Insurance companies

Special rules apply to a foreign corporation carrying on an insurance business in the United States that would qualify as an insurance company (based on its effectively connected income) if it were a domestic corporation.73 Under those rules, the foreign corporation generally is taxed on that effectively connected income in the same manner as a U.S. insurance company. Any other income of the foreign corporation is taxed under the gross-basis taxation rules described below.

Special rules apply for purposes of determining the effectively-connected income of an insurance company. The foreign-source income of a foreign corporation that is subject to tax under the insurance company provisions of the Code is treated as effectively connected, provided that such income is attributable to its U.S. business.74



Withholding tax

In the case of U.S.-source interest, dividends, rents, royalties, premiums, or other similar types of income (known as fixed or determinable, annual or periodical gains, profits and income), the United States generally imposes a flat 30-percent tax on the gross amount paid to a foreign person if such income or gain is not effectively connected with the conduct of a U.S. trade or business.75 This tax does not apply to insurance premiums paid with respect to a contract that is subject to the insurance premiums excise tax described above.76 The 30-percent gross-basis tax generally is collected by means of withholding by the person making the payment to the foreign person receiving the income.77 Accordingly, the tax generally is referred to as a withholding tax. In most instances, the amount withheld by the U.S. payor is the final tax liability of the foreign recipient and, thus, the foreign recipient files no U.S. tax return with respect to this income.

The United States generally does not tax capital gains of a foreign corporation that are not connected with a U.S. trade or business. Capital gains of a nonresident alien individual that are not connected with a U.S. business generally are subject to the 30-percent withholding tax only if the individual was present in the United States for 183 days or more during the year.78 Also subject to tax at a flat rate of 30 percent are any foreign person's gains from the sale or exchange of patents, copyrights, trademarks, and other like property, or of any interest in such property, to the extent the gains are from payments that are contingent on the productivity, use, or disposition of the property or interest sold or exchanged.79

Gains of a foreign person on the disposition of U.S. real property interests are taxed on a net basis under the Foreign Investment in Real Property Tax Act, even if they are not otherwise effectively connected with a U.S. trade or business.80 Similarly, rental and other income from U.S. real property may be taxed, at the election of the taxpayer, on a net basis at graduated rates.81

Although payments of U.S.-source interest that is not effectively connected with a U.S. trade or business generally are subject to the 30-percent withholding tax, there are significant exceptions to that rule. For example, interest from certain deposits with banks and other financial institutions is exempt from tax.82 Original issue discount on obligations maturing in six months or less is also exempt from tax.83 An additional exception is provided for certain interest paid on portfolio obligations.84 Portfolio interest generally is defined as any U.S.-source interest (including original issue discount), not effectively connected with the conduct of a U.S. trade or business, (1) on an obligation that satisfies certain registration requirements or specified exceptions thereto, and (2) that is not received by a 10-percent shareholder.85 This exception is not available for any interest received either by a bank on a loan extended in the ordinary course of its business (except in the case of interest paid on an obligation of the United States), or by a controlled foreign corporation from a related person.86 Moreover, this exception is not available for certain contingent interest payments.87



Earnings stripping

A foreign parent corporation with a U.S. subsidiary may seek to reduce the U.S. subsidiary's U.S. tax liability by having the U.S. subsidiary pay deductible amounts such as interest, rents, royalties, and management service fees to the foreign parent or other foreign affiliates that are not subject to U.S. tax on the receipt of such payments. Although the United States generally subjects foreign corporations to a 30-percent withholding tax on the receipt of such payments, this tax may be reduced or eliminated under an applicable income tax treaty. Consequently, foreign-owned U.S. corporations may seek to use certain treaties to facilitate earnings stripping transactions without having their deductions offset by U.S. withholding taxes.88

Generally, the Code limits the ability of corporations to reduce the U.S. tax on their U.S.- source income through earnings stripping transactions. A deduction for "disqualified interest" paid or accrued by a corporation in a taxable year is generally disallowed if two threshold tests are satisfied: the payor's debt-to-equity ratio exceeds 1.5 to 1 (the so-called "safe harbor"); and the payor's net interest expense exceeds 50 percent of its "adjusted taxable income" (generally taxable income computed without regard to deductions for net interest expense, net operating losses, and depreciation, amortization, and depletion).89 Disqualified interest includes interest paid or accrued to: (1) related parties when no Federal income tax is imposed with respect to such interest; or (2) unrelated parties in certain instances in which a related party guarantees the debt ("guaranteed debt"). Interest amounts disallowed under these rules can be carried forward indefinitely. In addition, any excess limitation (i.e., the excess, if any, of 50 percent of the adjusted taxable income of the payor over the payor's net interest expense) can be carried forward three years.

Under a provision included in the Tax Increase Prevention and Reconciliation Act of 2005, except to the extent provided by regulations, the foregoing earnings stripping rules apply to a corporate partner of a partnership.90 The corporation's share of partnership liabilities is treated as liabilities of the corporation for purposes of applying the earnings stripping rules to the corporation. The corporation's distributive shares of interest income and interest expense of the partnership are treated as interest income or interest expense of the corporation.



Branch level taxes

A U.S. corporation owned by foreign persons is subject to U.S. income tax on its net income. In addition, the earnings of the U.S. corporation are subject to a second tax, this time at the shareholder level, when dividends are paid. As discussed above, when the shareholders are foreign, the second-level tax is imposed at a flat rate and collected by withholding. Similarly, as discussed above, interest payments made by a U.S. corporation to foreign creditors are subject to a U.S. withholding tax in certain circumstances. Pursuant to the branch tax provisions, the United States taxes foreign corporations engaged in a U.S. trade or business on amounts of U.S. earnings and profits that are shifted out of, or amounts of interest deducted by, the U.S. branch of the foreign corporation.91 The branch level taxes are comparable to these second-level taxes. In addition, where a foreign corporation is not subject to the branch profits tax as the result of a treaty, it may be liable for withholding tax on actual dividends it pays to foreign shareholders.



U.S. income tax treaties

The United States has entered into comprehensive income tax treaties with more than 50 countries, including a number of countries with well-developed insurance industries such as Barbados, Germany, Switzerland, and the United Kingdom. The United States has also entered into a tax treaty with Bermuda, another country with a significant insurance industry, which applies only with respect to the taxation of insurance enterprises.92



Comprehensive tax treaties

The traditional objectives of U.S. tax treaties have been the avoidance of international double taxation and the prevention of tax avoidance and evasion. Another related objective of U.S. tax treaties is the removal of the barriers to trade, capital flows, and commercial travel that may be caused by overlapping tax jurisdictions and by the burdens of complying with the tax laws of a jurisdiction when a person's contacts with, and income derived from, that jurisdiction are minimal. To a large extent, the treaty provisions designed to carry out these objectives supplement U.S. tax law provisions having the same objectives; treaty provisions modify the generally applicable statutory rules with provisions that take into account the particular tax system of the treaty partner.

The objective of limiting double taxation generally is accomplished in treaties through the agreement of each country to limit, in specified situations, its right to tax income earned from its territory by residents of the other country. For the most part, the various rate reductions and exemptions agreed to by the source country in treaties are premised on the assumption that the country of residence will tax the income at levels comparable to those imposed by the source country on its residents. Treaties also provide for the elimination of double taxation by requiring the residence country to allow a credit for taxes that the source country retains the right to impose under the treaty. In addition, in the case of certain types of income, treaties may provide for exemption by the residence country of income taxed by the source country.

