Technical Advice Memorandum Holds That Premiums Paid to Controlled Foreign Corporation Insurance Company Constituted Subpart F Income
Premiums Paid to Controlled Foreign Corporation Insurance Company for Provisional Indemnification Receivables for Loss Reserves Must be Included in Subpart F Income under Sections 952 and 956 in TAM 201015030 (9/25/09).
In a technical advise memorandum issued last Fall, the National Office determined certain provisional indemnification receivables (PIR) for incurred but non-reported loss reserves are includable in a foreign insurer's subpart F insurance income and are effectively to be included in the of a U.S. shareholder of the foreign insurer on a pro rata basis under §§ 951 and 953.
Under the stated summary of the facts, the taxpayer is a U.S. shareholder of a foreign insurer, which is a controlled foreign corporation (CFC), i.e., §957 defines a CFC as a foreign corporation where more than 50% of the total combined voting power of all classes of stock entitled to vote or the total value of the stock of the corporation is owned by U.S. shareholders. A” U.S. shareholder” for this purpose, per §951, is a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.
The taxpayer has policies reinsured by the foreign insurer, including auto liability and general liability policies. The foreign insurer's shareholder agreement sets out a method to calculate a shareholder/insured's premium, depending on an actuarial firm estimating a shareholder/insured's predictable losses (Fund A) and other losses to the foreign insurer's retained limit (Fund B). The annual premium is the sum of the shareholder/insured's contributions to Fund A, Fund B, and the fixed costs of the program.
Loss and profit distribution rules as well as risk of loss allocations were contained among the shareholders/insured. More particularly, under the risk of loss rules, any additional premium assessments against the taxpayer were anticipated and the foreign insurer calculated them, in part, based on the PIR for incurred but as of yet unreported losses. The foreign insurer's financial statements for the relevant years included in income the increase in the receivables for PIR, and the taxpayer's federal income tax return for the relevant years excluded the increase in receivables for PIR in computing the taxpayer's deemed dividend income from the foreign insurer under subpart F. However, the taxpayer deducted the increase in the actuarial estimated reserves for incurred but not reported losses on the same basis as book income. This effectively resulted in a deduction without an income or revenue offset.
The taxpayer argued that changes in the PIR, representing potential assessments on shareholders/insureds , are reversed for the calculation of taxable earnings and profits for subpart F purposes because of their still contingent nature. The IRS maintained that under § 832 insurance company taxable income, a property and casualty insurance company must determine its gross income, in part, on an earned premium basis. Under that system, premiums are not earned when a policy is written or a premium collected, but the premium is earned over the period of coverage.
Technical Analysis
Neither the Code nor Regulations define the terms "insurance" or "insurance contract". The Supreme Court however that insurance involves both risk shifting and risk distribution. Helvering v. LeGierse, 312 U.S. 531 (1941). The risk transfer must be the risk of economic loss. See, e.g., Allied Fidelity Corp. v. Commissioner, 572 F. 2d 1190 (7th Cir. 1978), cert. denied. The risk must contemplate the fortuitous occurrence of a stated contingency, Commissioner v. Treganowan, 183 F. 2d 288, (2d Cir. 1950), and must not be merely an investment or business risk. Le Gierse, 312 U.S. at 542, Rev. Rul. 89-96, 1989-2 C. B. 114; Rev. Rul. 2007-47, 2007-2 C.B. 127.
Section 957(b) provides that for purposes only of taking into account income described in §953(a) (relating to insurance income), the term CFC includes not only a foreign corporation as defined in subsection (a) but also one of which more than 25% of the total combined voting power of all classes of stock (or more than 25% of the total value of the stock) is owned (per §958(a)) or is considered as owned per §958(b), by U.S. shareholders on any day during the taxable year of such corporation, where the gross amount of premiums or other consideration in respect of the reinsurance or the issuing of insurance or annuity contracts described in §953(a)(1) exceeds 75% of the gross amount of premiums or other consideration in respect of all risks.
For certain insurance companies, §953(c)(1)(a) provides that the term” U.S. shareholder “means with respect to any foreign corporation, a U.S. person (per §957(c)) who owns (within the meaning of § 958(a)) any stock of the foreign corporation. Under § 953(c)(1)(b) the term CFC has the meaning given to such term by §957(a) determined by substituting 25% or more for more than 50%. Under §953(c)(1)(C) the reference to pro rata share in section 951(a)(1)(A)(i) shall be determined under section 953(c)(5). As a CFC, its U.S. shareholders must include in gross income their pro rata shares of the corporation's subpart F income, as defined in §952, and the amounts determined under §956, which are based on the U.S. property held by the CFC. Section 951(a)(1)(A)(i) requires a U.S. shareholder of a CFC to include in gross income such shareholder's pro rata share of the CFC's subpart F income for the year.
