The rules of IRC § 1504 and Treas. Reg. § 1.1502-47 provide the general parameters for determining whether a domestic life insurance company (within the meaning of IRC § 816(a)) may join in filing a consolidated U.S. federal income tax return with one or more domestic nonlife insurance company (or non-insurance company) affiliates (a life/nonlife consolidated return). Pursuant to those rules, a recently acquired domestic life insurance company is not allowed to join in a life/nonlife consolidated return filed by the acquiring group for a period of five taxable years following the acquisition. The same result generally follows where:
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A newly organized domestic life insurance company does not meet the requirements of the tacking rule found in Treas. Reg. § 1.1502-47(d)(12)(v);
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An existing nonlife member of a life/nonlife consolidated group experiences a change in tax character (as described in Treas. Reg. § 1.1502-47(d)(12)(vii)) and, as a consequence, becomes a life insurance company; or
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An existing life member of a life/nonlife consolidated group undergoes a disproportionate asset acquisition (as described in Treas. Reg. § 1.1502-47(d)(12)(viii)).
Special consideration typically is given to these “lonely” life insurance companies (each, a Lonely Lifeco) while they reside outside the life/nonlife consolidated return.
In our Legal Alert of April 7, 2016, we offered our initial impressions of the recently proposed regulations under IRC § 385 (the Proposed Regulations), and we noted that the Proposed Regulations include a provision that treats the members of a consolidated group (as defined in Treas. Reg. § 1.1502-1(h)) as “one corporation” for purposes of those rules. However, for the reasons noted above, a Lonely Lifeco is not encompassed by the application of this rule to the relevant life/nonlife consolidated group. As a consequence, the Proposed Regulations have the potential to create new issues with respect to a number of ordinary fact patterns involving Lonely Lifecos. For example, consider a situation where:
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Lonely Lifeco cedes business to an affiliate that is a member of the life/nonlife consolidated group pursuant to an indemnity coinsurance arrangement completed on a funds withheld basis;
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Lonely Lifeco uses the same insurance-dedicated mutual funds (i.e., regulated investment companies (RICs)) as investment options for the separate accounts supporting the variable life insurance and annuity products offered by Lonely Lifeco as those used by an affiliate that is a member of the life/nonlife consolidated group; or
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Lonely Lifeco uses parent company stock to compensate an employee.
We discuss each of these scenarios in greater detail below.
Assumed Facts
For purposes of this discussion, assume that US Holdco, a domestic corporation that operates as a holding company, owns 100% of the stock of each of the following entities: 953(d) Co., a life insurance company organized under Country X law that has made an election under IRC § 953(d) to be treated as a domestic corporation for U.S. federal tax purposes; US Lifeco1, a domestic life insurance company; and US Lifeco2, a domestic life insurance company that US Holdco acquired one year ago from an unrelated party. This corporate structure is illustrated below.
Furthermore, assume that:
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At the beginning of Year 1:
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US Holdco, 953(d) Co., and US Lifeco1 constitute a U.S. consolidated group, i.e., a life/nonlife consolidated group, that files a life/nonlife consolidated return;
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US Lifeco 2 files a separate return for U.S. federal income tax purposes; and
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US Holdco is the common parent of an expanded group (as defined in Prop. Treas. Reg. § 1.385-1(b)(3)) comprised of US Holdco, 953(d) Co., US Lifeco1, and US Lifeco2.
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All notes issued between members of the expanded group are debt instruments described in Prop. Treas. Reg. § 1.385-3(f)(3), and none of those notes is eligible for the ordinary course exception described in Prop. Treas. Reg. § 1.385-3(b)(3)(iv)(B)(2).
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No issuer of a debt instrument has current year earnings and profits described in IRC § 316(a)(2) (thus calling off the exception that otherwise may be available under Prop. Treas. Reg. § 1.385-3(c)(1)).
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The expanded group has more than $50 million of debt instruments described in Prop. Treas. Reg. § 1.385-3(c)(2) at all times.
Scenario #1: Coinsurance on a Funds Withheld Basis
Facts. On Date A, Year 1, US Lifeco2 cedes a block of life insurance business to 953(d) Co. pursuant to an indemnity coinsurance arrangement completed on a funds withheld basis. Pursuant to the terms of this arrangement, (i) US Lifeco2 pays a reinsurance premium equal to $100x to 953(d) Co., and (ii) 953(d) Co. loans the assets comprising that $100x reinsurance premium back to US Lifeco2, with 953(d) Co. booking a receivable and US Lifeco2 booking a payable equal to the same amount. On Date B, Year 2, US Lifeco2 distributes $150x to US Holdco in a distribution. These facts are illustrated below.
Analysis. On account of the nature of the funds withheld arrangement, a debt instrument (within the meaning of IRC § 1275(a) and Treas. Reg. § 1.1275-1(d)) likely arises between US Lifeco2 and 953(d) Co., with US Lifeco2 being viewed as the funded member for purposes of the funding rule of Prop. Treas. Reg. § 1.385-3(b)(3). As a result, the $150x distribution by US Lifeco2 in Year 2 apparently would be caught by the non-rebuttable presumption set forth in Prop. Treas. Reg. § 1.385-3(b)(3)(iv)(B)(1), thus causing the entire funds withheld payable to be treated as stock of US Lifeco2 for all U.S. federal tax purposes as of Date B, Year 2.