Treaties define the term resident so that an individual or corporation generally will not be subject to tax as a resident by both of the countries. Treaties generally provide that neither country will tax business income derived by residents of the other country unless the business activities in the taxing jurisdiction are substantial enough to constitute a permanent establishment or fixed base in that jurisdiction. Treaties also contain commercial visitation exemptions under which individual residents of one country performing personal services in the other country will not be required to pay tax in that other country unless their contacts exceed certain specified minimums (e.g., presence for a set number of days or earnings in excess of a specified amount). Treaties address passive income such as dividends, interest, and royalties from sources within one country derived by residents of the other country either by providing that such income is taxed only in the recipient's country of residence or by reducing the rate of the source country's withholding tax imposed on such income. In this regard, the United States agrees in its tax treaties to reduce its 30-percent withholding tax (or, in the case of some income, to eliminate it entirely) in return for reciprocal treatment by its treaty partner.



U.S.-Bermuda tax treaty

The U.S.-Bermuda treaty generally exempts from U.S. taxation the business profits of a Bermuda insurance enterprise from carrying on the business of insurance (including insubstantial amounts of income incidental to such business), unless the insurance enterprise carries on business in the United States through a U.S. permanent establishment. For the purposes of the treaty, an insurance enterprise is defined as an enterprise whose predominant business activity is the issuing of insurance or annuity contracts or acting as the reinsurer of risks underwritten by insurance companies, together with the investing or reinvesting of assets held in respect of insurance reserves, capital, and surplus incident to the carrying on of the insurance business.



Permanent establishment

The permanent establishment concept is one of the basic devices used in income tax treaties to limit the taxing jurisdiction of the host country and thus to mitigate double taxation. Generally, an enterprise that is a resident of one country is not taxable by the other country on its business profits unless those profits are attributable to a permanent establishment of the resident in the other country. In addition, the permanent establishment concept is used to determine whether the reduced rates of, or exemptions from, tax provided for dividends, interest, and royalties apply, or whether those items of income will be taxed as business profits.

In general, under the United States Model Income Tax Convention of November 15, 2006 (the "U.S. model treaty") and many bilateral U.S. tax treaties, including the treaties with Barbados, Germany, Switzerland, and the United Kingdom, a permanent establishment is a fixed place of business in which the business of an enterprise is wholly or partly carried on.93 A permanent establishment includes a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry, or other place of extraction of natural resources.

The U.S. model treaty and many bilateral U.S. tax treaties provide that the following activities are deemed not to constitute a permanent establishment: (1) the use of facilities solely for storing, displaying, or delivering goods or merchandise belonging to the enterprise; (2) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for storage, display, or delivery or solely for processing by another enterprise; and (3) the maintenance of a fixed place of business solely for the purchase of goods or merchandise or for the collection of information for the enterprise. The U.S. model treaty and many bilateral U.S. tax treaties also provide that the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character does not constitute a permanent establishment. The U.S. model treaty and many bilateral U.S. tax treaties provide that a combination of these activities will not give rise to a permanent establishment, if the combination results in an overall activity that is of a preparatory or auxiliary character.

Under the U.S. model treaty and many bilateral U.S. tax treaties, if a person, other than an independent agent, is acting in a treaty country on behalf of an enterprise of the other country and has, and habitually exercises in such first country, the authority to conclude contracts in the name of such enterprise, the enterprise is deemed to have a permanent establishment in the first country in respect of any activities undertaken for that enterprise. This rule does not apply where the activities are limited to the preparatory and auxiliary activities described in the preceding paragraph.

No permanent establishment is deemed to arise, under the U.S. model treaty and many bilateral U.S. tax treaties, if the agent is a broker, general commission agent, or any other agent of independent status, provided that the agent is acting in the ordinary course of its business. Generally, whether an enterprise and an agent are independent is a factual determination, and the relevant factors in making this determination include: (1) the extent to which the agent operates on the basis of instructions from the principal; (2) the extent to which the agent bears business risk; and (3) whether the agent has an exclusive or nearly exclusive relationship with the principal.

The U.S. model treaty and many bilateral U.S. tax treaties provide that the fact that a company that is a resident of one country controls or is controlled by a company that is a resident of the other country or that carries on business in the other country does not in and of itself cause either company to be a permanent establishment of the other.



Exemption from the insurance premiums excise tax

Certain U.S. tax treaties, including the treaties with Germany, Switzerland, and the United Kingdom, apply to the insurance premiums excise tax of section 4371, in addition to the Federal income taxes imposed by the Code. Generally, when a foreign person qualifies for benefits under such a treaty, the United States is not permitted to collect the insurance premiums excise tax from that person. To prevent persons from inappropriately obtaining the benefits of exemption from the excise tax, the treaties generally include an anti-conduit rule. The anticonduit rule provides that the treaty applies to the insurance premiums excise tax only to the extent that the risks covered by the premiums are not reinsured with a person not entitled to the benefits of the treaty (or any other treaty that provides exemption from the excise tax).

The U.S. tax treaties with Barbados and Bermuda also provide that they apply to the insurance premiums excise tax, although the Senate's ratification of the U.S.-Bermuda treaty was subject to a reservation with respect to the treaty's application to the insurance premiums excise tax. Moreover, section 6139 of the Technical and Miscellaneous Revenue Act of 1988 provides that neither the U.S.-Barbados nor the U.S.-Bermuda treaty will prevent imposition of the insurance premiums excise tax on premiums, regardless of when paid or accrued, allocable to insurance coverage for periods after December 31, 1989.94 Accordingly, no exemption from the insurance premiums excise tax is available under those two treaties with respect to premiums allocable to insurance coverage beginning on or after January 1, 1990.

D. Present Law and Background of the Unrelated Business Income Tax and Debt-Financed Income

Present law of the unrelated business income tax and debt-financed property rules



Overview of the unrelated business income tax

The Code imposes a tax, at ordinary corporate rates, on the income that a tax-exempt organization obtains from an "unrelated trade or business ... regularly carried on by it."95 Most exempt organizations are subject to the tax.96 Generally, "unrelated trade or business" is "any trade or business the conduct of which is not substantially related ... to the exercise or performance by such organization of its charitable, educational, or other purpose."97 The Code thus sets up a three-part test for determining whether income from an activity is subject to the unrelated business income tax: (1) the activity constitutes a trade or business; (2) the activity is regularly carried on; and (3) the activity is not substantially related to the organization's taxexempt purposes. An organization that is subject to the unrelated business income tax and that has $1,000 or more of gross unrelated business taxable income must report that income on Form 990-T (Exempt Organization Business Income Tax Return).

Passive income, such as dividends, interest, royalties, certain rents, and certain gains and losses from the sale or exchange of property, is exempt from the unrelated business income tax.98 In general, the exemption for such passive income applies unless the income is derived from debt-financed property99 or is in the form of certain payments from certain 50-percent controlled subsidiaries.100 Other exemptions from the unrelated business income tax are provided for activities in which substantially all the work is performed by volunteers, for income from the sale of donated goods, and for certain activities carried on for the convenience of members, students, patients, officers, or employees of a charitable organization. In addition, special unrelated business income tax provisions exempt from tax certain activities of trade shows and State fairs, income from bingo games, and income from the distribution of certain low-cost items incidental to the solicitation of charitable contributions. Organizations liable for tax on unrelated business taxable income may be liable for alternative minimum tax determined after taking into account adjustments and tax preference items.



