Foreign insurers could use local reserves for section 954 income

Plain-English summary

Two U.S.-owned controlled foreign corporations sold life insurance and annuity products under their home country's insurance rules. They asked to use specified foreign statement reserves, plus related asset bases for separate account contracts, when calculating foreign personal holding company income. The IRS found that both companies were qualifying insurance companies, their contracts were exempt contracts, and the local regulator's reserving factors appropriately measured income under section 954(i)(4)(B)(ii). It approved use of underwriting, loss, and policyholder dividend reserves for life insurance and annuity contracts, as well as reserves and asset bases for separate account contracts. The ruling remained subject to revocation if material facts, business circumstances affecting the reserving method, or applicable law changed.

Ruling snapshot

• Question: Could the two foreign insurance companies use specified home-country reserves and separate account asset bases to compute foreign personal holding company income?
• Outcome: Approved.
• Key authorities: IRC §§ 817, 953, 954, and 957.

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201644008 Third Party Communication: None
Release Date: 10/28/2016 Date of Communication: Not Applicable
Index Number: 954.02-00
Person To Contact:
------------------- ------------------------
---------------------------------------------------------- Telephone Number:
----------------- ----------------------
------------------------- Refer Reply To:
----------------------------- CC:INTL:B05
PLR-106580-15
Date:
August 01, 2016

Legend

A = ------------------------
CFC 1 = -----------------------------
CFC 2 = ------------------------------------------
Country A = --------------
Parent = ----------------
US Sub = ------------------------------------------------
Corp A = --------------------------------------------------------
Corp B = ---------------------------------------------------------
X % = -----------
Y% = -----------
Z% = -----------
Regulator = --------------------------------------------------------
Day X = ------------

Dear ----------------:

In a letter dated A, you requested a ruling allowing CFC 1 and CFC 2 (collectively, the
“CFCs”) to use certain foreign statement insurance reserves in computing foreign
personal holding company income under section 954 on the grounds that these
insurance reserves are an appropriate means of measuring income within the meaning
of section 954(i)(4)(B)(ii). Specifically, you requested permission to use (1) the
underwriting reserves, loss reserves, and policyholders’ dividend reserves for life
insurance and annuity contracts reported by CFCs on their Country A Annual Report;
and (2) the underwriting reserves, loss reserves, and associated asset bases
PLR-106580-15 2

attributable to CFCs’ separate account-type contracts, as reported on the Country A
Annual Report.

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, through its
subsidiaries, in various lines of business, which primarily include life insurance, accident
and health insurance, credit insurance, annuities, endowment and retirement and
savings products. Parent directly and indirectly owns all the stock of US Sub. US Sub
owns all the stock of Corp A. Corp A owns all the stock of Corp B. Corp B owns
approximately X% of CFC 1. US Sub owns approximately Y% of CFC 1. Corp B also
owns approximately Z% of CFC 2. Parent represents that CFCs are controlled foreign
corporations as defined in section 957. CFCs are both engaged in the life insurance
business in Country A. CFC 1’s principal products are traditional life (both term
insurance and permanent insurance), variable whole life that employ separate account
funds, variable universal whole life, fixed annuities, and retirement insurance for both
companies and individuals. CFC 2’s principal products are individual and group
voluntary annuities and pension annuities.

Country A regulates any insurance business conducted in Country A through its
insurance laws and regulations. Regulator developed and is responsible for enforcing
insurance laws and regulations in Country A. An insurance company must obtain a
license from the Regulator to conduct an insurance business in Country A.

CFCs are licensed by the Regulator to sell life insurance and annuity contracts to
persons in Country A and are subject to regulation by Regulator as life insurance
companies. CFCs do not carry on business other than life insurance and certain
activities that are incidental to the life insurance business. Each of the CFCs derives
greater than 50 percent of its aggregate net written premiums from the issuance of life
insurance and annuity contracts covering applicable home country risks. No
policyholder, insured, annuitant, or beneficiary to a life insurance or annuity contract that
the CFCs issue is a related person as defined in section 954(d)(3). Parent has
represented that CFCs would be subject to tax under Subchapter L if they were
domestic corporations.

