Foreign annuity reserves may measure a CFC's insurance income

Plain-English summary

A domestic financial-services group owned controlled foreign corporations that issued payout annuities for foreign pension plans. The foreign insurance regulator required audited annual statements and reserves based on prospective actuarial valuations, prudent assumptions, and asset values marked to market. The IRS found that the surviving insurer was a qualifying insurance company and that its locally regulated annuity contracts were exempt contracts under IRC §§ 953 and 954. It ruled that the foreign statement reserves were an appropriate way to measure income for purposes of § 954(i)(4)(B)(ii). The insurer could therefore use those reserves to determine foreign personal holding company income if assets were marked to market consistently with local rules and the reserves included only policyholder-benefit amounts.

Ruling snapshot

• Question: Could the foreign insurers use their locally required annuity reserves when determining foreign personal holding company income?
• Outcome: Approved, subject to consistent mark-to-market accounting and limiting reserves to policyholder benefits.
• Key authorities: IRC §§ 953(e), 954(i)(4)(B)(ii); Treas. Reg. § 1.964-1(c)(3).

Full text (IRS public release)

Internal Revenue Service                                     Department of the Treasury
                                                             Washington, DC 20224

Number: 201637005                                            Third Party Communication: None
Release Date: 9/9/2016                                       Date of Communication: Not Applicable
Index Number: 954.02-00, 953.00-00
                                                             Person To Contact:
---------------------                                        ----------------------------, ID No. --------------
---------------------------                                  -----------------
--------------------------------------------                 Telephone Number:
----------------------                                       ----------------------
----------------------------------                           Refer Reply To:
                                                             CC:INTL:B05
                                                             PLR-118171-15
                                                             Date:
                                                             June 08, 2016


Parent                         = ---------------------------------------------
Subsidiary                     = --------------------------------------------
CFC A                          = -------------------------
CFC B                          = ---------------------------------------
CFC C                          = ------------------------------------
Holdco                         = ---------------------------------------
Country A                      = ----------------------
Country B                      = --------------------------
Insurance                      = ---------------------------------------------------------------------------------
Law                              -
Act                            = ---------------------------------------------------------------------------------
                                 ---------------------------------------------------------------
Authority                      = ------------------------------------------
Annual                         = ---------------------------------------------------------------------------------
Return                           ---------------------------------------------------------------------------------
Date 1                         = -------------------
Date 2                         = --------------------
Date 3                         = --------------------------
Month 1                        = ---------------
Month 2                        = ------
Year 1                         = -------
Year 2                         = -------
Year 3                         = -------
Year 4                         = -------
W                              = ----
X                              = ----
Y                              = ----

Dear ----------------:
                                           -2-

       In a letter dated Date 1, you requested rulings allowing CFC A and CFC B to use
certain foreign statement insurance reserves in computing their foreign personal holding
company income under section 954. You requested these rulings on the grounds that
these insurance reserves are an appropriate means of measuring income within the
meaning of section 954(i)(4)(B)(ii) and, accordingly, such reserves may be used in
determining foreign personal holding company income under section 954.

        The rulings given in this letter are based on facts and representations submitted
by Parent and accompanied by a statement executed under penalty of perjury by an
appropriate party. This office has not verified any of the materials submitted in support
of the request for rulings. Verification of the information, representations, and other
data may be required as part of the audit process.

                                          Facts

      Parent is a publicly-traded domestic corporation that is engaged in investment
banking, securities, investment management, insurance, and other financial services
through its various subsidiaries. Parent is the common parent of an affiliated group of
companies.

       In Year 1, Subsidiary, an indirect wholly-owned subsidiary of Parent, established
a wholly-owned insurance company, CFC A, under the laws of Country A. CFC A is
engaged in the insurance business in Country A. In Month 1, Year 2, Subsidiary
transferred all of the stock of CFC A to a wholly-owned holding company, Holdco, and
sold W percent of the stock of Holdco to various unrelated parties. Parent retains an X
percent ownership interest in Holdco.

       In Month 2, Year 3, CFC A acquired CFC C, a company organized in Year 4
under the laws of Country A. On Date 2, CFC C changed its name to CFC B. CFC B
was engaged in the insurance business in Country A. On Date 3, after the submission
of the Date 1 ruling request, CFC B merged all its assets and liabilities into CFC A
pursuant to a regulatory reorganization procedure applicable to Country A insurance
companies. This ruling will therefore refer to CFC A but will include CFC B for the
period from Date 1 through Date 3.

       CFC A’s operations involve the issuance of payout annuity contracts designed for
the Country A defined benefit pension plan market. Prior to the merger, CFC B issued
single premium payout annuity contracts for which it held reserves.