Overview of the debt-financed property rules

In general, income of a tax-exempt organization that is produced by debt-financed property is treated as unrelated business income in proportion to the acquisition indebtedness on the income-producing property. Special rules apply in the case of an exempt organization that owns an interest in a partnership (or a pass-through entity taxed as a partnership) that holds debtfinanced property.101 In general, in such cases, if the partnership incurs acquisition indebtedness with respect to property that, if held directly by the exempt organization, would not qualify for an exception from the debt-financed property rules, the receipt of income by the exempt organization with respect to such property may result in recognition of unrelated debt-finance income.

Acquisition indebtedness generally means the amount of unpaid indebtedness incurred by an organization to acquire or improve the property and indebtedness that would not have been incurred but for the acquisition or improvement of the property.102 Acquisition indebtedness does not include, however, (1) certain indebtedness incurred in the performance or exercise of a purpose or function constituting the basis of the organization's exemption, (2) obligations to pay certain types of annuities, (3) an obligation, to the extent it is insured by the Federal Housing Administration, to finance the purchase, rehabilitation, or construction of housing for low and moderate income persons, or (4) indebtedness incurred by a qualified organization to acquire or improve real property (the "real property exception").103



Exception for debt-financed real property investments by qualified organizations

For purposes of the real property exception, a qualified organization is: (1) an educational organization described in section 170(b)(1)(A)(ii)104 and its affiliated supporting organizations; (2) a qualified trust described in section 401(a) (hereinafter "pension funds"); (3) a title holding company described in section 501(c)(25) (insofar as it holds shares of organizations described in (1) or (2)105 ); or (4) a retirement income account described in section 403(b)(9).106 To qualify for the real property exception, an acquisition or improvement by the qualified organization must meet several requirements. These include: (1) a requirement generally that the price of the property is a fixed amount determined as of the date of the acquisition or completion of the improvement; (2) restrictions against payment of the indebtedness of the arrangement being dependent upon the revenue, income, or profits derived from the property; (3) restrictions concerning sale-leaseback arrangements; and (4) in general, a prohibition against seller financing.107

Additional requirements must be met for the real property exception to apply where the real property is held by a partnership in which a qualified organization is a partner. To qualify for the real property exception, the partnership must meet all of the above-described general requirements and must meet one of the following three requirements: (1) all of the partners of the partnership are qualified organizations; (2) each allocation to a partner of the partnership which is a qualified organization is a qualified allocation (within the meaning of section 168(h)(6)); or (3) the partnership satisfies a rule prohibiting disproportionate allocations.108

The disproportionate allocation rule requires two things: first, that the organization satisfy what commonly is referred to as the "fractions rule," and second, that each allocation with respect to the partnership have substantial economic effect within the meaning of section 704(b)(2).109 Under the fractions rule, the allocation of items to any partner that is a qualified organization cannot result in such partner having a share of the overall partnership income for any taxable year greater than such partner's share of overall partnership loss for the taxable year for which such partner's loss share will be the smallest.110 A partnership generally must satisfy the fractions rule on an actual basis and on a prospective basis for each taxable year of the partnership in which it holds debt-financed property and has at least one partner that is a qualified organization.111 The fractions rule generally is intended to prevent the shifting of disproportionate income or gains to tax-exempt partners of the partnership or the shifting of disproportionate deductions, losses, or credits to taxable partners.



Legislative history of the unrelated business income tax and debt-financed property rules



Business and debt-financed income prior to 1950

Until the introduction of the unrelated business income tax in 1950, exempt organizations enjoyed a full exemption from Federal income tax. There was no statutory limitation on the amount of business activity an exempt organization could conduct so long as the earnings from the business were used for exempt purposes. In court decisions, tax-exemption was extended to organizations that did not conduct any charitable programs, but rather operated commercial businesses for the benefit of a charitable organization. Tax exemption for such so called "feeder" organizations was recognized, for example in Roche's Beach, Inc. v. Commissioner,112 and C.F. Mueller Co. v. Commissioner.113

In addition to the use of feeder corporations as a source of revenue, another common practice of exempt organizations in the years before 1950 was the acquisition of real estate with borrowed funds. In a typical transaction, a tax-exempt organization would borrow the entire purchase price of real property, lease the property back to the seller under a long-term lease, and service the loan with tax-free rental income from the lease.114



Revenue Act of 1950

As a response to these practices, in the Revenue Act of 1950 Congress subjected charitable organizations (not including churches), and certain other exempt organizations to tax on their unrelated business income.115 The legislative history of the 1950 Act provides that "the problem at which the tax on unrelated business income is directed here is primarily that of unfair competition."116 Congress decided not to deny or revoke tax-exempt status solely because the organization carried on unrelated active business enterprises, but instead "merely [imposed] the same tax on income derived therefrom as is borne by their competitors."117 The Congress excluded from the tax certain passive forms of income, concluding that such passive income was "not likely to result in serious competition for taxable businesses having similar income"118 and "should not be taxed where it is used for exempt purposes because investments producing incomes of these types have long been recognized as proper for educational and charitable organizations."119

The 1950 Act also taxed as unrelated business income certain rents received in connection with the leveraged sale and leaseback of real estate.120 Here, Congress cited three objections to such transactions: (1) "the tax-exempt organization is not merely trying to find a means of investing its own funds at an adequate rate of return but is obviously trading on its exemption since the only contribution it makes to the sale and lease is its tax exemption"; (2) unchecked, such transactions could result in exempt organizations owning "the great bulk of the commercial and industrial real estate in the country ... lower[ing] drastically the rental income included in the corporate and individual income tax bases"; and (3) the "possibility ... that the exempt organization has in effect sold part of its exemption ... by ... paying a higher price for the property or by charging lower rentals than a taxable business could charge."121 This provision was a precursor to the present-law tax on unrelated debt-financed income.



Tax Reform Act of 1969

In the Tax Reform Act of 1969, Congress extended the unrelated business income tax to all exempt organizations described in section 501(c) and 401(a) (except United States instrumentalities).122 In addition, the 1969 Act expanded the tax on debt-financed income. The provision enacted in 1950 to tax income from certain leveraged sale-leaseback transactions involving real estate had proved ineffective, as taxpayers succeeded in structuring transactions that escaped the reach of the statute.123

The Supreme Court considered one such transaction in the Clay Brown case.124 In Clay Brown, a corporate business was sold to a charitable organization, which made a small or no down payment and agreed to pay the balance of the purchase price to the former shareholders out of profits from the property. The charity liquidated the corporation and leased the business assets back to the sellers, who formed a new corporation to operate the business. The newly formed corporation paid a large portion of its business profits as deductible "rent" to the charity, which then paid most of these receipts back to the original owners as installment payments on the initial purchase price. The Supreme Court agreed with the taxpayer's characterization of the transaction. The original owners thereby succeeded in converting business income that would have been taxable at ordinary income rates to capital gains, while the exempt organization acquired the ownership of a business largely or wholly without the investment of its own funds. Thus, under the 1950 legislation, exempt organizations continued to be able to leverage exempt status to buy businesses and investments on credit, often at more than market price, without contributing much if anything to the transaction other than tax exemption.125

Citing principally to cases such as Clay Brown and the ability of taxable parties to convert ordinary income into capital gain through leveraged sale-leaseback transactions with taxexempt organizations,126 the Congress in 1969 expanded the unrelated debt-financed income rules to cover not only certain rents from debt-financed acquisitions of real property, but to tax in addition other debt-financed income such as interest, dividends, other rents, royalties, and certain gains and losses from any type of property. The 1969 Act provided for certain limited exceptions to the tax on debt-financed income, such as where the debt-financed property is related to the organization's exempt functions.



