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CPAs & ADVISORS

TAX UPDATE Thomas F. Wheeland, CPAPartner

AGENDA

Annual Statement Accounting vs. The CodePolicyholder DividendsIRC §461 Rulings – Bonus AccrualsLoss ReservesLB&I Directive on Partial WorthlessnessCamp Tax Reform ProposalPotential Extenders ProvisionsUncertain Tax PositionsMeals & EntertainmentRepair RegulationsTax Exempt Interest – Non-Life Company AnalysisQ&A

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ANNUAL STATEMENT ACCOUNTING VS. THE CODE

State Farm case [110 AFTR 2d 2012-5778, 08/31/2012]7th Circuit decision involved punitive damages treated as part of loss reserves for SAP purposesTaxpayer relied upon annual statement treatment in claiming a deduction (on a discounted basis) for estimated punitive damagesCourt ruled in favor of IRS reasoning that the NAIC’s guidance only allowed for the inclusion of compensatory damages in loss reserves and did not provide such guidance with regard to punitive damagesAlso addressed an AMT issue holding that the ACE adjustment should be made on a consolidated basis and then allocated to the life and non-life subgroups

TAM 200939019 - IRS believes the inclusion of compensation related accruals (in this instance, retiree medical benefits) in LAE should not result in an immediate reserve deduction - §404 trumps §832

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POLICYHOLDER DIVIDENDSMass Mutual case [109 AFTR 2d 2012-837, 01/30/2012]

Court of Federal Claims decision involved a mutual life dividend guarantee, but is applicable to non-life dividends as wellThe court determined that the requirements of the “all events” test of §461 were met

The fact of the liability (although the identity of recipients was unknown) was established with reasonable accuracyEconomic performance had occurred (the guaranteed amount was always paid out)The taxpayer had elected the recurring item exception (an important finding was that the dividend was akin to a rebate or refund)

New York Life case [112 AFTR 2d 2013-5555, 08/01/2013]Second Circuit decision involving January dividends (credited in preceding December) and a minimum liability dividend (calculated as the lesser of the annual dividend or termination dividend)

January dividends credited in December did not meet “all events” test as policyholder could surrender the policy with no right to the credited dividends Minimum liability dividend failed to meet the “all events” test as well because insurer was under no contractual or statutory obligation to pay a termination dividend when the policyholder surrendered policy

PLR 200948042 IRS ruled that insurer’s “practice” of paying January anniversary dividends did not trump the terms of the policyTaxpayer’s argument that it must pay either a termination or policyholder dividend was rejected as well

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IRC §461 RULINGS – BONUS ACCRUALSFAA 20134301F

Formula approved in year of accrualDo not have to be an employee on date of payment to receive bonusFailed on 3 counts:

Company retained right after year end to modify or eliminate bonusesCommittee approval required after year end; role not merely ministerialSubjective individual performance rating impacted bonus

Rev. Rul. 2011-29Must be employee on date of payment to receive bonusThe “fact of the liability” for bonuses established by resolution or objective formulaAmounts forfeited are re-distributed to other employees

CCA 200949040Must be employee on date of payment to receive bonusBonus plan whereby amounts forfeited would be paid to a charityDifferent timing rules exist under §170 and §461; deduct in year of payment

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LOSS RESERVES

Acuity DecisionTaxpayer’s reserves found to be “fair and reasonable”Diversified writer with increasing premiums and changes in product mixReserves developed by internal actuary and within outside actuary’s rangeOutside actuary’s range was under 20% (14.6%)Taxpayer’s conservative reserve assumptions (“implicit margin”) supported by actual loss experience and exercise of professional judgment Court cited State Farm and Sears in deferring to annual statementCredentialed actuary employed multiple methods and complied with SSAP 55 and ASOPsHistory of positive development not determinativeUtah Medical parallels where management chose reserves w/in rangeDifferentiated from Minnesota Lawyers where range was excessiveCourt acknowledged that wider range appropriate for monoline companies

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LOSS RESERVES

Coordinated Issue Paper (CIP) on Reserve MarginsReserves must be fair and reasonable and represent actual unpaid lossesAdditions must be based upon actual loss experienceActuary’s opinion not entitled to any presumption or deferenceNote: Effective January 21, 2014, all CIPs have been de-coordinated

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LB&I DIRECTIVE ON PARTIAL WORTHLESSNESS

IRC§166(a)(2) provides for a partial worthlessness deduction for debtSAP 43R impairments related to loan-backed or structured securities such as REMICs may be deductible for tax purposes as well under the charge-off conformity rule of the directive2012 is the last year to which the directive appliesThe position still has technical support