The CFCs also issue separate account-type variable life insurance and annuity
contracts, which are separately identified and maintained, and are supported by
separately identifiable pools of assets. The assets in the pools are marked to market for
local regulatory reporting purposes and the associated reserve follows movements in
PLR-106580-15 3

the value of the assets (with very limited exceptions, such as surrender charges). For
Country A tax and insurance regulatory purposes, the CFCs are required to make asset
basis and reserve-related adjustments to its separate accounts (including premiums
received but not yet allocated to the separate accounts).

As required by Country A’s insurance laws and regulations, CFCs file Annual Reports
and financial statements with the Regulator. The Annual Reports are audited by an
external accounting firm in addition to the companies’ internal auditor. The accounting
records of CFCs that form the basis for preparing the Annual Reports are subject to
inspection by the Regulator at any time. The Annual Reports are made available to the
public. In addition to their use for regulatory purposes, the Annual Reports are used for
financial purposes, such as Country A credit rating, by lenders, and the public. Day X is
the official year end for life insurance companies operating in Country A.

To comply with Country A’s insurance laws, CFCs must establish and maintain reserves
for their obligations to holders of their life insurance and annuity contracts and must
report the amount of such reserves on the Country A Annual Report. The reserves at
issue in the ruling request are limited to the underwriting reserves, loss reserves, and
policyholders’ dividend reserves that the CFCs maintain on their Country A Annual
Reports for life insurance or annuity contracts.

CFCs have appointed a qualified actuary to be involved in matters designated by the
Regulator as actuarial matters, including the method of calculating reserves. The
actuary has knowledge and experience concerning actuarial matters for a company in
Country A engaged in the insurance business.

The reserve system for Country A includes the following requirements as to
assumptions and method with respect to life insurance and annuity contracts issued by
CFC 1. Underwriting reserves are required to secure the performance of future
obligations arising from life insurance contracts. CFC 1’s underwriting reserves are
comprised of insurance premium mathematical reserves and unearned premium
reserves. Generally, the reserve methods and mortality and interest assumptions are
submitted to the Regulator by a qualified actuary and subject to approval by the
Regulator. CFC 1 currently holds traditional life insurance reserves determined using
the net level premium method, universal life reserves using full account values, and
other fund-based reserves, also using full account value. CFC 1 also holds loss
reserves for outstanding claims (including claims that have been incurred but not
reported) under life insurance issued by CFC 1 and calculates the reserves using the
company’s individual accrued liability experience and estimates of liabilities for claims
incurred but not reported. The policyholders’ dividend reserves represent portfolio
profit-sharing components of the policies as of the statement date for profit sharing to be
credited at the next contract anniversary.

The reserve system for Country A includes the following requirements as to
assumptions and method with respect to life insurance and annuity contracts issued by
PLR-106580-15 4

CFC 2. Underwriting reserves are comprised of annuity account values during the
deferred annuity accumulation periods and annuity mathematical reserves for annuities
in the payout period. Generally, the reserve methods and mortality and interest
assumptions are submitted to the Regulator by a qualified actuary and subject to
Regulator approval. CFC 2 also holds loss reserves for outstanding benefit payments
under annuity contracts issued by CFC 2 and calculates the reserves using the
company’s individual accrued liability experience. In the case of a contract that is
treated as participating in the profit of a line-of-business portfolio, an amount of
policyholders’ dividend reserves would be held on the balance sheet for this provision.

Parent represents that: (1) CFCs are not engaged in any insurance business outside of
Country A and do not carry on any non-life insurance business; and (2) each contract
covered by the rulings requested is a life insurance contract or annuity contract for
federal income tax purposes, without regard to sections 72(s), 101(f), 817(h) and 7702.

