Tax Rulings Open A Pandoras Box

–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.

Flawed Rationale

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 [email protected]. John Latham is a partner in the firms Financial Services Offices Insurance Tax practice. He can be reached at [email protected].

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.