Questions raised for U.S. life insurers doing business abroad
By Jeff DelleFave and John Latham
The practice of issuing life and annuity policies to nonresident aliens through offshore branches has for years been a standard business model for U.S. life insurers seeking to operate abroad. However, official guidance issued by the Internal Revenue Service and the U.S. Department of the Treasury, in the form of two revenue rulings that address several key tax issues surrounding these transactions, raises many questions for U.S. life insurers doing business abroad.
Revenue Ruling 2004-75 explicitly addresses a central issue raised by these policies by concluding that income received by nonresident aliens under life insurance or annuity contracts issued by a foreign branch of a U.S. life insurer is U.S.-source income that is subject to 30% withholding tax, unless otherwise reduced by an income tax treaty.
Within a month after issuing this ruling, the IRS responded to intense pressure from the life insurance industry by issuing Revenue Ruling 2004-97 and indicating that it would postpone the effective date of the prior guidance under Revenue Ruling 2004-75. Under the new guidance, the U.S. withholding tax is applicable to payments made after Jan. 1, 2005.
As a result of the rulings, insurance companies will quickly need to assess the implications of the new guidance on their current business models and products. For those affected, the Jan. 1, 2005, effective date will pose significant challenges. Moreover, recent comments by the IRS would appear to suggest legislative relief is the most efficient course of action at this time for those companies seeking the withdrawal of the ruling.
Without legislative relief, regulatory relief or the restructuring of current business models, these rulings will place U.S. life insurers doing business abroad at a clear competitive disadvantage to their foreign peers in certain jurisdictions. While companies are taking the necessary steps to address these issues so that their current and future policyholders are not adversely affected by the ruling, it is unfortunate that U.S. life insurers are having to spend resources to address a ruling that flies in the face of sound tax policy.
Because Section 861 of the Internal Revenue Code is silent on the sourcing of income received under a life or annuity contract, to reach its conclusion the IRS has created analogies with other classes of income that are specified within the statute. Revenue Ruling 2004-75 concludes that income received under a life insurance or qualifying annuity contract represents an investment return on the cash value of the contract and is therefore analogous to interest, dividends, and earnings and accretions on pension fund assets.
In general, interest or dividends are considered U.S.-source income when the payor is a domestic company. For example, earnings and accretions on pension fund assets are U.S.-source income when the pension trust is domestic. Thus, by analogy, the IRS has concluded that income received under a life insurance or qualifying annuity contract is U.S.-source income when the issuer is a U.S. domestic corporation.
Nonresident aliens generally are subject to a 30% U.S. withholding tax on payment of U.S.-source interest, dividends and other investment income, unless specifically excluded by statute. Moreover, any payor of U.S.-source income that fails to withhold and remit U.S. withholding tax becomes primarily liable for the withholding tax due.
The Business Dilemma
The rulings have significant business implications for U.S. life companies writing business through foreign branches. Many of these companies historically have operated in branch form outside the U.S. for legal and regulatory reasons. Typically, they have taken the position that payments made to policyholders were not subject to U.S. withholding tax, either because they believed those payments to be non-U.S.-source income or otherwise qualified under a statutory exception to the general withholding tax rules.
The rulings may force U.S. companies to price a potential 30% withholding tax cost into their policies. This will place them at a severe competitive disadvantage vis-?-vis their global competitors. The American Council of Life Insurers, a vocal critic of the ruling, asserted that the IRS analysis is flawed and requested that the IRS immediately withdraw Ruling 2004-75 pending a period of public comment. As noted, in a partial response, the IRS then agreed to a prospective application of the ruling, but commented, in releasing Revenue Ruling 2004-97, that it believed “the legal position reflected in Revenue Ruling 2004-75 is correct.”
As a result of the two rulings, companies will need to consider:
–The applicability of the rulings and whether they should adhere to the rulings based on their specific circumstances.
–The business and tax risks presented if they do not follow the rulings logic and it is later determined that they should have done so.
–The business implications with respect to structuring new contracts.
–Whether any of the identified business risks can be minimized through other actions.
