1. Insurance Companies and Products: Litigation and Administrative Update “HEADLINE NEWS” Tom Quinn, Moderator Alexis MacIvor, Chief, Insurance Branch, IRS Office of Chief Counsel Mark S. Smith, PricewaterhouseCoopers, LLP AMERICAN BAR ASSOCIATION SECTION OF TAXATION INSURANCE COMPANIES COMMITTEE SEPTEMBER 18, 2015 CHICAGO, IL

2. Recent Headlines in Insurance Tax “Tax Court Applies Investor Control Doctrine in Jeffrey T. Webber v. Commissioner” “D.C. Circuit Affirms Taxpayer Win in Validus Reinsurance, Ltd. v. U.S.” “Taxpayers Comment on PFIC Proposed Regulation” “Service Declines to Rule on Employee Benefits Captive Arrangement” “IRS: Excess Loss Policies are not Insurance” “Service Addresses Section 72(s) Distribution Requirements in PLR” “Service and Treasury Release 2015-2016 Priority Guidance Plan for Insurance” “Other Developments Continue to Unfold” 2

3. Jeffrey T. Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015) In Jeffrey T. Webber v. Commissioner, a venture-capital investor and hedge fund manager established a grantor trust to purchase private placement variable life insurance policies on the lives of two elderly relatives. The policies were issued by a Cayman Islands company, and were supported by assets held in a life insurance company separate account. The separate account investments were investments in companies with which the policyholder was closely familiar and in which he also invested directly. In an attempt to avoid the investor control doctrine, the policyholder and company observed the “Lipkind protocol,” which prohibited direct contact between the policyholder and the investment manager, but did not prevent more than 70,000 e-mails representing the policyholder’s thoughts and recommendations on various investments. The policyholder also had the power to vote shares of stock held by the separate account, and had the power to extract cash and to derive other benefits. 3

4. Jeffrey T. Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015) Applying Skidmore v. Swift, the Tax Court gave considerable deference to the Service’s long line of revenue rulings concluding that a policyholder with direct or indirect control over the assets supporting a variable life insurance contract or variable annuity contract is treated as owner of those assets. In particular, the Tax Court found overwhelming evidence the policyholder actively managed all aspects of the investments in the separate account and noted that even absent deference to the IRS rulings, it would have adopted the “bedrock” principles underling them. The court’s opinion is long – the slip opinion has 92 pages – and is noteworthy for several reasons— It is only the second decided case to address investor control, and the first since 1985; The court rejected the taxpayer’s argument that section 817(h) preempts the investor control doctrine; As noted, the court accorded Skidmore deference to (some of) the Service’s rulings in the area; 4

5. Jeffrey T. Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015) Despite its harsh assessment of the case’s facts, the court declined to impose penalties because the policyholder relied in good faith on professional advice from competent tax professionals; The court did not discuss the “public availability” prong of the investor control doctrine, even though the facts in the case ran afoul of that prong as well. The court did not discuss the qualification of the life insurance contracts under section 7702 of the Code “The mortality risk charge was determined actuarially, but it rapidly decreased as the value of the separate accounts approached or exceeded the minimum death benefit of $2,720,000.” “If the investments in the separate account performed well, the beneficiary upon the insured’s death was to receive the greater of the minimum death benefit or the value of the separate account.” How widespread are investor control issues of this magnitude, and how might the case affect future tax planning? 5

6. Validus Reinsurance, Ltd. v. U.S., 786 F.3d 1039 (D.C. Cir. 2015) Section 4371 imposes an excise tax on insurance and reinsurance policies issued by a foreign insurer or reinsurer with regard to U.S. risks. The excise tax is equal to 4 percent of premiums paid on casualty insurance, or 1 percent of premiums paid on life insurance, accident and health insurance, annuity contracts, and reinsurance. Rev. Rul. 2008-15, 2008-1 C.B. 633, explains the IRS position that the excise tax may apply to a wholly-foreign transaction, including a retrocession of U.S. risks by one foreign reinsurer to another. In Validus Reinsurance, Ltd. v. U.S., 19 F. Supp.3d 225 (D.D.C. 2014), District Court for the District of Columbia granted summary judgment in favor of the taxpayer, a foreign reinsurer, concluding that Section 4371 does not apply to “retrocessions.” The court’s analysis applied the “plain language” of Section 4371, which refers to “insurance” and “reinsurance,” but not to retrocessions. The case called into question not only the validity of Rev. Rul. 2008-15, but also the treatment of transactions in which a U.S. reinsurer retrocedes U.S. risks to a foreign reinsurer. 6