Enactment of the real property exception

In the Miscellaneous Revenue Act of 1980, Congress enacted an exception to the debtfinanced income rules for certain real property investments by qualified pension trusts (the progenitor of the real property exception, described above). The exception did not apply, however, if any of five situations were present: (1) the acquisition price is not a fixed amount on the acquisition date; (2) the amount of indebtedness is dependent on the revenue, income, or profits derived from the debt-financed property; (3) the property is leased back to the seller (or a related party); (4) the property is acquired from or leased to a related person of the trust; and (5) the seller or person related to the trust provides nonrecourse financing, and the debt is subordinate to any other indebtedness on the property or the debt bore an interest rate significantly lower than that provided by unrelated parties.127

Congress believed that such an exception was warranted because "the exemption for investment income of qualified retirement trusts is an essential tax incentive which is provided to tax-qualified plans in order to enable them to accumulate funds to satisfy their exempt purpose - the payment of employee benefits."128 Real estate investments are attractive "for diversification and to offset inflation. Debt financing is common in real estate investments." In addition, the exemption provided to pension trusts was appropriate because, unlike other exempt organizations, the assets of such trusts eventually would be "used to pay taxable benefits to individual recipients whereas the investment assets of other [exempt] organizations ... are not likely to be used for the purpose of providing benefits taxable at individual rates." In other words, the exemption for qualified trusts generally resulted only in deferral of tax; unlike the exemption for other organizations. Congress also believed that the five limitations placed upon use of the exception would "eliminate the most egregious abuses addressed by the 1969 legislation."

In the Deficit Reduction Act of 1984, Congress extended the real property exception to educational organizations, finding that "educational organizations generally were unable to avoid taxation on income from real property acquired for investment purposes because few institutions had sufficient assets to purchase property not subject to debt."129 At the same time, Congress layered on additional conditions, including an absolute bar on seller financing and an anti-abuse rule in the case of qualified organizations that were partners in partnerships investing in debtfinanced real property. The new restrictions were needed because prior law was "inadequate to prevent the shifting of tax benefits between tax-exempt organizations and taxable entities."130

Between 1986 and 1988, Congress introduced and modified rules requiring that investments through a partnership satisfy a prohibition on disproportionate allocations, i.e., the requirements that each partnership allocation have substantive economic effect and that the partnership satisfy the "fractions rule."131

In 1993, Congress relaxed some of the conditions required to meet the real property exception. In general, leasebacks to the seller (or a disqualified person) are allowed if no more than 25 percent of the leasable floor space in a building is leased back and the lease is on commercially reasonable terms.132 Seller financing is permitted if the financing is on commercially reasonable terms.133 In addition, the fixed price restriction and the requirement that indebtedness not be paid out of revenue, income, or profits of the acquired property are relaxed for certain sales by financial institutions.134

E. Overview of Ways to Defer Services Income

1. Qualified plans



In general

Deferred compensation occurs when the payment of compensation to a service provider is deferred for more than a short period after the compensation is earned (i.e., the time when the services giving rise to the compensation are performed). Payment is generally deferred until some specified event, such as the service provider's death, disability, or other termination of services, or is deferred for a specified period of time, such as five or ten years.

The Code provides tax-favored treatment for certain types of employer-sponsored deferred compensation arrangements that are designed primarily to provide employees with retirement income. These arrangements include qualified defined contribution and defined benefit pension plans (sec. 401(a)), qualified annuities (sec. 403(a)), tax-sheltered annuities (sec. 403(b)), savings incentive match plans for employees or "SIMPLE" plans (sec. 408(p)), simplified employee pensions or "SEPs" (sec. 408(k)), and eligible deferred compensation plans of State or local governmental employers (sec. 457(b)). These plans are referred to as qualified retirement plans.

In the case of a qualified retirement plan, employees do not include contributions in gross income until amounts are distributed, even though the arrangement is funded and benefits are nonforfeitable. In the case of a taxable employer, the employer is entitled to a current deduction (within limits) for contributions even though the contributions are not currently included in an employee's income. Contributions to a qualified plan, and earnings thereon, are held in a taxexempt trust.

Present law imposes a number of requirements on qualified retirement plans that must be satisfied in order for the plan to be qualified and for favorable tax treatment to apply. These requirements include nondiscrimination rules that are intended to ensure that a qualified retirement plan covers a broad group of employees. The nondiscrimination requirements are designed to ensure that qualified retirement plans benefit an employer's rank-and-file employees as well as highly compensated employees.135 Under a general nondiscrimination requirement, the contributions or benefits provided under a qualified retirement plan must not discriminate in favor of highly compensated employees.136 Treasury regulations provide detailed and exclusive rules for determining whether a plan satisfies the general nondiscrimination requirement. For example, under the regulations applicable to qualified defined contribution plans and qualified defined benefit plans, the amount of contributions or benefits provided under the plan and the benefits, rights and features offered under the plan must be tested.137

Limits also apply on the amount of contributions that can be made to qualified plans and, in the case of defined benefit plans, on the amount that is payable annually from the plan. Limits also apply to the amount of an employer's deduction for contributions to qualified plans.

Qualified employer plans are also generally subject to the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). For example, ERISA generally requires that the assets of a pension plan be held in a trust established for the exclusive purpose of providing plan benefits.



Qualified cash or deferred arrangements (section 401(k) plans)

Under present law, many defined contribution plans include a qualified cash or deferred arrangement (commonly referred to as a "401(k) plan"), under which employees may elect to receive cash or to have contributions made to the plan by the employer on behalf of the employee in lieu of receiving cash. Contributions made to the plan at the election of the employee are referred to as elective deferrals. The maximum annual amount of elective deferrals that can be made by an individual for any taxable year is $15,500 (for 2007). In applying this limitation, elective deferrals under 401(k) plans, tax-sheltered annuities, SEPs, and SIMPLE plans are aggregated. An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions to a section 401(k) plan. As a result, the dollar limit on elective deferrals is increased for an individual who has attained age 50 by $5,000 (for 2007). An employee's elective deferrals must be fully vested. A special nondiscrimination test applies to elective deferrals under a 401(k) plan.



Tax-sheltered annuities (section 403(b) annuities)

A tax-sheltered annuity is also permitted to allow a participant to elect to have the employer make payments as contributions to the plan or to the participant directly in cash. As discussed above, the $15,500 annual limit on elective deferrals applies to elective deferral contributions to a tax-sheltered annuity. As with a 401(k) plan, special rules permit catch-up contributions to be made to a tax-sheltered annuity in the case of certain individuals, and special rules apply for purposes of nondiscrimination testing.



