- The Treasury Department published Notice 2023-20 on the Inflation Reduction Act’s Corporate Alternative Minimum Tax (“CAMT”) and its impact on the insurance industry as a bridge to future regulations and guidance.
- The notice includes useful relief on CAMT’s investment mark-to-market problems in variable insurance contracts and reinsurance transactions.
- The notice is ad hoc in nature and does not address other issues that insurance companies will face when implementing CAMT, or investment valuation-to-market issues for other industries.
The Treasury has issued new guidelines relating to insurance companies and the 15% corporate minimum tax on the accounting income of large corporations (“CAMT”). The guidance in Notice 2023-20 (the “Notice”) is intended to “help avoid significant unintended adverse consequences to the insurance industry” from the implementation of CAMT.
The notice addresses the treatment of certain variable contracts, as well as withheld reinsurance and modified coinsurance arrangements. The notice provides targeted relief in these situations for tax frictions that might otherwise arise from unrealized gains and losses in investment assets held by insurance companies.
The Notice does not resolve all of the uncertainties that insurance companies and other taxpayers will face when applying CAMT. The Treasury’s decision to provide limited mark-to-market relief may also suggest that the Treasury is not currently considering more general blanket relief for taxpayers in other industries who are required to mark their investment assets to market for financial reporting purposes.
The notice is intended to provide interim guidance pending promulgation of the proposed Treasury regulations. Until then, taxpayers can rely on the Notice.
- Variable life insurance and annuity contracts provide policyholders with a return that is based in part on the performance of investment assets held in separate insurance company accounts. The existing tax rules use a system of adjustments, including adjustments to the tax basis of assets in separate accounts, to ensure that insurance companies are not taxed on the appreciation or depreciation of investment assets in separate accounts, as these results ultimately transfer to policyholders.
- For financial accounting purposes, unrealized gains and losses on investment assets in a separate account are generally included in net income (or loss) in the applicable insurance company financial statement (“AFS”). However, corresponding and offsetting adjustments to the insurance company’s obligations to policyholders under the variable contracts result in no comprehensive financial accounting net income (or loss) from such unrealized gains and losses.
- The notice is intended to prevent material distortions that might otherwise arise in relation to variable life insurance and annuity contracts from the CAMT rules. Specifically, for the purposes of determining applicable income in a taxpayer’s financial statement (“AFSI”), the CAMT rules ignore unrealized gains on portfolio equity investments and, for partnership investments, consider only a distributive share of the partnership’s AFSI. However, the CAMT rules do not ignore offsetting adjustments to liabilities to variable contract policyholders. Thus, CAMT rules that would normally prevent taxpayer-adverse outcomes, such as CAMT liability for market gains on shares that are not marked to market for tax purposes, threaten to create inconsistencies for issuers of variable contracts.
- The notice provides targeted relief designed to eliminate this potential mismatch by ignoring changes in variable contractual obligations to the extent that the underlying income or gain on the investment assets of the separate account is ignored under the CAMT rules for investments in shares and partnerships.
comment: The relief provided by the Notice focuses narrowly on the distortions caused by the CAMT rules in relation to portfolio investments in shares and partnerships. The notice does not address other potential inconsistencies, including those that could arise within the main partnerships and controlled foreign corporations from their own financial income, which insurance company shareholders will need to consider (and which may not be offset by changes in the insurance the company’s liabilities and may not match the distributions related to such investments).
- The relief provided by the Notice also extends to certain other insurance contracts whose value depends on the value of the underlying assets, where the CAMT rules may create similar inconsistencies to AFSI. In particular, the Notice extends relief to regulated insurance products in foreign jurisdictions where the value of the contract depends, at least in part, on the value of the underlying assets and to closed group contracts created in connection with the “demutualization” of mutual insurance companies to ensure that that certain assets benefit only certain policyholders.
- In conventional coinsurance transactions, the cedant transfers to a reinsurer both the risk of the reinsured contracts (represented by reserve obligations) and the investment assets supporting the reserves. However, in reinsurance transactions with retained funds, the cedant retains the underlying investment assets. The ceding company records an offsetting liability (the funds withheld for payment) to the reinsurer (which in turn records a claim, which is usually accounted for as an embedded derivative) in respect of the retained investment assets from a financial accounting perspective. Similar rules apply to modified coinsurance.