The reserves covered by this ruling do not include: (1) deficiency reserves; (2)
contingency reserves; (3) equalization reserves; (4) excess interest reserves for excess
interest credited beyond the end of the taxable year; (5) reserves for administrative
expenses (including guarantees intended to cover future expenses associated with the
payment of claims such as bank fees or inflation risk); (6) underwriting or loss reserves
for non-cancellable and guaranteed renewable accident and health contracts; (7)
reserves for any amount to protect against a future decline in the value of investment
assets; or (8) any reserves for accrued liabilities.

                                       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.
Subpart F income includes, among other types of income, insurance income under
section 953 and foreign base company income under section 954.

Section 953(a)(1) defines the term “insurance income” to include any income that is
attributable to the issuing or reinsuring of an insurance or annuity contract, and that
would be taxed under Subchapter L if such income were the income of a domestic
insurance company. Section 953(a)(2) 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 953(e)(1) defines “exempt insurance income” as income derived by a qualifying
insurance company that is attributable to the issuing (or reinsuring) of an “exempt
contract” by such company and that is treated as earned by such company in its home
country for purposes of such country’s tax laws. “Exempt contracts” are defined under
section 953(e)(2) to include insurance or annuity contracts issued by a qualifying
PLR-106580-15 5

insurance company in connection with the lives or health of residents of a country other
than the United States, 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).

In general, section 953(e)(3) defines a “qualifying insurance company” as any CFC that:

   (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 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 home
country risks of such corporation and with respect to which no policyholder, insured,
annuitant, or beneficiary is a related person (as defined in 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(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 that are considered 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.”

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)). 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.

Section 817 generally provides special rules for certain variable contracts for purposes
of Part I of Subchapter L of the Code. Section 817(d) defines a “variable contract” as
any contract that (1) provides for the allocation of all or part of the amounts received
under the contract to an account which, pursuant to state law, is segregated from the
general asset accounts of the company, and (2) either provides for the payment of
annuities, is a life insurance contract, or provides funding for insurance on retired lives.
PLR-106580-15 6

If a contract satisfies the variable contract requirements, and the separate account that
funds the variable contract is treated as a segregated asset account, section 817
requires that certain adjustments be made to the insurance company’s asset basis and
insurance tax reserves with respect to the segregated asset account. Section 817(a)
provides that, with respect to any variable contract, reserves are adjusted (1) by
subtracting an amount equal to the sum of the amounts added from time to time (for the
taxable year) to the reserves separately accounted for by reason of appreciation in
value of assets (whether or not the assets have been disposed of) and (2) by adding
thereto an amount equal to the sum of the amounts subtracted from time to time
(for the taxable year) from such reserves by reason of depreciation in value of assets.

Under section 817(b), the basis of each asset in a segregated asset account is
increased or decreased by the amount of appreciation or depreciation, respectively, to
the extent the reserves or other items referred to in section 817(a) are adjusted. The
asset basis and insurance tax reserve adjustments offset any realized gain/loss
attributable to such marked assets at the insurance company level.

Section 954(i)(3) imposes separate contract treatment for “separate account-type
contracts,” a term which includes contracts not meeting the requirements of section 817.
Section 954(i)(3)(A) provides that, for purposes of applying section 954(i) and with
respect to any separate account-type contract (including any variable contract not
meeting the requirements of section 817), income credited under such contract is
allocable only to such contract. Income not allocable to a separate account-type
contract is allocated ratably among contracts.

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
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
PLR-106580-15 7

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 1 and CFC 2 are subject to regulation as life insurance companies by Country A.
CFC 1 and CFC 2 are licensed, authorized, and regulated by the Regulator, which is the
insurance regulatory body for Country A, to sell life insurance and annuity contracts to
persons other than related persons (within the meaning of section 954(d)(3)) in Country
A. Parent has represented that CFC 1 and CFC 2 each derive more than 50 percent of
their aggregate net written premiums from the issuance of life insurance and annuity
contracts covering applicable home country risks and with respect to which no
policyholder, insured, annuitant, or beneficiary is a related person (as defined in section
954(d)(3)). Finally, Parent has represented that CFC 1 and CFC 2 are engaged in the
life insurance business and would be subject to tax under Subchapter L if they were
domestic corporations. Accordingly, CFC 1 and CFC 2 are QICs under section
953(e)(3).