       The contracts issued by CFC A are designed to provide a stream of guaranteed
annuity payments to cover an employer’s existing pension obligations for its Country A
and Country B resident employees. The contracts cover obligations to current retirees
and active employees. The source of consideration for the annuities will be a
combination of employer and employee contributions.
                                           -3-

       There are no future premiums required by or allowed under the payout annuity
contracts. Some contracts have surrender rights on a bulk basis (whereby the pension
plan trustee of a contract may surrender the contract in exchange for a cash surrender
value), and individual deferred annuitants may also be entitled to individual surrender
values in lieu of future annuity payments.

        Typically, a pension plan will terminate shortly after the annuity contract is
purchased at which time the employee becomes the policyholder. Benefits are payable
to employees only upon retirement or upon the employee’s death before retirement as a
spousal benefit. The employee can elect to have benefits commence earlier or later
than the date of normal retirement (within a restricted range as provided by the
contract). Should the employee make such an election, the amount of future benefit
payments will be actuarially adjusted using actuarial assumptions guaranteed at issue
so that the present value of the adjusted benefit starting on the adjusted retirement date
will be equivalent to the present value of the original benefit starting on the normal
retirement date.

       CFC A issues premium payout annuity contracts. CFC A also issues non-single
premium payout annuity contracts to Country A pension plans and enters into
reinsurance agreements covering a portion of its risks under such contracts. CFC A
also reinsures annuity contracts written by unrelated Country A insurers.

       CFC A derives more than 50 percent of its aggregate net written premiums from
the issuance or reissuance of annuities covering risks in connection with the lives of or
health of residents of Country A and with respect to which no policyholder, insured,
annuitant, or beneficiary is a related person as defined in section 954(d)(3).

       CFC A issues and reinsures annuity contracts in connection with the lives and
health of residents of Country A and derives more than 30 percent of its net written
premium from contracts that cover Country A risks with respect to which no
policyholder, insured, annuitant, or beneficiary is a related person within the meaning of
section 954(d)(3).

       Parent has represented that CFC A would be subject to tax under subchapter L if
it were a domestic corporation.

       In Country A, financial services firms, including insurance companies, are
regulated by the Authority. The Authority is an independent, non-governmental body,
given statutory powers under the Act. The Authority requires that each insurance
company authorized by the Authority to conduct insurance business in Country A file an
annual insurance return. The Annual Return consists of audited financial information
and reports of auditors that the Authority uses for supervision. Annual Return
requirements include preparation of a revenue account, a balance sheet and profit and
loss account for the year; an actuarial investigation every twelve months; an audit of
                                            -4-

accounts; and the depositing of specific reports with the Authority. The deposited
documents are open to public inspection.

       CFC A is licensed by the Authority as an insurance company and is authorized to
sell annuities to residents of Country A and to reinsure similar contracts. Licensing by
the Authority is required in order to conduct insurance business in Country A. CFC A is
subject to regulation by the Authority as an insurance company. The annuity contracts
issued by CFC A are regulated as such by the Authority.

          Under Authority rules, CFC A is required to maintain financial resources,
adequate as to amount and quality, to ensure that there is no significant risk that its
liabilities to policyholders cannot be met as they fall due. Applicable rules specify the
methods and assumptions to be used by an insurance firm in calculating its required
reserves.

       In general, the Authority requires a firm to establish reserves using a prospective
actuarial valuation on prudent assumptions of all future cash flows expected to arise
under, or in respect of, each of its long-term insurance contracts. A prospective
valuation sets reserves at present value of the future net cash flows. The actuarial
valuation of reserves must be based on methods and assumptions that are appropriate
to the business of the firm, consistent year-to-year without arbitrary changes, consistent
with the method for valuing assets, and include appropriate margins for adverse
deviation of relevant factors. Relevant factors include future investment returns,
expenses, mortality, morbidity, policyholder options, persistency, and reinsurance.

       Under Authority rules, insurance company investments generally must be
marked to market, meaning valued at readily available close-out prices from
independent sources. Where marking to market is not possible, assets must be marked
to market using a model based on market input, and the modeled prices must be
checked regularly against market or other relevant sources. Country A rules also
require that reserve methods and assumptions must be consistent with the method of
valuing assets or must be consistent with marking the assets to market.

          The Authority has established special reserve requirements for index-linked
liabilities which include CFC A’s inflation-adjusted benefit described above. Index-
linked liabilities are those in respect of index-linked benefits. Index-linked benefits are
those provided under a long-term contract of insurance determined by reference to an
index of the value of property of any description.

        In addition to computing reserves as described for Country A regulatory
purposes, an insurer will use the same reserve amount in calculating Country A income
tax in connection with its pension plan business.

