By Albert J. DiGiacomo, CPA; Daniel A. Gregor, CPA; and Daniel J. Kusaila, CPA
The Tax Cuts and Jobs Act, signed into law on Dec. 22, 2017, has been described – quite accurately – as the most sweeping tax overhaul in more than 30 years. In addition to significant rate reductions and other changes that will affect all U.S. businesses, the new law contains a number of provisions written specifically to affect insurance companies.
These provisions obviously will have direct tax consequences for insurance businesses, but their impact extends beyond tax issues alone. Many of the provisions of the new tax law will also affect insurance companies’ financial reporting and management decisions in the years to come.
General Corporate Tax Provisions
One of the largest and most far-reaching provisions of the new tax law is a major cut in the corporate income tax rate. Starting in 2018, corporations are taxed at a flat rate of 21 percent, instead of the previous graduated rate structure that topped out at 35 percent. The new law also repeals the corporate alternative minimum tax (AMT). Companies that paid the AMT in the past and still have unused prior-year minimum tax credits will have until 2021 to use those credits. Fifty percent of the credits not used in each of the subsequent three years starting with 2018 will be refunded to the taxpayer. Credits not used by the end of 2021 will be fully refunded.
Another provision that will have major consequences for corporations, including insurance companies that file a consolidated income tax return with other C corporations, is the repeal of the net operating loss (NOL) carryback, along with changes to NOL carryforward rules. Starting with their 2018 returns, most companies no longer are able to carry back losses and apply them to prior years’ returns. Companies are still able to carry forward losses, but the amount is limited to 80 percent of their taxable income.
On the positive side, however, the 20-year limitation on carrying forward NOLs is eliminated, and companies now are allowed to carry forward NOLs indefinitely.
Note, however, that the changes in NOL provisions do not apply to property and casualty (P&C) insurance companies. For P&C carriers, the existing NOL rules still apply. Having separate NOL rules for various lines of business adds further complexity to many consolidated companies’ tax calculations, and also could affect future merger and acquisition or consolidation plans. Clarifying guidance hopefully will be forthcoming.
The new law also limits the deductibility of net interest expense to 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA). This limit applies for four years. Beginning in 2022, interest expense deductions will be limited to 30 percent of earnings before interest and taxes (EBIT).
Starting in 2018, the dividends-received deduction is reduced from 70 percent to 50 percent in the case of subsidiaries in which the company owns less than 20 percent of the stock. For dividends paid by subsidiaries that are between 20 percent and 80 percent owned, the deduction is reduced from 80 percent to 65 percent.
Other provisions that significantly affect insurers along with most other businesses include 100 percent expensing for certain new and used business assets, along with higher limitations on Section 179 expensing. Under certain conditions, companies also could qualify for new tax credits for up to 25 percent of the wages they pay to employees on paid family and medical leave. While these changes are likely to have a favorable impact on many companies, they could be offset by some of the law’s other changes, such as the elimination of entertainment expense deductions and limits on meals expense deductions.
P&C Industry Changes
In addition to the general tax provisions affecting all businesses, the new law singles out the insurance industry for special attention, with one entire section of the law devoted solely to insurance company issues. One of the most significant features of this section is the retention of the previous NOL rules for P&C insurers. Unlike life insurers (and most other businesses), P&C companies remain subject to the two-year carryback and 20-year carryforward rules. Moreover, P&C companies are not subject to the 80 percent limitation on the use of NOLs.
As noted, putting P&C companies on a different loss carryback and carryforward schedule than life insurers could lead to consolidation complexities for many companies. At a minimum, without clarifying guidance, it is possible a holding company with both life and P&C subsidiaries needs to keep detailed schedules for tracking purposes in order to apply the NOL rules appropriately for each subsidiary.
Another area with a significant impact on P&C companies involves changes to the calculation of loss reserves. Beginning in 2018, P&C companies no longer can elect to use their own, company-specific historical loss payment patterns for calculating reserves. Instead, they must use industrywide standards as incorporated into the published discounting factors.
Starting in 2018, rates determined on the basis of the corporate bond yield curve will replace the annual federal rate in the development of loss reserve discount factors. This change is anticipated to produce steeper discounts, thereby reducing reserve deductions. In addition, the discount period for certain long-tail lines of business is extended from 10 to 24 years.
In many cases, the combined effects of these changes to loss reserve calculations will be negative. While cash taxes will not be affected until tax years after 2017, companies might be required to account for the one-time transition adjustment in their 2017 deferred tax balances. This would involve calculating the Dec. 31, 2017, reserves using the new method in 2018, and then spreading the taxable income effects of the transition adjustment over a period of eight years.
Changes to the proration rate also are included in the new law. To offset the effects of the reduced corporate tax rate, the previous 15 percent proration reduction now is replaced with a 25 percent reduction.
Life Insurance Industry Changes
Like P&C carriers, life insurance companies also were given special attention in the new law. The effects of the changes – both positive and negative – are significant.
