Copyright 2010 Congressional Quarterly, Inc.All Rights Reserved. CQ Congressional Testimony
July 14, 2010 Wednesday
CAPITOL HILL HEARING TESTIMONY
REINSURANCE TAXATION; COMMITTEE: HOUSE WAYS AND MEANS; SUBCOMMITTEE: SELECT REVENUE MEASURES
TESTIMONY-BY: STEPHEN E. SHAY, DEPUTY ASSISTANT SECRETARY
AFFILIATION: UNITED STATES DEPARTMENT OF THE TREASURY
Statement of Stephen E. Shay Deputy Assistant Secretary, International Tax Affairs United States Department of the Treasury
Committee on House Ways and Means Subcommittee on Select Revenue Measures
July 14, 2010
Mr. Chairman, Ranking Member Tiberi, and distinguished Members, I appreciate the opportunity to testify regarding tax issues relating to reinsurance.
Reinsurance serves many legitimate non-tax purposes, allowing insurance companies to manage risk, efficiently allocate capital, and address regulatory requirements. Certain features of current U.S. tax rules relating to reinsurance transactions among affiliates can, however, create inappropriate incentives to use reinsurance to shift profits out of the United States. My testimony will discuss the use of reinsurance in the marketplace, the current federal tax treatment of reinsurance transactions, the particular tax policy concerns raised by reinsurance with foreign affiliates, and the Obama Administration’s proposal addressing those issues.
Reinsurance is essentially insurance for insurance companies. A reinsurance policy allows an insurer to obtain insurance protection from a reinsurer for all or a portion of the risks it directly insures in exchange for the payment of a premium to the reinsurer. Reinsurance is widely used throughout the insurance industry for a number of business reasons. A company writing insurance must maintain capital and reserves to cover potential policyholder claims. An insurer’s ability to write insurance is therefore limited in part by the amount of capital it maintains. A direct insurer appropriately can reduce its obligation to maintain capital and reserves to cover losses to the extent that it reinsures a risk. As a result, reinsurance with unrelated reinsurers can allow insurers to write additional business (or offer higher limits to policyholders) without having to raise more capital and, in addition, can protect insurers against catastrophic losses.
When used within an affiliated group of companies, reinsurance does not reduce the overall risk for which the group is liable. Nevertheless, reinsurance remains an important tool among affiliates that can be used to transfer premiums and associated risks within an affiliated group, in order to efficiently allocate capital for regulatory and other business purposes, such as allowing insurers to lower overall costs by pooling capital from insurance written by various affiliates. Affiliate reinsurance may also be used to lower taxes, by, for example, shifting premium income and returns on reserves from higher-tax to lower-tax jurisdictions.
Tax Treatment of Insurance and Reinsurance
Property and casualty (P&C) insurance and reinsurance companies engaged in business in the United States are subject to tax on the income they earn from premiums as well as investment. In determining premiums earned for purposes of determining U.S. tax, a P&C company is entitled to a deduction for premiums paid for reinsurance, whether those premiums are paid to an affiliate or to an independent reinsurer. When reinsurance premiums with respect to U.S. risks are paid to a foreign reinsurer, the premiums are generally subject to a one percent excise tax. U.S. tax treaties often provide an exemption from the excise tax, however, subject to anti-abuse rules designed to prevent the excise tax relief from being passed on to a reinsurer not eligible for excise tax relief under a tax treaty.
Where all of the parties involved are U.S. taxpayers, the premiums paid for reinsurance will give rise to a deduction for the insurer, and corresponding income for the reinsurer, and the group’s overall U.S. tax position will remain effectively unchanged. Thus, in the purely domestic context, affiliate reinsurance allows insurers to efficiently allocate capital, generally with no change to their overall U.S. federal tax burden.