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CAMP TAX REFORM PROPOSALReduce top corporate tax rate to 25%Repeal AMT and revise NOL rulesEliminates exclusion of performance-based compensation from §162(m)

Life reserves – increase in discount rate to compute tax reservesNon-life reserves – increase in rate, loss payment pattern lengthening, no company electionIncrease in DAC percentagesChange in proration rulesRepeal of §833 (BCBS entities)

Removes benefits for small life and non-life insurers Limits COLI interest expense exception to 20% owners for new contractsRepeal of §847 – Special Estimated Tax PaymentsInternational provisions

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POTENTIAL EXTENDERS PROVISIONS50% Bonus DepreciationSection 179 ExpensingR&E Credit

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UNCERTAIN TAX POSITIONS

New SSAP 101 UTP standard may require companies to establish tax contingencies for the first timeLike the GAAP standard, the new SAP standard requires companies to analyze tax positions by employing a “more likely than not” thresholdOnly applies to federal and foreign income tax positionsAssumes a review by the relevant taxing authority with full knowledge of factsException for temporary differencesSAP only filers should carefully apply SSAP 101’s regime to minimize tax contingencies and avoid the need to disclose on Schedule UTP

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MEALS & ENTERTAINMENT

Revised §274 regulationsProvides guidance as to who will be subject to 50% disallowanceIf employer has a reimbursement or expense allowance arrangement:

Limitation applies to employee if reimbursement is treated as compensation; applies to employer if not treated as such

Can be subject to written agreement between independent contractors and clients/customers

If no written agreement, limitation applies to independent contractor to extent he/she does not “account” for expenses; otherwise, applies to client/customer

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REPAIR REGULATIONS

Generally effective for tax years beginning on or after January 1, 2014Companies can early adopt in years beginning on or after January 1, 2012Incidental materials and supplies can be deducted in the tax year their cost is paidNon-incidental materials can be deducted under the de minimis expensing rule ($5,000 per invoice)Final companion regulations governing general asset accounts and disposition of depreciable property expected soon

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TAX EXEMPT INTEREST – NON-LIFE COMPANY ANALYSIS

Regular tax and alternative minimum tax break-even analysisAssume taxable income is $1,000,000 before tax-exempt interest deductionRegular tax rate is 35%; AMT rate is 20%; no state taxesTax-exempt interest (net of proration) is $(500,000)Regular taxable income is $500,000 and tax is $175,000AMTI = $500,000+[$500,000*75%] = $875,000 and tax is $175,000Break-even level in example is $(588,235) of tax exempt interest net of $88,235 of proration

After-tax yield comparison (35% federal tax rate; no state tax)A 5% taxable bond has an after-tax yield of 3.25%A 5% tax-exempt bond has a 4.7375% after-tax yieldA 3.43% tax-exempt bond has an after-tax yield of 3.25%

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TAX PROVISION EXAMPLE - FACTS

Pre-Tax Income of $10,000,000Permanent Differences of $(1,000,000) - $(350,000) Tax Effected Temporary Differences (I/S Items) of $3,000,000 - $1,050,000 Tax Effected Increase in Nonadmitted Receivables of $400,000 - $140,000 Tax EffectedIncrease in Unrealized Gains of $1,400,000 – $490,000 Tax EffectedDeferred Tax Assets BOY EOY

Income Statement Items (at 35%) $3,500,000 $ 4,550,000 DTANonadmitted Assets (at 35%) $1,050,000 $ 1,190,000 DTAUnrealized Gains (at 35%) $ (700,000) $(1,190,000) DTLGross DTA $3,850,000 $ 4,550,000 DTANonadmitted DTA $ (850,000) $ (550,000) AssumedAdmitted DTA $3,000,000 $ 4,000,000 DTA

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TAX PROVISION EXAMPLE – CURRENT AND DEFERRED PROVISIONS

Taxable Income $12,000,000Tax Rate 35%Current Tax Expense $ 4,200,000 42.0%

Change in DT $ (1,000,000) Benefit

Change in Nonadmitted $ (300,000) BenefitChange in Unrealized Gains $ 490,000 ChargeChange in DTA $ (1,190,000) Benefit(11.9)%

Total Taxes (SAP FN) $ 3,010,000 30.1%

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TAX PROVISION EXAMPLE

Effective Tax Rate 30.1%Impact of Nonadmitted Assets 1.4%

Effective Tax Rate (P&L Related) 31.5%

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