CFC 1 and CFC 2 issue life insurance and annuity contracts in connection with the lives
and health of residents of Country A, a country other than the United States. CFC 1 and
CFC 2 derive more than 30 percent of their 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 1 and CFC 2 must establish, maintain, and calculate their underwriting reserves
and loss reserves in accordance with the insurance laws and regulations prescribed by
the Regulator. The Regulator requires a life insurance company to determine the
amount of its underwriting reserves based on guidance provided by the Regulator.
CFC 1 and CFC 2 must set forth their underwriting reserves and loss reserves on the
PLR-106580-15 8

Country A Annual Report, which must be filed annually with the Regulator. These
reserves are the measure of the legal obligations to policyholders on the financial
statement used for regulatory purposes by life insurance companies doing business in
Country A (whether U.S.-owned, locally-owned, or owned by companies headquartered
in other foreign countries). The Regulator requires CFC 1 and CFC 2 to hold reserves
for the fulfillment of claims owed to policyholders and beneficiaries. The reserves are
not catastrophe, deficiency, equalization, or similar reserves. Under the rules
prescribed by the Regulator for determining reserves required to be calculated for
purposes of the Country A Annual Report, the method, interest rate, the mortality and
morbidity assumptions and other factors taken into account provide an appropriate
means of measuring income within the meaning of section 954(i)(4)(B)(ii).

For Country A insurance regulatory purposes, CFC 1 and CFC 2 are each required (1)
to mark to market its portfolio investment assets held pursuant to its separate account-
type contracts, (2) to adjust the bases of its marked portfolio investment assets to fair
market value, and (3) to adjust its underwriting reserves and loss reserves in order to
offset any realized gain or loss attributable to the marked assets. The asset basis and
reserve-related adjustments prevent CFC 1 and CFC 2 from reporting distortions in the
amount and timing of its income on its Country A Annual Report to the Regulator. This
method clearly reflects income as does the rules provided by section 817 for domestic
insurance companies taxed under subchapter L. Under the rules prescribed by the
Regulator for determining reserves required to be calculated for purposes of the
Country A Annual Report, the method, interest rate, the mortality and morbidity
assumptions and other factors taken into account provide an appropriate means of
measuring income within the meaning of section 954(i)(4)(B)(ii).

                                     Ruling

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

(1) Under the facts set forth above, the foreign statement underwriting reserves, loss
reserves, and policyholders’ dividend reserves maintained by CFC 1 and CFC 2 with
respect to their exempt life insurance or annuity contracts are an appropriate means of
measuring income within the meaning of section 954(i)(4)(B)(ii) and may be used in
determining the foreign personal holding company income of CFC 1 and CFC 2 under
section 954(i).

(2) Under the facts set forth above, the foreign statement underwriting reserves, loss
reserves, and associated asset bases attributable to CFC 1’s and CFC 2’s separate
account-type contracts are an appropriate means of measuring income within the
meaning of section 954(i)(4)(B)(ii) and may be used in determining the foreign personal
holding company income of CFC 1 and CFC 2 under section 954(i).

                                    Caveats

PLR-106580-15 9

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 1 or CFC 2
which would impact its reserving method; or (3) a change in the applicable law or
foreign rules relating to the current reserving method of CFC 1 or CFC 2.

                              Procedural Statements

This ruling is directed only to CFC 1 and CFC 2. 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 with this office, a copy of this letter is
being sent to your authorized representative.

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,


                                Mark E. Erwin
                                Branch Chief, Branch 5
                                Office of Associate Chief Counsel (International)

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