       Parent represents that the reserves CFC A is required to establish under Country
A rules are not catastrophe, deficiency, equalization, or similar reserves.
                                          -5-

       Parent has also represented that for purposes of determining foreign personal
holding company income, CFC A would follow the Country A mark-to-market method
applicable to assets under Country A financial statement rules and would base reserves
only on amounts attributable to policyholder benefits if a favorable ruling is granted
allowing CFC A to use foreign statement reserves under section 954(i).

       Pursuant to Section 954(i)(4)(B)(ii) and Treas. Reg. §1.964-1(c)(3), Parent has
requested a ruling on behalf of CFC A that the reserves as required to be set forth by
CFC A for its annuity contracts on its Country A Annual Return provide an appropriate
means of measuring income and accordingly, the amount of these reserves may be
used in determining foreign personal holding company income under section 954,
provided that assets are marked to market consistent with Country A rules and the
reserve is based only on amounts attributable to policyholder benefits.

                                          Law

       In general, a United States shareholder of a controlled foreign corporation
(“CFC”) must include in gross income its pro rata share of the CFC’s Subpart F income
for each year. Sec. 951(a). Subpart F income includes, among other types of income,
insurance income under section 953 and foreign base company income under section

954. Sec. 952(a)(1) and (2). Section 953(a) defines the term “insurance income” to
include any income which is attributable to issuing or reinsuring an insurance or annuity
contract and which would be taxed under Subchapter L if such income were the income
of a domestic insurance company. Section 953 provides that section 953 insurance
income does not include “exempt insurance income” derived by a “qualifying insurance
company.” Section 953(b)(3) provides that reserves for any insurance or annuity
contract shall be determined in the same manner as under section 954(i).

        Section 954(a)(1) defines the term “foreign base company income” to include,
among other types of income, foreign personal holding company income. Section
954(c)(1) sets forth the types of income (e.g., interest and dividends) that are
considered to be foreign personal holding company income. Section 954(i)(1) provides
that for purposes of section 954(c)(1), foreign personal holding company income does
not include “qualified insurance income” of a “qualifying insurance company.”

       In general, section 953(e)(3) defines a “qualifying insurance company” as any
controlled foreign corporation which:

        (A)   is subject to regulation as an insurance company by its home country, and
is licensed, authorized, or regulated by the applicable insurance regulatory body for its
home country to sell insurance or annuity contracts to persons other than related
persons (within the meaning of Code section 954(d)(3)) in such home country;

       (B)   derives more than 50 percent of its aggregate net written premiums from
the issuance by such controlled foreign corporation of contracts covering applicable
PLR-118171-15                                 6

home country risks of such corporation and with respect to which no policyholder,
insured, annuitant, or beneficiary is a related person (as defined in Code section
954(d)(3)); and

     (C)    is engaged in the insurance business and would be subject to tax under
Subchapter L if it were a domestic corporation.

        Section 954(i)(2) defines the term “qualified insurance income” to mean income
of a qualifying insurance company falling into two categories. The first category is
income received from unrelated persons and derived from investments made by a
qualifying insurance company or qualifying insurance company branch (collectively
referred to as a “QIC”) either of its reserves allocable to exempt contracts or of 80
percent of its unearned premiums from exempt contracts (as both are determined in
accordance with section 954(i)(4)). Sec. 954(i)(2)(A). The second category is income
received from unrelated persons and derived from investments made by a QIC of an
amount of its assets allocable to exempt contracts equal to: (1) in the case of property,
casualty, or health insurance contracts, one-third of the premiums earned on those
contracts during such year; and (2) in the case of life insurance or annuity contracts, 10
percent of the reserves described in section 954(i)(2)(A) for such contracts. Sec.
954(i)(2)(B).

       Exempt contracts are defined under section 953(e)(2) to include insurance or
annuity contracts issued by a qualifying insurance company in connection with the lives
or health of residents of a country other than the U.S. but only if such company derives
more than 30 percent of its net written premiums from otherwise exempt contracts
which cover applicable home country risks and with respect to which no policyholder,
insured, annuitant or beneficiary is a related person within the meaning of section
954(d)(3).

       Section 954(i)(4)(B)(i) generally provides that in the case of life insurance and
annuity contracts, a QIC’s reserves allocable to exempt contracts are equal to the
greater of (1) the net surrender value of the contract or (2) the reserve determined
under section 954(i)(5). Section 954(i)(4)(B)(ii), however, provides:

       The amount of the reserves under section 954(i)(4)(B)(i) shall be 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.