Section 952(a) defines subpart F income to include, among other things, insurance income as defined in §953, and foreign base income, per § 954. In effect, § 951 provides for the inclusion in the taxable income of a U.S. shareholder its share of current earnings and profits of a foreign insurance company as "deemed dividends." Section 953(a)(1) defines “insurance income”, including income that would be taxed under subchapter L (§§801-848) as if the company was a domestic insurance company.. Amounts includable as deemed dividends are computed on the same basis as a domestic insurance company's taxable income. See §832 and in particular §832(b)(3), which defines underwriting income as the premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred. Section 832(b)(4) provides that the term premiums earned on insurance contracts during the taxable year means an amount computed as follows: (A) from the amount of gross written premiums written on insurance contracts during the taxable year, deduct return premiums and premiums paid for reinsurance; (B) to the results so obtained, add 80% of the unearned premiums on outstanding business at the end of the preceding taxable year and deduct 80% of the unearned premiums on outstanding business at the of the taxable year. Section 832(b)(5) defines losses incurred during the taxable year on insurance contracts based on a series of calculations. For meaning of “unearned premium” see Treas. Reg. §1.832-4(a)(8)(i) i.e., unearned premium for a contract, other than a contract described in §816(b)(1)(B, is the portion of the gross premium written that is attributable to future insurance coverage during the effective period of the insurance contract. Unearned premiums do not include any additional liability established by the insurance company on its annual statement to cover premium deficiencies. See also NAIC, Statements of Statutory Accounting Principles (SSAP) No. 53 (setting forth guidelines for the reporting of earned but unbilled premiums).
Taxpayer takes the position that the change in the PIR, which represents potential assessments on shareholder/insureds, on the books of Foreign Insurer, which is a CFC, are reversed for the calculation of taxable earnings and profits for subpart F purposes because of their contingent nature. When the assessments are actually determinable, they are included in the calculation of taxable earnings and profits of Foreign Insurer as claims indemnification. Taxpayer believes that the PIR are not contractually determinable with certainty at the close of the taxable year and therefore should not be includable under SSAP No. 53 as written premiums on a NAIC annual statement.
National Office’s Rejection of Taxpayer’s Return Position Argument
The National Office disagreed with the taxpayers' omitting the PIR payments from Subpart F income. Its reasoning is set forth in steps. First, section 832 requires a property and casualty insurance company to determine its gross income, in part, on an earned premium basis. Under this system, a premium is not earned when a policy is written or when the premium is collected. Rather, the premium is earned over the period of coverage. Under § 832(b)(4), earned premiums are composed, in part, of gross written premiums during the taxable year less return premiums and premiums paid for reinsurance. The amount of written premiums is then converted to an earned basis by means of the reduction allowed with respect to the net increase in unearned premiums during the taxable year. The items taken into account under § 832(b)(4) closely track items reflected in calculating earned premiums. The determination of gross written premiums in section 832(b)(4) necessarily includes certain amounts that would not otherwise be accruable under general tax accrual principles because the insurance company either has not received the premium or does not have an enforceable right to collect these amounts.
The PIR estimates due to Foreign Insurer from the shareholder/insured based on estimated incurred but not reported losses must be included in Foreign Insurer's earned premiums under § 832(b)(4) without regard to whether the amounts would meet the all events test for accrual of income by a non-insurance company. This is mandated by §446(b) in clearly reflecting underwriting income, i.e., premiums earned and losses incurred must be computed on the same basis. Thus, the deduction for unpaid loss reserves in excess of Fund A must be offset by the increase in PIR.
Here, pursuant to the shareholders/insureds agreement with the CFC Insurer, the shareholders are required to pay additional premiums based on incurred but not reported losses. Foreign Insurer has included these additional premiums in its financial income, but has excluded them from its computation of subpart F taxable income and earnings and profits. However, Foreign Insurer has included in financial and taxable income the expected premiums (CIR) from shareholder/insureds based upon its actuarially determined reserves for reported losses. There should be no distinction between these receivables and the additional receivables from shareholder/insured on incurred but not reported losses. Thus, Foreign Insurer must also include PIR in taxable subpart F income as it does with its financial income.
TAM Holding
The PIR is includable in the calculation of Foreign Insurer's earnings and profits. The changes to the Foreign Insurers subpart F income and earnings and profits to reflect the PIR are included in Taxpayer's income on a pro-rata basis under §§951 and 953.