Implications for International Tax Policy
Revenue Ruling 2004-75 brings into focus a central question of international taxation: how to determine the source of income realized by a taxpayer. Most of the source rules have been specified in the tax code, while others have come about through regulation and judicial interpretation. In each instance, the application of the source rules depends on the characterization of the income whose source is in question.
Despite the limited discussion contained in the latest ruling, the IRS has left some critical questions unanswered and has raised a number of policy questions.
First, regardless of the validity of the analogy, by not characterizing the payments in question as either interest or dividends the ruling fails to address the potential statutory withholding tax exceptions applicable only with respect to interest. For example, given the paucity of authoritative guidance on the taxation of annuity contracts written through foreign branches, some U.S. life insurers have sought relief under one of the few statutory exemptions from U.S. withholding tax.
The rationale is that payments with respect to offshore annuity contracts lacking sufficient mortality risk may fail the U.S. tax definition of an annuity and thus may qualify under the portfolio debt exception from U.S. withholding tax. Such determinations involve a detailed analysis of the underlying contractual terms. In 1990 the IRS revoked its prior published ruling holding that the portfolio interest exemption did apply, stating that the matter was under further review. No further guidance has since been issued.
Second, as is the case with derivative financial instruments, the ruling highlights the need for regulatory guidance in dealing with sourcing of payments under financial contracts where there is difficulty in finding a persuasive statutory sourcing analogy. The Treasury Department has broad authority to promulgate regulations under IRC Section 863 to determine the sourcing for tax purposes of items not specifically enumerated in the statute. Under this authority, Treasury has issued regulations which provide that the source of income under a notional principal contract is the residence of the recipient.
As a result, payments made from the U.S to a foreign person under a derivative contract are not subject to U.S. tax. Under these rules, it may even be argued that under certain circumstances, annuities might be more appropriately viewed as derivatives of a type that the return thereon is not subject to withholding.
Under the rationale of the ruling, payments with respect to a policy covering entirely non-U.S. risks, supported by assets invested entirely outside the United States, would become U.S.-source income simply because the U.S. insurer operates in branch form in the host country.
As a result of this ruling, a U.S. life insurer may seek to make its offshore branch a subsidiary, but may be precluded from doing so by the legal and regulatory exigencies of the host country. Moreover, the ruling may remain problematic for those companies writing business through offshore subsidiaries that have elected to be taxed as domestic corporations under IRC Section 953(d).
In this regard, sourcing income received under life or annuity contracts based on the situs of activity giving rise to the contract or the situs of the risk being covered may be a more equitable policy. As a matter of policy, the conduct of a life insurance business does not lend itself to easy manipulation of the companys location. Such a business requires a local presence, including a sales force, supporting resources and adequate capital surplus.
Further, the activities of a life insurer do not differ depending on whether the policies it is selling in a particular market are more or less investment-oriented. And in any event, the investment orientation of a policy sold through an offshore branch should not be determinative for U.S. tax purposes. Investment orientation is relevant for purposes of policyholder taxation, and the United States should not be concerned with the taxation of non-U.S. policyholders.
Moreover, there is statutory authority for determining source based on the situs of risk. Rules under IRC Section 861(a)(7) assign U.S. source to underwriting income derived from the insurance of U.S. risks. This is further defined as gain derived from underwriting or reinsuring any insurance or annuity contract in connection with the lives or health of U.S. residents. Conversely, foreign underwriting income is defined in Section 862(a)(7) as income derived from insuring foreign lives.
While these code sections generally apply only to the underwriting income of insurers, applying the ruling would produce the unusual result in which income received by the insurer was treated as foreign-source income, while payment of those same amounts to foreign customers in connection with life insurance policy surrenders or annuity contract payments would be treated as U.S.-source income.
Jeff DelleFave is a partner in Ernst & Youngs International Tax Practice. He can be reached at firstname.lastname@example.org. John Latham is a partner in the firms Financial Services Offices Insurance Tax practice. He can be reached at email@example.com.
Reproduced from National Underwriter Edition, February 18, 2005. Copyright 2005 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.