March 17, 2021
US IRS says assumption of reinsurance agreement does not result in base erosion payments
In PLR 202109001, the United States (US) Internal Revenue Service (IRS) concluded that a domestic taxpayer (Taxpayer) did not make a base erosion payment when it and two related foreign corporations (FC1 and FC2) entered into an agreement (Agreement) under which FC1 will be substituted for FC2 as retrocessionaire. Taxpayer had previously retroceded the risks to FC2 after originally assuming them from a related domestic insurer (Corp A). According to the IRS, the Agreement did not increase Taxpayer's liability under the base erosion and anti-abuse tax (BEAT) imposed by Internal Revenue Code1 Section 59A.
The IRS also indicated that amounts paid or accrued by Taxpayer under its original reinsurance agreements will remain base erosion payments if they meet the definition of a base erosion payment under Section 59A and its regulations.
Parent, Taxpayer, and Corp A (all domestic corporations) and foreign corporation FC2 are indirect subsidiaries of foreign corporation FC1. Foreign corporation FC3 is a reinsurance company. FC1 owns a percentage of FC3.
Taxpayer reinsured nonlife risks underwritten by Corp A. Taxpayer then retroceded to FC1, on a quota-share basis, a portion of the risks it had reinsured from Corp A. Taxpayer subsequently entered into another quota-share reinsurance agreement with FC2 under which Taxpayer retroceded to FC2 an additional portion of the risks Taxpayer had reinsured from Corp A (Retrocession 1). FC2 then reinsured the risks it had assumed to FC1, under another reinsurance agreement (Retrocession 2). FC1 also entered into a reinsurance agreement (Retrocession 3) with FC3 by which it reinsured the risks it had assumed under Retrocession 2. Retrocessions 1, 2 and 3 were all done on a "funds withheld" basis whereby the party ceding the risk could withhold assets equal to the statutory reserves that otherwise would have been paid to the reinsurer as reinsurance premiums.
To reduce operational complexity and administrative burden, Taxpayer, FC1 and FC2 entered into the Agreement. Under the Agreement, FC1 would be substituted for and replace FC2 as the direct reinsurer under Retrocession 1, and FC1 would accept and assume all rights, duties, liabilities and obligations for the indemnity reinsurance. The Agreement restructured and replaced Retrocession 1 and terminated and replaced Retrocession 2. Taxpayer paid no new consideration as a result of the Agreement. Taxpayer represented that the obligations in Retrocession 1 and the Agreement constitute insurance for federal income tax purposes. Taxpayer also represented that Retrocession 1 may be accounted for as prospective insurance.
Law and analysis
Under Section 59A, BEAT applies to base erosion payments paid or accrued in tax years beginning after 31 December 2017. A base erosion payment is any deductible amount paid or accrued by an applicable taxpayer to a foreign person (as defined in Section 6038A(c)(3)) that is a related party. Section 59A(d)(3) defines base erosion payments to also include any premium or other consideration paid or accrued by the taxpayer to a related foreign person for any reinsurance payments under Sections 803(a)(1)(B) or 832(b)(4)(A).
In its analysis, the IRS referenced Treas. Reg. Section 1.809-5(a)(7)(ii), which defines assumption reinsurance as "an arrangement whereby another person (the reinsurer) becomes solely liable to the policyholders on the contracts transferred by the taxpayer. Such term does not include indemnity reinsurance or reinsurance ceded." The IRS also cited Beneficial Life Ins. Co. v. Commissioner, 79 T.C. 627, 645 (1982), nonacq. on other grounds, 1984-2 C.B. 1, which held that an assumption of reinsurance is considered a sale by the ceding company to the reinsuring company.
The IRS found that the Agreement will operate as an assumption reinsurance transaction because FC1 will be substituted for FC2 as the counterparty under Retrocession 1. Further, the Agreement will operate as a sale by FC2 to FC1 so any amount paid or accrued under the Agreement is solely between FC1 and FC2. Moreover, citing Revenue Ruling 82-122, the IRS found that changing the counterparty obligated to the taxpayer under a contract does not always result in a deemed termination of the contract regarding the taxpayer. In this case, the Agreement does not result in a deduction for Taxpayer under Section 832(b)(4)(A) for premiums paid for reinsurance.
The IRS thus concluded that the Agreement does not affect Taxpayer's BEAT liability under Section 59A, so Taxpayer will not be treated as making a base erosion payment under Section 59A(d)(3) solely as a result of the Agreement.
The IRS does not particularly elaborate in the PLR on what payment or deemed payment could be subject to BEAT. Presumably, the potential BEAT issue underlying the PLR is whether, under US federal income tax principles, the Agreement results in a deemed payment from Taxpayer to FC2 from the accrued value that may be embedded in either the insurance or investment assets supporting the reserve liabilities.
The ruling does not provide further details regarding how Retrocession 1 was "restructured." Assuming there was no change other than to replace the name of the party on the contract, the IRS's conclusion regarding the tax impact of the Agreement appears consistent with the accounting treatment under the National Association of Insurance Commissioners (NAIC) statutory accounting principles when there is merely a substitution of the reinsurer without any other change in the economics of the original arrangement. In nonlife reinsurance transactions such as the one outlined here, the ceding company (Taxpayer) generally would not need to alter its NAIC statutory account treatment for recognition of the transaction, and such treatment would not result in any deemed payments made by Taxpayer to FC2. Under that approach, similar to what the IRS concludes, no deductible payments to a foreign related party could be subject to BEAT. The IRS does not address the funds-withheld arrangement in the PLR, perhaps because the issue was not fully explored. If it had been, presumably the IRS would have reached a similar conclusion, which likely would have been consistent with the underlying accounting treatment.
The Internal Revenue Code references NAIC statutory accounting principles in certain circumstances under Subchapter L (see Sections 846 and 832 in the nonlife insurance context and Section 811 in the life insurance context). General US federal income tax principles, however, still apply to transactions (e.g., application of the affiliated group rules). Both the courts and the IRS have looked to NAIC statutory accounting principles in various contexts (e.g. American Financial Group and Consolidated Subsidiaries v. US, 678 F.3d 422 (6th Cir. 2012); State Farm Mutual Auto Insurance Co. v. Commissioner, 698 F.3d 357 (7th Cir. 2012); American International Group Inc. v. United States, 38 Fed. Cl. 274 (1997); PLR 8742004; PLR 9033031; and PLR 202109005). While this PLR does not address the issue of deferring to the requirements of NAIC statutory accounting principles, it further illustrates circumstances when the IRS has reached a conclusion consistent with those principles.
Payments such as reinsurance premiums typically paid by a US ceding company to a foreign related reinsurance company are generally subject to BEAT. As in this PLR, the IRS has indicated in other PLRs that amounts paid or accrued by Taxpayer to FC1 and FC2 under the reinsurance agreements will remain base erosion payments if they meet the definition of the term "base erosion payment."
A PLR is a written statement issued to a particular taxpayer that interprets and applies tax laws to the taxpayer's specific, represented set of facts, and may not be used or cited as precedent by other taxpayers. Thus, although the ruling is instructive on how the IRS might rule regarding a particular matter, organizations are cautioned not to rely on the ruling as authority.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (United States), International Tax and Transaction Services
Ernst & Young LLP (United States), Global Compliance & Reporting – Insurance Sector
Ernst & Young LLP (United States), International Tax and Transaction Services – Transfer Pricing Controversy