the Active Insurance Exception may not apply because the exception is applicable only to income derived in the active conduct of an insurance business ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  30. PFIC – Insurance Exception • Predominantly Engaged in an Insurance Business • Engaged in active conduct of an insurance business • No specific guidance • 1988 Senate report refers to “income received by bona fide insurance companies” • Analogizing to the legislative history of sec. 953(e) would require tested entity to operate in manner consistent with other bona fide commercial insurance companies that sell insurance to unrelated parties and to conduct managerial activities with respect to major functions of the insurance business • Sec. 1297(b)(2)(A) regulations for active conduct of a banking business cross reference to Treas. Reg. 1.367(a)-2T(b) • Others argue “active conduct” simply requires that entity be a bona fide insurance company • Question as to whether the company must issue at least one insurance or reinsurance contract • Note that, for purposes of interpreting “active trade or business” provision under the Limitation of Benefits clause, the Protocol to the U.S.-Ireland Income Tax Treaty states that an insurance company is deemed to be engaged in an “active insurance business” by simply being engaged in an insurance business ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  31. PFIC – Insurance Exception • Predominantly Engaged in an Insurance Business • Insurance business must be predominant business • No guidance on what it means to be “predominantly” engaged • Generally, 1988 Senate Report indicates that company would not meet this test if company maintains financial reserves in excess of reasonable needs of insurance business • Percentage income required for “predominantly” engaged • Generally, a high percentage of entity’s income must be insurance related • “Safe” standard is that at least 80% of total gross income is from underwriting and investment income earned by an insurance company. See, e.g., sec. 904(d) financial services income rules • A lower percentage may be adopted. See, by analogy, former sec. 954(h) enacted as part of the Taxpayer Relief Act of 1997 (corporation predominately engaged in active conduct of banking, financing, or similar business if more than 70% of its gross income is derived from such business); see also similar rules for banking business in current sec. 954(h) • Reasonable reserves • No guidance on what constitutes “reasonable reserves” • One source of guidance is actuarial determinations made under methods adopted by NAIC • Reasonable reserves could include each point of an actuary’s range of estimated reserves (including high end of such range) ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  32. PFIC – Insurance Exception • Derived in Active Conduct of an Insurance Business • No guidance on meaning of “derived” • Dictionary definition of derived means “to trace from a source or origin” • Applying proposed regs under sec. 1296 involving the banking area would appear to require that the only amount excluded from passive income is income from active conduct of an insurance business • Other income would still be be passive • Legislative history further indicates intent to limit sec. 1297(b)(2)(B) exception solely to income derived by certain insurance companies with reasonable reserves • It does not appear appropriate to disqualify a company simply because of excess reserves • Doing so would convert the “predominantly” requirement to mean “exclusively” • Nonetheless, income attributable to excess reserves may be treated as passive ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  33. PFIC – Chairman Baucus’s International Tax Reform Draft General Modifications • The provision repeals the present law asset test for determining whether a foreign corporation is a PFIC, and it reduces the income test threshold for status as a PFIC from 75 to 60 percent. Accordingly, under the provision a foreign corporation is a PFIC if 60 percent or more of its gross income for the taxable year is passive income • The provision repeals the present law rules that impose an interest charge when a U.S. person who owns stock of a PFIC receives an excess distribution in respect of that stock • The provision also repeals the rules relating to elective annual taxation in respect of qualified elective funds. In its place, the provision requires a U.S. person who owns non-publicly-traded PFIC stock to include in income annually a deemed return on the PFIC stock equal to the Federal short-term rate plus five percent Treatment of marketable PFIC stock • Under present law a U.S. person who owns marketable PFIC stock may elect the mark-to-market regime in lieu of the present law section 1291 interest charge rules. The provision makes the mark-to-market regime mandatory in all circumstances in which a U.S. person owns PFIC stock that is marketable. ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  34. PFIC – Chairman Baucus’s International Tax Reform Draft Treatment of marketable stock – (continued) • The provision also modifies the definition of marketable stock. Marketable stock under the provision includes, in addition to stock covered by the unmodified portion of the present law definition, stock • in any foreign corporation that is subject to governmental regulation comparable to Federal regulation of regulated investment companies (mutual funds), and • that is redeemable or otherwise disposable at its net asset value or at any other price determined under an independent valuation method fixed at the time of purchase Repeal of active insurance exception • The provision repeals the present law rules that exclude income derived from an active insurance business from the definition of passive income • The definition of passive income is tied to the subpart F rules discussed earlier • Passive income generally includes investment income, but excludes qualified insurance income of a qualifying insurance company ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  35. PFIC and CFC Overlap • Policy considerations of PFIC investments held by insurance companies • Coordination of PFIC regime with subpart F regime • In the case of sec. 1291’s excess distributions regime, the PFIC rules could take priority over the subpart F regime for certain distributions from, and dispositions of, PFIC stock held by any CFC • Coordination of PFIC regime with subchapter L for domestic insurance companies and CFCs taxed under subchapter L (if the company were domestic) • In the case of sec. 1291’s excess distributions regime, policy considerations indicate that certain distributions from, and dispositions of, PFIC stock held, directly or indirectly, by any insurance company CFC could be excluded from the PFIC regime • Other alternatives? • Coordinate PFIC Regime with Subpart F Regime • Current Proposed Regulations • Under the 1992 proposed regulations, Treasury had recommended that, in the case of sec. 1291’s excess distributions regime, the PFIC