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Sutherland Observation. Even if the $150x distribution did not occur in Scenario #1, consideration should be given to whether the funds withheld payable nevertheless could be treated as stock if that payable is not documented in the manner required by Prop. Treas. Reg. § 1.385-2 and the exceptions to the application of that section otherwise do not apply (for example, because the stock of US Holdco is publicly traded). In this regard, the funds withheld payable likely falls outside the definition of an applicable instrument provided in Prop. Treas. Reg. § 1.385-2(a)(4)(i); however, Treasury and the IRS have indicated a desire to broaden that definition to cover interests that are not otherwise issued “in form” as a debt instrument. |
Scenario #2: RIC Overlap
Facts. During Year 1, US Lifeco1 begins to sell variable annuity contracts to the general public and offers two insurance-dedicated mutual funds—RIC1 and RIC2—as investment options for the separate accounts supporting those contracts. Prior to Date A, Year 2, each of RIC1 and RIC2 (i) is wholly owned by the separate accounts of US Lifeco1, and (ii) is treated as wholly owned by US Lifeco1 for U.S. federal tax purposes. During Year 2, US Lifeco2 begins to offer variable annuity contracts to the general public that offer RIC1 and RIC2 as possible investment options for the separate accounts supporting those contracts. On Date A, Year 2, the separate accounts of US Lifeco2 invest $10x in each of RIC1 and RIC2 in exchange for a 10% interest in each of RIC1 and RIC2. On Date B, Year 2, US Holdco lends $15x to US Lifeco2 in exchange for a surplus note. These facts are illustrated below.
Analysis. Under the definition of expanded group used for purposes of the Proposed Regulations, each of RIC1 and RIC2 is a member of the US Holdco expanded group. Thus, taking into account the 36-month look-back period included in the non-rebuttable presumption, US Lifeco2’s acquisition of a 10% interest in each of RIC1 and RIC2 constitutes an acquisition of expanded group stock subject to the funding rule. As a consequence, the entirety of the surplus note issued by US Lifeco2 on Date B, Year 2, constitutes stock of US Lifeco2 for all U.S. federal tax purposes.
Sutherland Observations.
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The exception provided under Prop. Treas. Reg. § 1.385-3(c)(3) for “funded acquisitions of subsidiary stock by issuance” is not available under the facts of Scenario #2 because US Lifeco2 acquires only a 10% interest in each of RIC1 and RIC2, rather than the greater than 50% interest required under that exception.
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As an alternative to the facts of Scenario #2, consider a situation in which US Lifeco2 organizes RIC1 and RIC2 on Date A, Year 1, and puts a small amount of seed money capital into those funds in exchange for fund shares. Thereafter, on Date B, Year 2, US Lifeco1 lends $15x to US Lifeco2 in exchange for the surplus note. Finally, on Date C, Year 3, US Lifeco2’s interest in each of RIC1 and RIC2 drops below 50% on account of the now seasoned funds being offered to the separate accounts of US Lifeco1 or, for that matter, the separate accounts of one or more unrelated life insurance companies. Under these facts, the exception provided under Prop. Treas. Reg. § 1.385-3(c)(3) ceases to apply as of Date C, Year 3, thus causing US Lifeco2’s acquisitions of RIC1 and RIC2 shares on Date A, Year 1, to be treated as acquisitions of expanded group stock that trigger the application of the funding rule.
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Scenario #3: Avoiding a Zero-Basis Problem, but Triggering a Debt-Equity Problem
Facts. Y, an individual, is an employee of US Lifeco2. Pursuant to an agreement between US Holdco and US Lifeco2 to compensate Y for services provided to US Lifeco2, US Holdco transfers 10 shares of US Holdco stock with a fair market value of $10x to Y on Date A, Year 1. Under Treas. Reg. § 1.1032-3, US Lifeco2 is treated as purchasing the US Holdco stock from US Holdco for $10x of cash (i.e., cash deemed to have been contributed to US Lifeco2 by US Holdco), and then transferring the US Holdco stock to Y. On Date B, Year 2, US Lifeco1 lends $15x to US Lifeco2 in exchange for a surplus note. These facts are illustrated below.
Analysis. Taking into account the 36-month look-back period included in the non rebuttable presumption, US Lifeco2’s acquisition of 10 shares of US Holdco stock—as directed by Treas. Reg. § 1.1032-2—constitutes an acquisition of expanded group stock subject to the funding rule. As a consequence, $10x of the $15x surplus note issued by US Lifeco2 on Date B, Year 2, constitutes stock of US Lifeco2 for all U.S. federal tax purposes. The remaining $5x of the $15x surplus note is not recharacterized as stock under the funding rule.
Sutherland Observations.
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As noted above, the fiction of Treas. Reg. § 1.1032-3 gives rise to the deemed stock acquisition by US Lifeco2 that triggers the application of the funding rule in Scenario #3. Although this result seems unavoidable under the broad language of the funding rule, one has to question whether it should be the result obtained from the application of the Proposed Regulations. In effect, the Proposed Regulations cause what otherwise constitutes a taxpayer-friendly provision in Treas. Reg. § 1.1032-3 to give rise to a rather unfortunate result, i.e., an otherwise bona fide debt instrument being treated as stock for all U.S. federal tax purposes.
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Like Scenario #2, the exception provided under Prop. Treas. Reg. § 1.385-3(c)(3) is not available under the facts of Scenario #3 because US Lifeco2 acquires only a transitory interest in the stock of US Holdco.
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Concluding Thoughts
The preamble to the Proposed Regulations offers little indication that any of the foregoing scenarios, and accompanying tax consequences, were considered during the process of drafting the new rules. Nevertheless, these results appear to be genuine possibilities for Lonely Lifecos under the Proposed Regulations. Accordingly, if the Proposed Regulations are finalized in substantially similar form, it will be advisable to monitor the transactions being undertaken by Lonely Lifecos while they reside outside the life/nonlife consolidated return, lest they run afoul of the new rules.