- For financial accounting purposes, both withheld investment assets and withheld payables are marked as marketable in the financial statements of the transferor company. However, the transferor generally reports the unrealized gains and losses on the investment assets as part of its other comprehensive income (“OCI”), while reflecting the offsetting changes in the retained receivables (generally equal to the unrealized gains and losses included in OCI) in your financial statement for net income. Conversely, the reinsurer takes into account changes in its corresponding claim in the financial statement of net income, but there is generally no offsetting impact on its liabilities because the underlying policy liabilities are not affected by the investment performance.
comment: The volatility of embedded derivative accounting was seen as a major obstacle to withholding transactions for some taxpayers even before the Inflation Reduction Act, and this was exacerbated by the potential for triggering the minimum tax.
- The Notice acknowledges that because CAMT rules generally only look at income from the taxpayer’s financial statements (not OCI), withholding reinsurance and modified coinsurance transactions can artificially increase or decrease AFSI, creating CAMT distortions for both ceding companies, and for reinsurers as well.
comment: The Notice’s recognition that unrealized investment gains and losses reported in OCI are not net income (or loss) in the financial statements and therefore generally do not create a discrepancy with taxable income (determined on a realization basis) respects Senator Ron Wyden’s statement of August 6, 2022 that OCI is not included in income from financial statements.
- The notice provides targeted relief from distortions otherwise caused by withholdings and modified coinsurance discrepancies. In the case of the transferor company, changes in net income relating to retained fund liabilities that correspond to unrealized gains and losses on retained assets are excluded from AFSI if the gains and losses themselves are not included in AFSI, eliminating the mismatch. Excluded for the reinsurer are any gains or losses from AFSI due to changes in the value of its retained claims corresponding to unrealized gains and losses on retained assets.
- The AFSI exemptions provided by the Notice for ceding companies and reinsurers do not apply to the extent that they have already made a “fair value” election to mark a position on the balance sheet to market that would offset the volatility of the income statement of the scenarios described in the Notice, such as selecting a reinsurer to adjust reserve liabilities based on the same markup that applies to retained assets.
comment: The Treasury’s focus on harmonizing with fair value elections may be helpful for taxpayers already considering such elections to mitigate similar problems with embedded derivative accounting under the OECD’s second pillar global minimum tax rules. However, there is still considerable uncertainty in the interactions between Pillar II and CAMT regimes.
FORMER TAX-EXEMPT INSURANCE COMPANIES
- The notice provides guidance to assist certain insurance entities that were historically tax-exempt but subject to tax by an act of Congress in applying CAMT in relation to AFSI determinations involving legacy asset tax basis.
AREAS LEFT UNADDRESSED
- While the notice provides welcome guidance on some of the key issues raised by the insurance industry, the notice’s targeted approach leaves questions remaining on several important issues for insurers as well as other industries that had hoped the guidance was aimed at preventing of adverse effects on the insurance industry may provide relief more broadly.
- Consolidation of life insurance and general property. The restrictions that apply to the consolidation of life and non-life insurance companies for tax purposes do not apply for accounting purposes, creating potential inconsistencies between taxable income and AFSI for CAMT purposes that may be addressed in additional guidance.
- Other book tax differences. Market valuation of investment assets (under certain circumstances) is the only area where Treasury has provided relief to the insurance industry for the general volatility created by differences in tax, GAAP and statutory accounting calculations, leaving unfinished business. For example, all three sets of rules have different standards for whether a reinsurance contract counts as reinsurance or a loan or deposit arrangement. Similarly, Treasury has not addressed the impact of CAMT on mark-to-market accounting for non-equity assets for taxpayers outside the reinsurance space.
comment: The hierarchy of financial statements in CAMT prioritizes GAAP and IFRS over statutory financial statements. This approach departs from the historical approach of US tax law, which accorded great deference to statutory accounting as prescribed by insurance regulators.