rules should take priority over the subpart F regime for certain distributions from, and dispositions of, PFIC stock held by CFCs (see Prop. Treas. Reg. 1.1291-2(f)(3) and Prop. Treas. Reg. 1.1291-3(e)(4)(ii)) ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  36. PFIC and CFC Overlap • Coordinate PFIC Regime with Subpart F Regime – (continued) • Questions remain as to continued applicability of these proposed regs • Regulations never finalized • Post-1992 legislation enacted by Congress may point to a Congressional desire to reverse the paradigm of the 1992 proposed regulations • Section 1297(d) provides, for PFIC purposes, that a corporation is not treated with respect to a shareholder as a PFIC during the period in which it was a CFC and its shareholder was a US shareholder, even if no subpart F inclusion is required for such US shareholder • Section 1296(f) permits a CFC to make a MTM election under sec. 1296(k). Any amount included in gross income under sec. 1296 is treated as FPHC income under sec. 954(c)(1)(A), but subject to any exceptions, limitations, or exclusions under subpart F ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  37. PFIC and CFC Overlap • Coordinate PFIC Regime with Subchapter L for Domestic Insurance Companies and CFCs Taxed Under Subchapter L (if Domestic) • Policy support under subchapter L rules for insurance company’s general accounts • Character-conversion policy consideration: Insurance companies are subject to tax at ordinary rates on all income (including capital gains) and thus, under subchapter L, there is no character-conversion risk • Deferral policy consideration: Congress specifically intended deferral of investment income under subchapter L until such time as the tax reserve method permits • Under subchapter L, investment income is offset with reserve deductions (with certain adjustments), which permits deferral of investment income to better match actuarially determined expected losses • In contrast, PFIC regime aims to accelerate the US federal income tax of investment income without regard to any other tax attributes, such as reserve deductions • PFIC regime would therefore create a disadvantage to investing in foreign mutual funds ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  38. PFIC and CFC Overlap • Coordinate PFIC Regime with Subchapter L for Domestic Insurance Companies and CFCs Taxed Under Subchapter L (if Domestic) • Policy support under subchapter L rules for segregated asset accounts • Segregated asset account for variable life or annuity contracts • Funds held in segregated account for policyholder with amounts paid out for life or annuity benefits reflecting investment return and asset value of account • Under subchapter L, a life insurance company must remove (realized or unrealized) gains or losses reflected in reserves, and assets must be adjusted for amount of gain or loss removed from reserves • No company-level tax on gains or losses in underlying assets of segregated asset account • Effectively mark-to-market treatment, but gains or losses increase asset values and reserves and are thereby eliminated from company’s tax base until amounts paid out to policyholders • Dividend included in investment income of a segregated account is credited to reserves, so no net taxable income to the insurance company • Dividend and gains or losses on assets ultimately taxed when cash value is paid out to policy holder • Character-conversion policy consideration: Impact of segregated account taxation is that amounts are taxed at ordinary (not capital gains) rates when paid to policyholder • Deferral policy consideration: • No insurance company level tax • Dividends and realized or unrealized gains or losses are deferred until cash value paid out to policyholder ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  39. PFIC and CFC Overlap • Coordinate PFIC Regime with Subchapter L for Domestic Insurance Companies and CFCs Taxed Under Subchapter L (if Domestic) • Policy support for insurance company CFCs • Subchapter L policy considerations equally apply to insurance company CFCs • Subpart F permits certain underwriting and investment income to be offset by the tax reserve • Subpart F income taxed as ordinary income, so no character-conversion risk • Under secs. 953(e) and 954(i), Congress explicitly permitted deferral of certain insurance company CFC that have qualifying underwriting and investment income • Results in conflict between PFIC and subpart F regimes re timing of US taxation of investment income attributable to a PFIC investment held by an insurance company CFC • Active Insurance Exception of sec. 1297(b)(2)(B) excludes from passive income any investment asset or investment income attributable to an active insurance business if the foreign corporation would have been taxed under subchapter L ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  40. BEPS Overview ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  41. BEPS Overview • Unprecedented increase in the attention paid to the corporate tax affairs of companies. Tax high on agenda for G8/G20 governments • OECD has issued an Action Plan on base erosion and profit sharing (BEPS) as a response to this • Tax authorities require increased disclosure on tax payments, allocations and planning on a country-by-country basis • Group structures using tax havens have come under increased scrutiny • Erosion of profits via excessive interest deductions is being reviewed with rules expected to limit their use • Transfer pricing methodologies face increased examination ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  42. BEPS Overview • 15 point action plan aiming to align taxation and the creation of economic value • Performed via amendments to double tax treaties, Commentary on OECD Model Tax Convention and transfer pricing guidelines • Largely a response to high public concern into tax avoidance by multinationals • In a change from past OECD publications, has received endorsement from G8/G20 and made political headlines • Ambitious project – all actions implemented by December 2015 latest (compare with Article 7 guidance) • However, if successful will result in fundamental reform to international tax framework ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  43. BEPS Overview Points for companies to consider • How would the media respond to my effective tax rate, and how can we explain it to them? • Should global tax policy and governance be refreshed? • What are the proposed country-by-country reporting requirements, will extra processes be required, and to which authorities will the information be disclosed? • Are there impacts on existing intra-group arrangements? • Will the risk of taxable permanent establishments (both actual and deemed) need to be re-evaluated? • Does transfer pricing documentation need updating and re-assessing? ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

  44. Questions? ABA - International Insurance Subcommittee - Phoenix - January 24, 2014

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