7. Validus Reinsurance, Ltd. v. U.S., 786 F.3d 1039 (D.C. Cir. 2015) May 26, 2015, the Court of Appeals for the D.C. Circuit affirmed the grant of summary judgment to the taxpayer, but on narrower grounds. Validus Reinsurance, Ltd. v. U.S., 786 F.3d 1039 (D.C. Cir. 2015). According to the court, the text of Section 4371 is ambiguous as to its application to foreign retrocessions of U.S. risks. On the one hand, retrocessions may be viewed as a type of reinsurance, and the purpose of the provision is best served by treating retrocessions similarly to reinsurance. On the other hand, the provision does not refer to retrocessions, and on these facts the result would be extraterritorial application of a U.S. tax provision. The court’s opinion explored these competing applications of section 4371 by analyzing what it means for premiums paid on reinsurance to “cover” policies. Finding ambiguity, the court applied the presumption against extraterritoriality because there is no clear indication that Congress intended the tax to apply to premiums on foreign-to-foreign retrocessions. The presumption against extraterritorial application of U.S. law is a longstanding, non-tax principle to the effect that unless there is a clear contrary congressional intent, a court must presume that a state has no extraterritorial application. 7

8. Validus Reinsurance, Ltd. v. U.S., 786 F.3d 1039 (D.C. Cir. 2015) By adopting this analysis, the court of appeals removed an anomalous application of the lower court’s decision that arguably excused from section 4371 taxation a retrocession from a US reinsurer to a foreign reinsurer. To many taxpayers, the landscape returned to what was generally thought to be the application of the provision before Rev. Rul. 2008-15. What does the decision put in motion? ◦Government decision to appeal or not appeal ◦Reconsideration of Rev. Rul. 2008-15 ◦Treatment of claims for refund ◦Additional planning 8

9. Exception from Passive Income for Certain Foreign Insurance Companies, REG- 108214-15 Under Section 1297(a), a foreign corporation is a “Passive Foreign Investment Company,” or PFIC, if— ◦75 percent or more of its gross income for the taxable year is passive income, or ◦The average percentage of assets held for the taxable year that produce passive income or held for the production of passive income is at least 50 percent. Section 1297(b) defines passive income as income of a kind that would be foreign personal holding company income, such as dividends, interest, royalties, rents, and certain other types of income. Section 1297(b)(2)(B) excludes from the definition of “passive income” income that is derived in the active conduct of an insurance business by a corporation that is predominantly engaged in an insurance business and would be subject to tax under Subchapter L if it were a domestic company. 9

10. Exception from Passive Income for Certain Foreign Insurance Companies, REG- 108214-15 IRS has long been concerned that some companies were claiming insurance company status in order to take advantage of the active insurance business exception of Section 1297(b)(2)(B), and published Notice 2003-34 to alert taxpayers to the issue. Senate Finance Committee Ranking Member Ron Wyden expressed concern to the Service that the provision was being exploited by some companies to avoid taxation on income that was not derived in the active conduct of an insurance business, and IRS Commissioner Koskinen committed to the publication of guidance on the active conduct of an insurance business. April 24, 2015, IRS proposed regulations that, if adopted, would provide guidance on when income is treated as derived in the active conduct of an insurance business. Under the regulations – 10

11. Exception from Passive Income for Certain Foreign Insurance Companies, REG- 108214-15 the term “active conduct” has the same meaning as in regulations under Section 367(a) (concerning transfers to foreign corporations), except that officers and directors are not considered to include the officers and employees of related companies; Insurance business includes both underwriting activities and investment activities that are required to support or are substantially related to insurance contracts; and Investment activities are treated as required to support or as substantially related to insurance contracts to the extent the income from the activities is earned from assets that are held to meet obligations under the contracts. The preamble to the proposed regulations also requests comments on how to determine the portion of a foreign insurer’s assets that are held to meet obligations under insurance contracts, including the use of a specified percentage of the insurer’s total insurance liabilities for the year. 11

12. Exception from Passive Income for Certain Foreign Insurance Companies, REG- 108214-15 Comment deadline was July 23, 2015, and comments were received from a variety of entities-- ◦Captive Insurance Companies Association ◦Debevoise & Plimpton ◦National Risk Retention Association ◦PricewaterhouseCoopers Tax Services, Ltd (Bermuda) ◦Advantage Insurance Holdings, Ltd. The comments echoed several broad themes— Existing business practice favors the use of contractors over employees to achieve economies of scale and to reflect the nature of activities associated with reinsurance; IRS guidance interpreting the active banking exception from passive income does not require that the bank’s business be conducted by officers and directors; and Insurance reserves should not be limited to life insurance reserves and unpaid losses, but also (for example) categories of reserves under Section 807(c)(3)-(6); 12