Eligible deferred compensation plans of State and local governments (section 457 plans)

Compensation deferred under a section 457 plan of a State or local governmental employer is includible in income when paid. The maximum annual deferral under such a plan generally is the lesser of (1) $15,500 (for 2007) or (2) 100 percent of compensation. A special, higher limit applies for the last three years before a participant reaches normal retirement age (the "section 457 catch-up limit"). In the case of a section 457 plan of a governmental employer, a participant who has attained age 50 before the end of the taxable year may also make catch-up contributions up to a limit of $5,000 (for 2007), unless a higher section 457 catch-up limit applies. Only contributions to section 457 plans are taken into account in applying these limits; contributions made to a qualified retirement plan or section 403(b) plan for an employee do not affect the amount that may be contributed to a section 457 plan for that employee. Thus, for example, a State or local government employee covered by both a section 457 plan and a section 401(k) or 403(b) plan can contribute up to $15,500 (for 2007) to each plan for a total of $31,000. In the case of a plan that fails to meet the dollar limitations or any other requirement of section 457 (an "ineligible plan"), compensation is includible in income for the first taxable year in which there is no substantial risk of forfeiture.138



2. Nonqualified deferred compensation



In general

A nonqualified deferred compensation arrangement is generally any deferred compensation arrangement that is not a qualified retirement plan. Nonqualified deferred compensation arrangements are contractual arrangements between a service recipient (e.g., an employer or a hedge fund) and a service provider (e.g., an employee or an entity that operates as a hedge fund manager) covered by the arrangement. Such arrangements are structured in whatever form achieves the goals of the parties; as a result, they vary greatly in design. Considerations that may affect the structure of the arrangement are the current and future income needs of the service provider, the desired tax treatment of deferred amounts, and the desire for assurance that deferred amounts will in fact be paid.

ERISA contains exemptions from its requirements for certain nonqualified deferred compensation arrangements. Most nonqualified deferred compensation arrangements are designed to fall within these ERISA exemptions. Thus, nonqualified deferred compensation arrangements are generally not subject to the protections of ERISA. For example, there is no requirement that a nonqualified deferred compensation arrangement be funded by a trust established for the exclusive purpose of providing plan benefits.139

The Code and ERISA do not limit the amount that can be deferred by a service provider under a nonqualified deferred compensation arrangement.



Tax treatment of service provider



In general

The American Jobs Creation Act of 2004140 added section 409A to the Code which provides specific rules governing the tax treatment of nonqualified deferred compensation.141 Prior to section 409A, there were no rules that specifically governed the tax treatment of nonqualified deferred compensation. In determining the tax treatment of nonqualified deferred compensation prior to enactment of section 409A, a variety of tax principles and Code provisions were relevant, including the doctrine of constructive receipt, the economic benefit doctrine, the provisions of section 83 relating generally to transfers of property in connection with the performance of services, and provisions relating specifically to nonexempt employee trusts (sec. 402(b)) and nonqualified employee annuities (sec. 403(c)). Section 409A does not override these tax principles and Code provisions. Thus, they are relevant in determining the tax treatment of nonqualified deferred compensation and are discussed below. Section 409A does not prevent the inclusion of amounts in gross income under any provision or rule of law earlier than the time provided under its rules.

Under section 409A, unless certain requirements are satisfied, amounts deferred under a nonqualified deferred compensation plan are currently includible in income to the extent not subject to a substantial risk of forfeiture. The requirements imposed under section 409A affect the way that nonqualified deferred compensation arrangements are now commonly structured.



General income inclusion rules

In the case of a cash-basis taxpayer, if the nonqualified deferred compensation arrangement is unfunded, then the compensation is generally includible in income when it is actually or constructively received under section 451 (unless earlier income inclusion applies under section 409A).142 Income is constructively received when it is credited to an individual's account, set apart, or otherwise made available so that it may be drawn on at any time.143 Income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. A requirement to relinquish a valuable right in order to make withdrawals is generally treated as a substantial limitation or restriction.

In general, an arrangement is considered funded if there has been a transfer of property under section 83. Section 83 provides rules for the tax treatment of property transferred in connection with the performance of services and generally applies to a funded nonqualified deferred compensation arrangement.144

The economic benefit doctrine is based on the broad definition of gross income in the Code (sec. 61), which includes income in whatever form paid. Under the economic benefit doctrine, if an individual receives any economic or financial benefit or property as compensation for services, the value of the benefit or property is includible in the individual's gross income. For example, courts have applied the economic benefit doctrine to the receipt of stock options or the receipt of an interest in a trust.145 A concept related to economic benefit is the cash equivalency doctrine.146 Under this doctrine, if the right to receive a payment in the future is reduced to writing and is transferable, such as in the case of a note or a bond, the right is considered to be the equivalent of cash and the value of the right is includible in gross income.147



Section 409A

In general.-Under section 409A, all amounts deferred by a service provider under a nonqualified deferred compensation plan148 for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture149 and not previously included in gross income, unless certain requirements are satisfied. If the requirements of section 409A are not satisfied, in addition to current income inclusion, interest at the rate applicable to underpayments of tax plus one percentage point is imposed on the underpayments that would have occurred had the compensation been includible in income when first deferred, or if later, when not subject to a substantial risk of forfeiture. The amount required to be included in income is also subject to a 20-percent additional tax.

Under regulations, the term "service provider" includes an individual, corporation, subchapter S corporation, partnership, personal service corporation (as defined in sec. 269A(b)(1)), noncorporate entity that would be a personal service corporation if it were a corporation, or qualified personal service corporation (as defined in sec. 448(d)(2)) for any taxable year in which such individual or entity accounts for gross income from the performance of services under the cash receipts and disbursements method of accounting.150 Section 409A does not apply to a service provider that provides significant services to at least two service recipients that are not related to each other or the service provider. This exclusion does not apply to a service provider who is an employee or a director of a corporation (or similar position in the case of an entity that is not a corporation).151 In addition, the exclusion does not apply to an entity that operates as the manager of a hedge fund or private equity fund. This is because the exclusion does not apply to the extent that a service provider provides management services to a service recipient. Management services for this purpose means services that involve the actual or de facto direction or control of the financial or operational aspects of a trade or business of the service recipient or investment management or advisory services provided to a service recipient whose primary trade or business includes the investment of financial assets, such as a hedge fund.152

For purposes of section 409A, a nonqualified deferred compensation plan is any plan that provides for the deferral of compensation other than a qualified employer plan153 or any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan.

The regulations also provide that certain other types of plans are not considered deferred compensation, and thus are not subject to section 409A. For example, if a service recipient transfers property to a service provider, there is no deferral of compensation merely because the value of the property is either not includible in income under section 83 by reason of the property being substantially nonvested or is includible in income because of a valid section 83(b) election.154 Another exception applies to amounts that are not deferred beyond a short period of time after the amount is no longer subject to a substantial risk of forfeiture.155 Under this exception, there generally is no deferral for purposes of section 409A if the service provider actually or constructively receives the amount on or before the last day of the applicable 21/2 month period. The applicable 21/2 month period is the period ending on the later of the 15th day of the third month following the end of: (1) the service provider's first taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture; or (2) the service recipient's first taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture. Special rules apply in the case of stock options.156

The regulations provide exclusions from the definition of nonqualified deferred compensation for individuals who participate in certain foreign plans, including plans covered by an applicable treaty and broad-based foreign retirement plans.157 In the case of a U.S. citizen or lawful permanent alien, nonqualified deferred compensation does not include a broad-based foreign retirement plan, but only with respect to the portion of the plan that provides for nonelective deferral of foreign earned income and subject to limitations on the annual amount deferred under the plan or the annual amount payable under the plan. In general, foreign earned income refers to amounts received by an individual from sources within a foreign country that constitutes earned income attributable to services.

