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August 30, 2011updated 15 Mar 2017 6:10pm

Uncle Sam on the hunt for tax revenue

On the hunt for more tax revenue, the Obama administration is turning its attention to potential new sources lurking in the life industry, including corporate-owned life insurance and life settlements As budget woes worsen in the US, the federal government is on the hunt for new sources of revenue

By Charles Davis

On the hunt for more tax revenue, the Obama administration is turning its attention to potential new sources lurking in the life industry, including corporate-owned life insurance and life settlements. However, the administration faces stiff opposition from the Republican Party, reports Charles Davis.

 

As budget woes worsen in the US, the federal government is on the hunt for new sources of revenue. While Republicans vow to block any new tax increases, the administration has made it clear that it will attempt to increase tax rates on three of the life industry’s most profitable and highest-volume products, corporate-owned life insurance (COLI) and variable life and variable annuities.

The life insurance industry warns of dire consequences to the tax planning of small businesses and families and is opposed to the plan as well. The industry’s political odds could improve as Congress and the administration are under pressure to close tax loopholes as a means of addressing runaway budget deficits. There is no way to reach any meaningful deficit reduction without addressing both cuts and increased revenue.

In April 2011, 31 of the 37 members of the tax-writing House Ways and Means Committee wrote a letter to the Obama administration asking it to abandon efforts to impose new taxation on COLI as well as limiting life insurers’ dividends received deduction on variable life and variable annuity products.

The administration replied, defending its taxation goals by saying it was merely trying to end the “tax arbitrage” that results when interest expense allocable to tax-preferred inside build-up on life insurance contracts is deductible. Specifically, this refers to the practice of profiting from differences between the way transactions are treated for tax purposes. For instance, in the case of variable annuities, it means allowing interest expense to build up inside a variable annuity and then also making the contract tax deductible.

The White House proposal addresses issues left unmentioned by the COLI best practices provision of the 2006 Pension Protection Act.That provision addressed consumer protection issues and abuses in use of COLI by businesses that had been addressed by several courts in the late 1990s and in early 2000s.

In announcing the proposals in the administration’s proposed budget for 2012 in February, Treasury Secretary Timothy Geithner justified the new taxes by saying: “We are taking the next step in creating fairness in our economy by ending loopholes that allow companies to avoid paying taxes whilems of hardworking families and small businesses pay their fair share.”

The same provisions were included in administration budgets for fiscal years 2010 and 2011, but each year Congress gave them a cold reception, Geithner said.

 

New tax on business

The COLI shift would effectively be a new tax on business, according to a joint statement from industry bodies, including the American Council of Life Insurers, the Association for Advanced Life Underwriting and the National Association of Insurance and Financial Advisors.

In the joint statement the organisations stated: “The COLI proposal would impose new taxes on life insurance used by businesses small and large. Many businesses use COLI to protect against financial or job loss stemming from the death of owners or key employees. COLI is also used to ensure business continuation. In addition, COLI is a widely used funding mechanism for employee and retiree benefits. Congress affirmed the benefits and tax treatment of COLI and ensured its responsible use in bipartisan legislation enacted in 2006.”

The administration’s spending plan would also reduce the dividend received deduction life insurers utilise in accounts that fund variable life insurance and variable annuity contracts. The deduction is estimated to be worth $2.4bn over the next five years.

“With our economy still recovering from the recent crisis, public policy should encourage families and businesses to responsibly plan for their financial futures. The administration’s budget proposal would have the opposite effect,” according to the statement.

The COLI proposal would deter companies from deducting the interest expense on the cash value of life insurance policies they have taken out on executives, effectively taxing the inside buildup of newly sold policies. The move would reduce the federal deficit by an estimated $7.7bn between 2012 and 2021.

The proposed change to the calculation of dividends-received deductions was floated last year and has been brought back for a second chance as well. The administration’s measure would reduce the deduction that a life insurer received based on the proportion of its policyholder reserves to its separate-account assets.

 

Life settlements targeted

Another proposal would step up tax reporting on life settlements, ensuring the payment of tax on the death benefits, as well as reporting in connection with the sale of the policy to ensure that the seller paid taxes on the proceeds. Specifically, under the regulation planned for introduction in 2012 anyone who purchases an interest in an existing life insurance contract with a death benefit of $500,000 or more would have to report the purchase price, the buyer’s and seller’s taxpayer identification numbers (TIN) and the issuer and policy number to the Internal Revenue Service (IRS) to the insurance company that issued the contract to the seller. Upon payment of any policy benefits to the buyer, the insurance company would be required to report the benefit payment and the buyer’s TIN to the IRS.

Finally, another provision would hit banks and thrift holding companies with an accountability fee in order to recoup cash used for the Troubled Asset Relief Program.

Even in their present form, if all were enacted, a team of analysts from stock broking firm Keefe Bruyette Woods Inc came to the conclusion that they may still have only a small effect on company profits.

“Although general account DRD [dividend received deduction] is discussed, our initial reading is that the proposal, like last year, would primarily affect separate account DRD,” the analysts wrote. “As a result, it appears the impact would fall primarily on companies with material separate account business.”

Odds are long, however, that any of the provisions will remain intact, given the fractious politics in Washington these days. The Republican Party remains completely opposed to any new revenue at all, making compromise impossible – at least until the political will runs headlong into electoral politics.

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