13. Exception from Passive Income for Certain Foreign Insurance Companies, REG- 108214-15 The use of a fixed percentage to measure the portion of a company’s assets held to meet obligations under insurance contracts would be too inflexible; Special provision should be made for maintenance of a company’s ratings and new market entrants; Special provision should be made for captive insurers and risk retention groups, which already are subject to the RPII rules; and Special provisions should be made for holding companies and for differing capital requirements for different lines of insurance business. So, what’s next? ◦Final regulations are on the 2015-2016 Priority Guidance Plan. ◦Hearing is scheduled for September 18. ◦Are there any reactions so far to industry comments? 13

14. IRS Won’t Rule on Employee Benefits Captive, PLR-T-103519-15 (Doc. 2015-18327) In Rev. Rul. 2014-15, 2014-1 C.B. 1095, a VEBA was responsible for health insurance coverage of certain retirees of its sponsor. The VEBA entered into an arrangement with a captive insurance company wholly-owned by the sponsor of the VEBA to fund that coverage. Consistent with numerous prior revenue rulings, the ruling concludes that the arrangement qualifies as an insurance contract, and the captive qualifies as an insurance company. The ruling, however, contains a large number of caveats concerning self-insured medical reimbursement plans, deductibility of VEBA contributions, welfare benefit funds, and deferred compensation. In a recent memorandum, the National Office informed an LB&I Industry Director that it had declined to rule on a PLR request “in the interest of sound tax administration.” Although the facts of the memorandum are heavily redacted, the “Law” and “Concerns” sections of the memorandum suggest that the taxpayer requesting the ruling maintained a benefit plan of some sort for either current or retired employees, and wished to fund some benefits under the plan through an insurance contract with a captive insurer wholly-owned by the plan sponsor. 14

15. IRS Won’t Rule on Employee Benefits Captive, PLR-T-103519-15 (Doc. 2015-18327) As redacted, the memorandum provides few facts but many concerns— ◦“ … might not have the tax consequences claimed by Taxpayers.” ◦“ … assuming the insurance contract arrangements are welfare benefit funds … “ ◦“ … section 264(a) (premiums on a life insurance policy or endowment or annuity contract) … “ ◦“ … section 72(u) (annuity contract not held by held by natural persons) … “ ◦“ … tax benefit rule … ” ◦“ … section 4976 (disqualified benefit of a welfare benefit fund … “ ◦“ … definition of an insurance company for federal income tax purposes.” Provided enough employees or retirees are covered, one would have thought the requirements of insurance risk, risk shifting, risk distribution, and insurance in the commonly accepted sense were well established in the context of coverage purchased for employees or retirees, even from a captive insurer. Are the concerns here primarily the noninsurance rulings that were requested? 15

16. IRS: “excess loss policies” are not insurance CCA 201533011 FACTS: Six S Corporations and Administrator (collectively, “Group Entities”), all owned by the same individual, entered into 10-year “excess loss policies” with a state-law “pure captive insurance company.” Administrator is a C Corporation that collects amounts from HMO’s on a capitated, monthly basis, and pays subcapitation fees to the 6 S Corporations. The 10-year excess loss policies provided for total premiums to be paid evenly over 10 years, and covered losses in excess of attachment points that were not determined until at least Year 4, but were described in the business plan filed with the State DOI as representing the present value of future losses under the policies. The attachment points were originally 150% of premiums paid, but were increased to 170% of premiums paid, also in Year 4. According to IRS, there is evidence that the parties expected the policy limits to be reached. The Group entities deducted amounts paid under the policies as insurance premiums. 16

17. IRS: “excess loss policies” are not insurance CCA 201533011 ANALYSIS: No risk shifting because the policy limits were expected to be reached. ◦Rev. Rul. 89-96: Similar analysis as to loss event that already took place, where limit expected to be reached ◦Rev. Rul. 2007-47: Similar analysis as to loss event that is certain to occur, where limit expected to be reached ◦Policy was economically a prefunding, designed to yield a fixed annual interest rate of 7.25% plus tax benefit Not insurance in the commonly accepted sense ◦Premiums not actuarially determined ◦Attachment point determined several years after contracts entered into ◦Contracts priced to produce a fixed yield 17