Permissible distribution events.-Under section 409A, distributions from a nonqualified deferred compensation plan may be allowed only upon separation from service (as determined by the Secretary), death, a specified time (or pursuant to a fixed schedule), change in control of a corporation (to the extent provided by the Secretary), occurrence of an unforeseeable emergency, or if the participant becomes disabled. A nonqualified deferred compensation plan may not allow distributions other than upon the permissible distribution events and, except as provided in regulations by the Secretary, may not permit acceleration of a distribution. In the case of a specified employee who separates from service, distributions may not be made earlier than six months after the date of the separation from service or upon death. Specified employees are key employees158 of publicly-traded corporations.

Deferral elections.-Section 409A requires that a plan must provide that compensation for services performed during a taxable year may be deferred at the participant's election only if the election to defer is made no later than the close of the preceding taxable year, or at such other time as provided in Treasury regulations. In the case of any performance-based compensation based on services performed over a period of at least 12 months, such election may be made no later than six months before the end of the service period. The time and form of distributions must be specified at the time of initial deferral. A plan may allow changes in the time and form of distributions subject to certain requirements.

Back-to-back arrangements.-Back-to-back service recipients (i.e., situations under which an entity receives services from a service provider such as an employee, and the entity in turn provides services to a client) that involve back-to-back nonqualified deferred compensation arrangements (i.e., the fees payable by the client are deferred at both the entity level and the employee level) are subject to special rules under section 409A. For example, the final regulations generally permit the deferral agreement between the entity and its client to treat as a permissible distribution event those events that are specified as distribution events in the deferral agreement between the entity and its employee. Thus, if separation from employment is a specified distribution event between the entity and the employee, the employee's separation is a permissible distribution event for the deferral agreement between the entity and its client.159



Timing of the service recipient's deduction

Special statutory provisions govern the timing of the deduction for nonqualified deferred compensation, regardless of whether the arrangement covers employees or nonemployees and regardless of whether the arrangement is funded or unfunded.160 Under these provisions, the amount of nonqualified deferred compensation that is includible in the income of the service provider is deductible by the service recipient for the taxable year in which the amount is includible in the service provider's income.161



Employment taxes and reporting

In the case of an employee, nonqualified deferred compensation is generally considered wages both for purposes of income tax withholding and for purposes of taxes under the Federal Insurance Contributions Act ("FICA"), consisting of social security tax and Medicare tax. However, the income tax withholding rules and social security and Medicare tax rules that apply to nonqualified deferred compensation are not the same.

In the case of an employee, nonqualified deferred compensation is generally subject to income tax withholding at the time it is includible in the employee's income as discussed above. In addition, amounts includible in income are required to be reported on the employee's Form W-2 for the year includible in income. Income tax withholding and Form W-2 reporting are required even if the employee has already terminated employment. Income tax withholding and Form W-2 reporting are required when amounts are includible in income even if no actual payments are made to the employee.162

In the case of a service provider who is not an employee, nonqualified deferred compensation amounts includible in income generally are required to be reported on a Form 1099 for the year includible in income. Income tax withholding generally does not apply to such amounts.

The Code provides special rules for applying social security and Medicare taxes to nonqualified deferred compensation of employees.163 In general, nonqualified deferred compensation is subject to social security and Medicare tax when it is earned (i.e., when services are performed), unless the nonqualified deferred compensation is subject to a substantial risk of forfeiture. If nonqualified deferred compensation is subject to a substantial risk of forfeiture, it is subject to social security and Medicare tax when the risk of forfeiture is removed (i.e., when the right to the nonqualified deferred compensation vests). This treatment is not affected by the timing of income inclusion.

In the case of a self-employed individual, nonqualified deferred compensation amounts that are includible in income are also taken into account in determining net earnings from selfemployment for social security and Medicare tax purposes unless an exception applies.

The Code requires annual reporting to the IRS of amounts deferred even if such amounts are not currently includible in income for that taxable year.164 The IRS has postponed the effective date of the statutory requirement and announced that an employer (or other payor) is not required for 2005 and 2006 to report amounts deferred during the year under a nonqualified deferred compensation plan subject to section 409A.165



Offshore arrangements



In general

The requirements under section 409A apply in the case of deferred compensation of a U.S. person participating in offshore operations such as a hedge fund located outside of the U.S. The general requirements of section 409A (i.e., the rules relating to elections, distributions and no acceleration of benefits) apply similarly to U.S. persons whether their activities are conducted in the United States or abroad.166



Foreign trusts

Section 409A requires current income inclusion in the case of certain offshore funding of nonqualified deferred compensation. Under section 409A, in the case of assets set aside (directly or indirectly) in a trust (or other arrangement determined by the Secretary) for purposes of paying nonqualified deferred compensation, such assets are treated as property transferred in connection with the performance of services under section 83 (whether or not such assets are available to satisfy the claims of general creditors) at the time set aside if such assets (or trust or other arrangement) are located outside of the United States or at the time transferred if such assets (or trust or other arrangement) are subsequently transferred outside of the United States. Any subsequent increases in the value of, or any earnings with respect to, such assets are treated as additional transfers of property.

Interest at the underpayment rate plus one percentage point is imposed on the underpayments that would have occurred had the amounts set aside been includible in income for the taxable year in which first deferred or, if later, the first taxable year not subject to a substantial risk of forfeiture. The amount required to be included in income is also subject to an additional 20-percent tax.

The provision does not apply to assets located in a foreign jurisdiction if substantially all of the services to which the nonqualified deferred compensation relates are performed in such foreign jurisdiction. The Secretary has authority to exempt arrangements from the provision if the arrangements do not result in an improper deferral of U.S. tax and will not result in assets being effectively beyond the reach of creditors.

III. LEGISLATIVE PROPOSALS IN RECENT CONGRESSES

A. Proposals Relating to Offshore Reinsurance

H.R. 1755 (107th Congress)

H.R. 1755, "Reinsurance Tax Equity Act of 2001," was introduced in the House of Representatives by Nancy Johnson and Richard Neal during the 107th Congress on May 8, 2001. The bill would amend section 832(b)(4) of the Code to deny a deduction for premiums paid for direct or indirect reinsurance of U.S. risks with a "related insurer" in certain circumstances. However, when calculating its taxable income, an insurance company may generally deduct reinsurance recovered from a related insurer to the extent a deduction for the premium paid for the reinsurance was disallowed as a result of the bill. A U.S. risk includes any risk related to property in the United States, or liability arising out of the activity in, or in connection with the lives or health of residents of, the United States. A "related insurer" means a reinsurer owned or controlled directly or indirectly by the same interests (within the meaning of section 482) as the person making the premium payment.

The deduction is not denied if: (1) the income attributable to the reinsurance to which such premium relates is includible in the gross income of such reinsurer or one or more domestic corporations or citizens or residents of the United States; or (2) the related insurer establishes to the satisfaction of the Treasury Secretary that the taxable income (as determined under section 832) attributable to the reinsurance is subject to an effective rate of income tax imposed by a foreign country greater than 20 percent of the maximum rate specified in section 11 of the Code. A related insurer may elect to treat income from the reinsurance of U.S. risks, which is not otherwise includible in gross income, as income that is effectively connected with the conduct of a U.S. trade or business.