Where the affiliated reinsurer is located outside the United States, however, the tax consequences vary significantly depending on whether the insurance group is owned by a foreign parent corporation (a “foreign-owned group”) or a U.S. parent corporation (a “U.S.-owned group”). In the case of a U.S.-owned group, the income from both premiums and investment returns of a foreign affiliate of the U.S.-owned group generally is subject to current U.S. tax (under the anti-deferral rules of subpart F of the Internal Revenue Code and thus without regard to whether the income earned by the affiliate is distributed). Thus, while a domestic insurer is entitled to a deduction for reinsurance premiums paid to a foreign affiliate, the reinsurance premiums and investment income earned by that foreign affiliate are subject to current U.S. tax. Thus, in the case of a U.S.-owned group, reinsuring U.S. risks with a foreign affiliate generally does not affect the overall level of U.S. taxation.
In contrast, in the case of a foreign-owned group, reinsurance of U.S. risks with a foreign affiliate can result in a significant reduction in the overall U.S. taxation with respect to those risks. While a domestic subsidiary of a foreign parent is entitled to a deduction for reinsurance premiums paid to a foreign affiliate, the income of a foreign affiliate from reinsuring U.S. risks, including investment income on assets supporting its reserves, is not subject to U.S. income tax unless the foreign affiliate carries on business in the United States. (The premiums may be subject to the one percent excise tax, unless it is waived by treaty.) As a result, a foreign-owned insurance company reinsuring a U.S. risk with a foreign affiliate can achieve a significantly lower U.S. tax burden with respect to insurance of U.S. risks than a U.S.-owned insurance company (though if the reinsured business is not profitable as a result of losses on the covered risks, those losses do not provide a U.S. tax benefit as would case be the case for a U.S.-owned group).
Although reinsurance, including affiliate reinsurance, is often used for legitimate business purposes, the ability of a foreign- owned group to reduce or eliminate U.S. income tax on U.S. risks reinsured with its foreign affiliates (including the U.S. tax on associated investment income) creates a significant tax incentive for a foreign-owned group to use affiliate reinsurance to move income from insurance of U.S. risks offshore to low tax jurisdictions.
The Obama Administration’s Budget Proposal
The Obama Administration’s FY 2011 Budget included a proposal (the “Budget Proposal”) designed to address the incentives created by current U.S. tax rules and to level the playing field between U.S.-owned and foreign-owned groups insuring U.S. risks. Under the Budget Proposal, a U.S. insurance company would be denied a deduction for certain reinsurance premiums paid to an affiliated foreign reinsurance company with respect to U.S. risks insured by the insurance company or its U.S. affiliates, to the extent that: (1) the premiums received by the foreign affiliated reinsurer are not subject to U.S. income tax, and (2) the amount of reinsurance premiums (net of ceding commissions) paid to foreign reinsurers exceeds 50 percent of the total direct insurance premiums received by the U.S. insurance company and its U.S. affiliates for a line of business. A foreign affiliate reinsurer that would otherwise be denied a deduction would be permitted to avoid the application of the provision by electing to treat its income from related party insurance with respect to U.S. risks as effectively connected income for U.S. tax purposes and thus subject to U.S. income tax.
The Budget Proposal would reduce the incentive to use reinsurance to move profits offshore and thereby reduce U.S. tax, by reducing the U.S. tax benefit for doing so in cases in which a U.S. insurer enters into excessive reinsurance with foreign affiliates not subject to U.S. tax. Reducing this inappropriate incentive will help ensure that U.S. tax rules do not facilitate the avoidance of U.S. tax by insurers of U.S. risks.
The Administration believes that it is important to level the playing field between U.S.-owned and foreign-owned insurance companies. We have put forward one specific proposal to do so but remain open to other proposals to achieve this goal.
Mr. Chairman, we appreciate the leadership role that you, Senator Menendez, and the Ways and Means and Finance Committees have taken on this subject. We look forward to working with you and other members of the Subcommittee, as well as the full Committee, on this important issue.
Thank you for the opportunity to testify before the Subcommittee today. I would be pleased to answer any of your questions.
July 14, 2010