18. IRS: “excess loss policies” are not insurance CCA 201533011 ANALYSIS, continued: Taxpayer must include premium payments in income when received or accrued ◦Section 1.451-1(a), Schlude v. Commissioner, 372 U.S. 128 (1963) Taxpayer cannot deduct claims until economic performance is satisfied (payment) ◦Section 1.461-1(a)(2); 1.461-4(g)(7) How typical is the arrangement? Why no discussion of Rent-a-Center v. Commissioner, Securitas Holdings, Ltd. v. Commissioner? If the arrangement was economically a prefunding (a 7.25% loan), why include premiums in income? 18

19. PLR 201532026 – The Section 72(s) Distribution Requirement Section 72(s) provides that an otherwise- qualifying contract is not treated as an annuity contract for purposes of the Code unless it provides that— ◦(A) If the holder dies after the ASD and before the entire interest has been distributed, the remaining portion will be distributed as least as rapidly as under the method being used as of the date of death; and ◦(B) If the holder dies before the ASD, the entire interest will be distributed within 5 years of death. Under section 72(s)(2), if a portion of the holder’s interest is payable to a designated beneficiary, the portion may be distributed over the designated beneficiary’s life or life expectancy provided distributions begin within 1 year of the holders death “or such later date as the Secretary by regulations may prescribe.” No such regulations have been promulgated to date. In PLR 201532026, a taxpayer was a partial, nonspouse beneficiary under two annuity contracts. Upon the death of the owner of the contracts, the taxpayer timely filed her annuity payout options. A second individual had a competing claim to proceeds under both annuities. 19

20. PLR 201532026 – The Section 72(s) Distribution Requirement As a result of the competing claims, the annuity issuers deferred payouts under either annuity, and the dispute was resolved more than one year after the annuity owner’s death. Notwithstanding the attempted election within the section 72(s) period, the Service concluded that because more than 1 year had passed since the annuity owner’s death, section 72(s) required that the annuity proceeds be paid out within 5 years of the owner’s death. Even though the delay in distributions under the contracts resulted from the competing claims under the contract, the PLR reasoned that the requirement that payments commence within 1 year of death was explicit in the Code, and no regulations had been promulgated to extend that date. The result in PLR 201532026 results from a literal application of the plain language of the Code. Are there analogous circumstances where the Code requires regulations, but the Service simply exercises its discretion under a provision? Is the result here fair and, if not, what is the appropriate recourse? 20

21. New Priority Guidance Plan for Insurance- “What’s Old is New Again” 2014-2015 Priority Guidance Plan for insurance: 7 items 1. Final regulations under §72 on the exchange of property for an annuity contract. 2. Guidance on annuity contracts with a long-term care insurance rider under §§72 and 7702B. 3. Guidance clarifying whether the Conditional Tail Expectation Amount computed under AG 43 should be taken into account for purposes of the reserve ratio test under §816(a) and the statutory reserve cap under §807(d)(6). 4. Guidance providing de minimis relief under §833. 5. Guidance on exchanges under §1035 of annuities for long-term care insurance contracts. 6. Regulations under §7702 defining cash surrender value. 7. Guidance relating to captive insurance companies. 21

22. New Priority Guidance Plan for Insurance- “What’s Old is New Again” 2015-2016 Priority Guidance Plan for insurance: The same 7 items, with changes 1. Final regulations under §72 on the exchange of property for an annuity contract. 2. Regulations under §§ 72 and 7702 defining cash surrender value. 3. Guidance on annuity contracts with a long-term care insurance rider under §§72 and 7702B. 4. Guidance clarifying whether the Conditional Tail Expectation Amount computed under AG 43 should be taken into account for purposes of the reserve ratio test under §816(a) and the statutory reserve cap under §807(d)(6). Guidance under §§807 and 816 regarding the determination of life insurance reserves for life insurance and annuity contracts using principles-based methodologies, including stochastic reserves based on conditional tail expectation. 5 Guidance providing de minimis relief under §833. 6. Guidance on exchanges under §1035 of annuities for long-term care insurance contracts. 7. Guidance relating to captive insurance companies. 22

23. New Priority Guidance Plan for Insurance- “What’s Old is New Again” Several of the items have been on the Priority Guidance Plan for many years. Considerable work has been done developing the issues, and the industry has provided a great deal of background information. How will the items be prioritized for guidance? Why was the cash value project expanded to address Section 72? How linked are the AG 43 and Life PBR guidance projects, and how might issues within each project be prioritized for guidance? Are the same people working on the projects, and what follow up might there be for product issues that arise as a result of the adoption of Life PBR, in particular the adoption of new mortality tables? 23

24. Other Developments “Stay tuned!” 24

25. QUESTIONS? 25