H.R. 4192 (106th Congress)

H.R. 4192 was introduced in the House of Representatives by Nancy Johnson and Richard Neal during the 106th Congress on April 5, 2000. This bill would amend section 845 to alter the treatment of related-party reinsurance. Under the bill, if a domestic person directly or indirectly reinsures a United States risk with a related foreign reinsurer, then the investment income of the domestic person shall be increased each year by an amount equal to the product of (1) the average of the applicable federal mid-term rates determined under section 1274(d)(1) and (2) the sum of the reserves and liabilities related to the U.S. risks ceded to the foreign reinsurer as shown on the national statement approved by the National Association of Insurance Commissioners. A U.S. risk includes any risk related to property in the United States, or liability arising out of the activity in, or in connection with the lives or health of residents of, the United States. An insurer is a "related foreign insurer" with respect to any domestic person if such person and foreign insurer are owned or controlled directly or indirectly by the same interest (within the meaning of section 482).

Generally, this rule is not applicable if: (1) the foreign reinsurer retaining the reinsurance includes the income attributable to the reinsurance of the U.S. risks on its U.S. tax return either as a result of having made an election to be taxed as a domestic insurance company under section 953(d) or because such income is effectively connected with the foreign reinsurer's U.S. trade or business; (2) the foreign reinsurer elects to file a tax return and pay tax on income from the reinsurance of U.S. risks ceded to it by related domestic persons as if such income were effectively connected to a U.S. trade or business; (3) one or more domestic corporations or U.S. individuals include the income attributable the reinsurance of the U.S. risks ceded to the related foreign reinsurer on its tax return under subpart F; or (4) the foreign reinsurer establishes to the satisfaction of the Treasury Secretary that the taxable income (as determined under section 832) attributable to the reinsurance is subject to an effective rate of income tax imposed by a foreign country greater than 20 percent of the maximum rate specified in section 11 of the Code.

The 1 percent excise tax on premiums paid to foreign reinsurers does not apply to premiums to which the bill applies.

B. Proposal Relating to Unrelated Debt-Financed Income

H.R. 3501 (110th Congress)

H.R. 3501 was introduced in the House of Representatives by Sander Levin during the 110th Congress on September 7, 2007. The bill amends section 514(c) of the Code to provide an exception to the unrelated debt-financed income rules for certain investments by tax-exempt organizations in qualified securities or commodities. Specifically, the bill provides that, where a tax-exempt organization is a limited partner in a partnership that holds qualified securities or commodities, indebtedness incurred or continued by the partnership in purchasing or carrying any such asset will not be "acquisition indebtedness" for purposes of the debt-financed income rules. Qualified securities and commodities generally include securities described in section 475(c)(2) of the Code, commodities described in section 475(e)(2) of the Code, and any option or derivative contract with respect to such a security or commodity.

To qualify for the exception for investments in qualified securities or commodities, the partnership must satisfy the special rules that apply to investments in partnerships under the present-law real estate exception to the debt-financed income rules. The Secretary is given the authority to issue regulations providing for certain other anti-abuse rules as necessary or appropriate to carry out the purposes of the bill.

IV. ISSUES AND ANALYSIS

A. Issues and Analysis Relating to Reinsurance

In general

Both domestically-controlled and foreign-controlled insurance companies regularly cede a portion of their U.S. risks to affiliated or unaffiliated U.S. or foreign reinsurers. In general, the shifting, distribution, and geographic diversification of risks that may be accomplished by ceding such risks are valid business purposes. Further, ceding U.S. risks to foreign reinsurers generally serves a valid business purpose of minimizing multiple layers of regulation and consolidating regulatory oversight authority in a more business-favorable jurisdiction.

The industry recognizes, however, that some companies may take such reinsurance activities to the limit. A business arrangement under which an insurer cedes most of its risks to one reinsurer is known in the industry as "fronting." Fronting raises issues of whether the insurer is acting as an agent of the reinsurer, and whether a foreign reinsurer is engaged in a trade or business in the United States, and if so, whether the activities result in the reinsurer having a permanent establishment in the United States to which the ceded premiums are attributable.

In the case of foreign-based companies that reinsure policies issued or reinsured by independent or affiliated U.S. insurance companies, a well-advised reinsurer may in most cases avoid being engaged in a trade or business and having a permanent establishment in the United States by not having an office in the United States, by keeping separate the affairs of the foreign and U.S. companies, and by carefully following the formalities of contracts. In that case, the U.S. insurer may deduct its reinsurance premiums; those premiums are subject to neither net income nor withholding tax by the United States, notwithstanding that the reinsurance covers U.S. risks. The tax cost of such an arrangement is the one-percent excise tax on the reinsurance premiums,167 plus any U.S. income tax imposed on ceding commissions paid by the reinsurer to the ceding insurer. The premiums may or may not be subject to tax in the country in which the foreign reinsurer is resident, depending on the tax law there; generally this income is lightly taxed in the countries most frequently availed of, compared to U.S. tax rates.168 Further, because the premiums are actually paid to the foreign reinsurer, it may invest these funds, including in the United States. In so doing, it may avail itself of potentially low local tax rates,169 as well as, in the case of U.S. investment, the "securities trading safe harbor" tax exemption of section 864(b) and other portfolio investment exemptions.170 At the same time, a related foreign reinsurer's consolidated financial statements are not affected by such related-party reinsurance transactions.

The above tax profile is in contrast to that of U.S.-based reinsurers, whose U.S. companies' income is subject to taxation in the United States when earned and whose controlled foreign corporations' insurance income is generally subject to U.S. tax under subpart F.171 The distribution of share ownership of a foreign corporation may determine, in part, whether it and its foreign subsidiaries are subject to the controlled foreign corporation tax regime or is able to obtain the superior tax treatment accorded other foreign corporations. A foreign corporation that is majority-owned, or even 100-percent-owned, directly or indirectly, by U.S. persons is not a controlled foreign corporation if its ownership is dispersed such that the majority of the voting power or value of the foreign corporation is not owned, directly or indirectly, by U.S. persons owning 10 percent or more of the voting power of the corporation's stock.



Earnings stripping

In the case of the systematic reduction of the U.S. tax base of a U.S. foreign controlled company ("FCC") by its foreign parent by means of interest deductions - known as earnings stripping - Congress has provided a set of rules that disallow deductions for amounts of interest deemed to be excessive.172 The rules apply regardless of the taxpayer's or related creditor's intent or the existence of a valid business purpose for such debt. Indeed, it may be presumed that the debt qualifies as such under general debt-equity principles and that there is a valid business purpose for such debt. The earnings stripping rules operate in a mostly mechanical fashion to disallow the portion of the FCC's interest deduction over a certain threshold. The disallowed deductions may be carried forward indefinitely for use in future years.