Section 954(i)(4)(B)(ii) was originally enacted by section 614 of the Job Creation and
Worker Assistance Act of 2002. Under the Protecting Americans from Tax Hikes
(PATH) Act of 2015 (P.L. 114-113, 12/18/2015), section 954(i) was permanently
PLR-118171-15                                7

extended and made effective for taxable years of foreign corporations beginning after
December 31, 2014, and for taxable years of U.S. shareholders with or within which
such taxable years of such foreign corporations end. In its Technical Explanation to the
PATH Act, the staff of the Joint Committee on Taxation explains section 954(i)(4)(B)(ii)
as follows:

      The provision does, however, permit a taxpayer in certain circumstances, subject
      to approval by the IRS through the ruling process or in published guidance, to
      establish that the reserve for such contracts is the amount taken into account in
      determining the foreign statement reserve for the contract (reduced by
      catastrophe, equalization, or deficiency reserve or any similar reserve). IRS
      approval is to be based on whether the method, the interest rate, the mortality
      and morbidity assumptions, and any other factors taken into account in
      determining foreign statement reserves (taken together or separately) provide an
      appropriate means of measuring income for Federal income tax purposes.

Joint Comm. on Taxation, Technical Explanation of the Revenue Provisions of the
Protecting Americans from Tax Hikes Act of 2015, House Amendment #2 to the Senate
Amendment to H.R. 2029 (Rules Committee Print 114-40) (JCX-144-15 (December 17,
2015)).
                                     Analysis

        CFC A is subject to regulation as an insurance company by Country A. CFC
A is licensed, authorized, and regulated by the Authority, which is the insurance
regulatory body for Country A, to sell annuity contracts to persons other than related
persons (within the meaning of Code section 954(d)(3)) in Country A. Parent has
represented that CFC A derives more than 50 percent of its aggregate net written
premiums from its issuance of annuity contracts covering risks in connection with the
lives or health of residents of Country A and with respect to which no policyholder,
insured, annuitant, or beneficiary is a related person (as defined in Code section
954(d)(3)). Finally, Parent has represented that CFC A is engaged in the insurance
business and would be subject to tax under Subchapter L if it were a domestic
corporation. Accordingly, CFC A is a QIC.

        CFC A issues annuity contracts in connection with the lives and health of
residents of Country A, a country other than the U.S. CFC A derives more than 30% of
its net written premiums from contracts that cover Country A risks with respect to which
no policyholder, insured, annuitant, or beneficiary is a related person within the meaning
of section 954(d)(3). Such contracts are, therefore, exempt contracts within the
meaning of section 953(e)(2).

       CFC A must establish, maintain, and calculate the reserves in accordance with
rules prescribed by the Authority. CFC A must set forth the reserves on the Country A
Annual Return, which must be filed annually with the Authority. As such, the reserves
are the measure of the legal obligations to policyholders on the financial statement used
PLR-118171-15                                  8

for regulatory purposes by life insurance companies doing business in Country A
generally (whether U.S.-owned, locally owned, or owned by companies headquartered
in other foreign countries). The Authority requires that CFC A hold reserves for the
fulfillment of claims of policyholders and their beneficiaries. The reserves are not
catastrophe, deficiency, equalization, or similar reserves. Under the rules prescribed by
the Authority for determining reserves set forth on the Country A Annual Return, the
method, the interest rate, the mortality and morbidity assumptions, and other factors
taken into account provide an appropriate means of measuring income for Federal
income tax purposes.

                                          Rulings

       Based on the information submitted and the representations made, we rule as
follows:

        Under the facts set forth above, the foreign statement reserves maintained by
CFC A (and CFC B for years prior to the merger into CFC A) with respect to its exempt
annuity contracts are an appropriate means of measuring income within the meaning of
section 954(i)(4)(B)(ii), and accordingly, the amount of these reserves may be used in
determining CFC A’s (and CFC B’s for years prior to the merger into CFC A) foreign
personal holding company income under section 954, provided that assets are marked
to market consistent with Country A rules and the reserves include only amounts
attributable to policyholder benefits.

                                          Caveats

        We express no opinion on any provisions of the Code or regulations not
specifically covered by the above ruling. This ruling will be subject to revocation if any
of the following circumstances occurs: (1) a change in the material facts on which this
ruling was based; (2) a material change in the business circumstances of CFC A which
would impact its reserving method; or (3) a change in the applicable law or foreign rules
relating to CFC A’s current reserving method.

                                 Procedural Statements

      This ruling is directed only to CFC A (and CFC B for the period from Date 1
through Date 3). Section 6110(k)(3) provides that it may not be used or cited as
precedent.

       Except as expressly provided herein, no opinion is expressed or implied
concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter.

       In accordance with the power of attorney on file in this office, a copy of this letter
is being sent to your authorized representatives.
PLR-118171-15                               9


       A copy of this letter must be attached to any income tax return to which it is
relevant. Alternatively, taxpayers filing their returns electronically may satisfy this
requirement by attaching a statement to their return that provides the date and control
number of the letter ruling.

                                     Sincerely,


                                     Steven D. Jensen
                                     Senior Counsel, Branch 5
                                     Office of Associate Chief Counsel (International)