One obvious negative change is the elimination of the small life insurance company deduction. The previous law allowed small life insurers to deduct up to $1.8 million in taxable income under certain circumstances. Even though the new lower tax rate helps offset the loss of this deduction somewhat, the net effect is likely to be particularly painful for many smaller life insurance companies. It is interesting to note that the new law does not eliminate a similar deduction for P&C companies.
The new law also makes significant changes to Section 848 of the Internal Revenue Code (IRC 848), which spells out how insurers should capitalize their policy acquisition costs. Beginning in 2018, capitalization rates for deferred acquisition costs are increased to 2.09 percent of net premiums for annuities, 2.45 percent for group life policies, and 9.20 percent for all other contracts.
In addition, the amortization period for these costs is increased to 15 years, although the first $5 million in direct policy acquisition costs still are amortized over a five-year period, as was the case under the previous law. The net effect of the changes to IRC 848 is an increase to taxable income for most life insurers in future years.
Life insurers’ tax reserve calculations under IRC 807 are simplified since they no longer need to factor in actuarial data and interest rate projections to calculate tax reserves. Tax reserves now are the greater of the net surrender value or 92.81 percent of the reserve prescribed by National Association of Insurance Commissioners (NAIC).
Similar to P&C companies, life insurers are required to recompute their opening 2018 tax reserves under the new law, compare reserves to their ending 2017 tax reserves under old law, and amortize the difference into income over eight years.
Under IRC 807(f), the previous 10-year spread on the recomputation of life reserves is changed to four years. This makes life reserve computation methods consistent with other accounting method changes. While the Section 807 changes simplify tax reserve calculations, there are some additional transition issues that need to be handled.
Proration rules for the exclusion of tax advantaged investment income for life insurers now are set at 70 percent for the company’s share and 30 percent for the policyholder. This also simplifies tax calculations for life insurers.
Finally, unlike P&C carriers, life insurance companies no longer are subject to special NOL carryback and carryforward provisions. Instead, life insurers are governed by the same NOL rules as most other corporations.
International Tax Provisions
The act also has a major effect on insurance businesses with international operations, as it modifies the previous worldwide tax system to a modified territorial system. The new law provides U.S. corporations with a 100 percent deduction for dividends they receive on their foreign-sources income, provided the domestic corporation owns at least 10 percent of the foreign subsidiary paying the dividend. This provision might have a significant impact on many U.S.-based insurance businesses that have partial ownership interests in foreign insurers.
The law contains a number of provisions designed to prevent U.S. corporations from using this exemption to repatriate cash accumulated by their foreign subsidiaries tax-free. Under the one-time deemed repatriation rules, companies are taxed on these repatriated earnings at a reduced rate of 15.5 percent on liquid assets and 8 percent on illiquid assets. Companies may elect to spread out the resulting tax liabilities over a period of eight years.
The rewrite of tax law for international businesses also contains a number of provisions that are specific to the insurance industry. One of the most significant of these is a restriction on the insurance business exception to the passive foreign investment company (PFIC) rules. The net effect could be that some insurance companies will become subject to the PFIC rules, and thus might no longer be subject to the favorable tax deferral they once enjoyed.
Other changes include modifications to certain terms regarding ownership rules in controlled foreign corporations (CFCs) and the definition of U.S. shareholders in such corporations. There also is a new minimum tax on base erosion payments such as interest, rents, royalties, and services, and a new tax on U.S. shareholders’ aggregate net income from a CFC that is treated as global intangible low-taxed income.
Accounting Issues for Insurers
In addition to its direct impact on insurance companies’ tax calculations, the new tax law also will have significant effects on other aspects of their business, particularly their accounting and financial reporting functions.
For example, although the tax changes will not affect companies’ 2017 tax returns, they will have an impact on companies’ 2017 financial statements. Companies subject to U.S. generally accepted accounting principles (GAAP) and NAIC statutory accounting principles (SAP) rules will need to recalculate the value of any deferred tax assets or liabilities to reflect the new reduced tax rate, one-time tax reserve transition adjustment, and all other relevant changes.
With the repeal of the corporate AMT and imminent refunding of previously generated AMT credits, a taxpayer might find it most appropriate to reclass the AMT credit deferred tax asset as a current tax receivable.
Companies with international operations also need to assess the effect of the deemed repatriation rules. Their 2017 financial statements will need to record current and noncurrent tax liabilities for the taxes that will be due on these repatriated earnings in the coming years.
The new law also affects insurance businesses' financial reporting requirements under the NAIC’s “Statement of Statutory Accounting Principle No. 101 – Income Taxes” (SSAP 101). The variations in NOL limitations between life insurance and P&C companies could be especially challenging in this area, particularly as they pertain to deferred tax asset admissibility.
The final text of the 2017 tax reform was more than 1,000 pages long, so in addition to the changes noted here, there are numerous other provisions that could also have an effect on insurance companies of all types and sizes. Insurers should be prepared to devote significant time and attention to studying the impact the new law will have on their companies.
Insurers also should seek out professional expertise to help them manage both the tax and financial reporting aspects of the new law, as well as to evaluate the law’s potential impact on their companies’ long-term business strategies and operational processes.