The earnings stripping rules are generally not affected by U.S. income tax treaties because they affect residents of the United States, not residents of treaty countries. When it enacted these rules, Congress did not believe they violated U.S. treaty obligations. The Committee on Ways and Means stated that "[t]he committee does not believe that the impact of this limitation on foreign-owned entities violates any treaty nondiscrimination provision....If the committee should be incorrect in its technical interpretation of the interaction between this provision and U.S. treaties, however, it does not intend that any contrary treaty provision defeat its purpose in enacting this limitation."173



Foreign related-party reinsurers and earnings stripping

Earnings stripping transactions can involve the payment of deductible amounts other than interest.174 Even though interest earnings stripping is not a perfect analogy to reinsurance in every detail, the effects on the U.S. tax base of an FCC that reinsures U.S. risks with its foreign parent companies or foreign related parties is the same as earnings stripping. The Reasons for Change for the earnings stripping rules in the Ways and Means committee Report sets forth general principles that appear to be equally applicable to foreign related party reinsurance:

The committee believes, as a general matter, that it is appropriate to limit the deduction for interest that a taxable person pays or accrues to a tax-exempt entity whose economic interests coincide with those of the payor. To allow an unlimited deduction for such interest permits significant erosion of the tax base. Allowance of unlimited deductions permits an economic unit that consists of more than one legal entity to contract with itself at the expense of the government.

*****

The committee is particularly concerned that this ability to avoid tax tends to give an unfair advantage to business operations owned by foreign and other tax-exempt persons, as compared with business operations owned by taxable U.S. persons. In addition, such an advantage may enhance foreign investors' abilities to take over U.S. businesses, inasmuch as their reduced tax burden permits such investors to pay a higher price for a U.S. business than competing taxable domestic investors can pay. The committee believes that all such potential investors in U.S. businesses should compete on a level basis.175

If the rationale for the earnings stripping rules applies to foreign related-party reinsurance transactions, then it should be possible to devise a set of rules analogous to those of section 163(j) that would disallow, and possibly defer, deductions for ceding "excessive" reinsurance premiums covering U.S. risks paid by FCCs to foreign related persons, notwithstanding any current tax treaty provision.176

Despite the broad similarity between earnings stripping and foreign related-party reinsurance transactions, such reinsurance rules would not be identical to the earnings stripping rules because the two factual patterns are not identical. For example, by ceding premiums, an insurer generally decreases its financial leverage and debt-equity ratio, unlike the earnings stripping-by-debt scenario, in which these are increased. The ceding of premiums thus increases the ceding company's financial and regulatory capacity to write (or reinsure) more premiums, which may, in turn, be ceded. This creates a business incentive for an FCC and its foreign parent company to engage in or to increase fronting-type activities.

In general, such a reinsurance provision would disallow deductions for premiums for U.S. risk ceded to tax-exempt related persons. A person would be considered tax-exempt to the extent of a treaty or Code reduction in withholding or other tax, including the elimination of withholding tax on premiums under Treasury Regulation section 1.1441-2(a)(7),177 taking into account the imposition of the one-percent excise tax on reinsurance premiums. One general approach might be to closely follow the rules of section 163(j) to disallow a deduction for the amount of reinsurance premiums paid to foreign related parties to the extent the amount of reinsured premiums exceeds 50% of an amount similar to "adjusted taxable income."178 As in the case of interest earnings stripping, disallowed deductions and an attribute analogous to "excess limitation" could be carried forward from prior years and taken into account.179

The earnings stripping rules do not apply unless the FCC's debt-to-equity exceeds a safeharbor ratio of 1.5 to 1.180 This amount is generally designed to be greater than the median debtto-equity ratio of U.S. corporations.181 As in the case of earnings stripping rules, providing an overall safe harbor could protect the companies from disallowance of deductions due to year-toyear changes in profitability. Such a safe harbor could be based on concepts analogous to the debt-equity ratio, for example, a median percentage of premiums ceded to unrelated parties on a group basis. This could be determined on the basis of overall industry transactions pertaining to unrelated party transactions, by lines of business, or based on some fixed criteria (as in section 163(j)).

An alternative line-drawing approach might be to attempt to match up the FCC's premium-ceding tax burden with the tax burden that is imposed on U.S.-based insurers ceding premiums to their controlled foreign corporations. Proponents of such an approach might view this type of equalization approach as an opportunity to reform or reduce the current system of subpart F taxation of insurance income.182



Discussion of earnings stripping approach

Some would argue that such a set of reinsurance-stripping rules is necessary to place U.S.-owned and FCC insurance companies on a level playing field, and that it is important to prevent other forms of earnings stripping in addition to interest. Others would argue that since there is a business purpose for such reinsurance, there should not be a formulaic limit imposed on deductions for ceded premiums. Applying a more equal amount of tax with respect to the insurance and reinsurance of U.S. risks does, in fact, level the playing field, but only with respect to tax. Some would argue that such a set of rules would cause property and casualty insurance coverage to become more difficult to obtain or would make such coverage much more expensive. Some proponents of this view might caution that the availability of appropriate insurance coverage at a reasonable cost, particularly catastrophic coverage, is a critical element in today's economy, and that adding any additional tax burden upon such insurers would put such availability at serious risk. Others would argue that the U.S. property and casualty market would not be disrupted thereby and would not become more expensive than the premiums currently charged by U.S. insurers who are unable to cede their premiums to an untaxed or lowtaxed foreign parent. These proponents might point to foreign manufacturers such as Toyota and Honda, which have built several factories in the United States since the earnings stripping rules were imposed in 1989, and which are still manufacturing and selling goods in the U.S. market notwithstanding those rules.

Some would find the imposition of an earnings stripping-type provision to address related party reinsurance attractive because it would provide a degree of built-in flexibility to permit an appropriate level of business-driven reinsurance arrangements. Proponents might also suggest that, because it is possible for FCCs to engage simultaneously in both related party reinsurance transactions and earnings stripping using interest deductions, it would also be necessary to coordinate the two sets of rules, and that it is generally simpler to coordinate similar rules. Such coordination rules might also serve a policy objective of better equalizing the U.S. tax burden for the foreign insurance industry compared to other foreign industries.

Another potential benefit of an earnings stripping-type regime is that it would minimally interfere with the operation of tax treaties and therefore it would be difficult or impossible to avoid such a regime by using a tax treaty. Others might argue that such rules violate the spirit, if not the letter, of tax treaties. In addition, since earnings stripping-type rules are not dependent upon tax treaties or foreign effective tax rates, the impact of an earnings stripping regime may not be circumvented by moving foreign reinsurance operations to another foreign country.



Deduction disallowance183

A related approach is to disallow deductions to the insurer for premiums paid for the direct or indirect reinsurance of U.S. risks with a related foreign reinsurer. Under this approach, the entire amount of the deduction for reinsurance premiums is disallowed, while neither a safe harbor analogous to the 1.5 to 1 debt-equity ratio safe harbor of section 163(j) nor a carryforward of the disallowed deductions is permitted. However, this approach provides an exception for reinsurance premiums subject to income tax by a foreign country at an effective rate greater than 20 percent of the maximum rate of tax specified in section 11, i.e., greater than seven percent.

Opponents of this approach argue that the effective tax rate test unfairly favors certain countries' reinsurers while disfavoring those in other countries,184 and that different taxpayers may calculate effective tax rates differently. They further argue that, by not providing a safe harbor, this approach operates harshly against all foreign related party reinsurance, even though there may be an important business purpose for reinsuring at least some risks in this manner. Proponents argue that such measures are necessary in order to terminate the tax planning opportunities available only to FCCs and their foreign affiliates and that it is appropriate to set a minimum effective rate of foreign tax to ensure that such reinsurance is equitably burdened with tax in some jurisdiction.

Continue

Click here to Contact Us

[Top of Page]