The IRS Large Business and International (LB&I) division on August 24, 2018, publicly released a directive to provide guidance on the federal income tax treatment of AG 43 reserves for all open tax years, and principle-based reserves for the 2017 tax year.
Read the LB&I directive*
* An LB&I directive is a memorandum from the LB&I Division Commissioner within the Internal Revenue Service (IRS) to IRS directors and field specialists in order to provide notice and field direction on the application of a particular section or concept within the Internal Revenue Code.
For the past two years, the IRS and the life insurance industry have been working on an "Industry Issue Resolution" (IIR) project under sections 807 and 816 regarding the determination of life insurance reserves for life insurance and annuity contracts using principle-based methodologies, including stochastic reserves based on "Conditional Tail Expectations" (CTE).
The IRS released a directive (LB&I-04-0818-015 (August 24, 2018)) to address the IIR project.
The directive is focused on the tax reserve calculations applicable to: (1) variable annuity contracts subject to the reserve method in Actuarial Guideline XLIII (AG 43) and Valuation Manual, part 21 (VM-21) for statutory accounting purposes; and (2) life insurance contracts subject to the reserve method in Valuation Manual, part 20 (VM-20) for statutory accounting purposes and for which the insurance company implemented VM-20 in 2017.
The directive includes a glossary of defined terms. Unless otherwise designated, the defined terms in this TaxNewsFlash are consistent with the directive. If an insurance company does not satisfy the requirements of this directive for such variable annuity and life insurance contract, then regular audit procedures would apply.
The directive is elective and distinguishes between reserves for three types of contracts:
If an insurance company implements the Accepted Method for Eligible VA Contracts, it must also implement the Accepted Method for Life Insurance contracts for any Eligible Life Insurance Contracts.
For the 2017 tax years that end before January 1, 2018, under section 807(d)(3), the tax reserve method that applies to a variable annuity contract is the "Commissioners' Annuity Reserve Valuation Method" (CARVM) prescribed by the National Association of Insurance Commissioners (NAIC) that is in effect on the date the contract was issued. Similarly, the tax reserve method that applies to a life insurance contract is the "Commissioners' Reserve Valuation Method" (CRVM) prescribed by the NAIC that is in effect on the date the contract was issued.
CARVM for variable annuities is interpreted in AG 43, which clarifies the assumptions and methodologies that comply with the intent of the “Standard Valuation Law” (SVL). AG 43 became effective on December 31, 2009, for all variable annuity contracts issued on or after January 1, 1981. AG 43 was effectively incorporated in part 21 of the Valuation Manual (VM-21) adopted by the NAIC on December 2, 2012. VM-21 is effective for all variable annuity contracts issued on or after January 1, 2017.
Part 20 of the Valuation Manual (VM-20) prescribes minimum reserve valuation standards for individual life insurance contracts. VM-20 incorporates a principle-based reserve standard similar in concept to the AG 43 standard for variable annuity contracts. The requirements of VM-20 constitute the CRVM requirements effective for certain life insurance contracts issued on or after January 1, 2017. Life insurance companies have a three-year period (i.e., until January 1, 2020) to adopt VM-20. The directive provides guidance on the calculation of tax reserves for the covered contracts under section 807. [The directive states that no inferences are to be drawn that any deduction is allowed for asset adequacy reserves or deficiency reserves.]
The "Federally Prescribed Reserve" for an eligible VA contract equals the sum of: (1) the tax "Standard Scenario Amount"* (SSA) (factoring in tax interest and mortality assumptions); and (2) 96% of the excess (if any) of the "Allocated Conditional Tail Expectation Amount" over the SSA (not tax adjusted).
The implementation of the acceptable method under the directive ("Accepted Method") for Eligible AG 39 VA Contracts depends on whether a 10-year spread is required. In general, the Accepted Method requires a 10-year spread unless:
If no 10-year spread is required, then for computing taxable income on the 2017 tax return, the beginning-of-year 2017 reserves for these contracts should equal the end-of-year 2016 reserves reported on the insurance company’s originally filed 2016 return. End-of-year 2017 reserves should be computed factoring in the Federally Prescribed Reserve described above.
If a 10-year spread is required, then the insurance company has a choice of two options (described below). However, if an insurance company has a tax year that is not an open year after the earliest open year that is a VM-21/AG 43 year tax, then the first option must be used.
Under the directive, taxpayers generally calculate a tax SSA as if the method prescribed in the Accepted Method was adopted in the earliest open year that is a VM-21/AG 43 year. The difference in the end-of-year tax reserves calculated based on the old method and the Accepted Method represents a section 807(f) change in reserve basis adjustment. The cumulative hypothetical section 807(f) amount that would have been amortized through December 31, 2017, is then included in 2017 taxable income, and the remaining unamortized balance as of December 31, 2017, is amortized ratably over the remainder of the 10-year period.
* The SSA means the reserve determined by applying the standard scenario method as described in AG43 or VM-21, as applicable to an Eligible VA Contract.
For these contracts, life insurance companies generally follow methodology and implementation procedures similar to the methodology and implementation procedures for Eligible VA Contracts.
The Federally Prescribed Reserve for an Eligible Life Insurance Contract equals the sum of: (1) The tax adjusted "Net Premium Reserve," as described in VM-20 and adjusted for factoring in tax interest and mortality assumptions; and (2) 96% of the excess (if any) of the "Allocated Deterministic Reserve / Stochastic Reserve" (if any) over the Net Premium Reserve (not tax adjusted).
The directive contains several other useful pieces of information, including:
Tax professionals were anticipating release of the directive and appreciate that it has been issued in conjunction with the 2017 tax return filing season. The directive indicates that the IRS now accepts that the stochastic portions of statutory reserves (e.g., the CTE for AG 43) qualify as tax reserves even though stochastic computations do not use the prescribed interest rate or the accepted actuarial table. The 4% haircut appears to reflect an estimate of the difference between AG 43/VM-21 and VM-20 provisions and the requirements of section 807 (before January 1, 2018). If the statutory cap applies, the CTE should be included in full.
The new tax law substantially modified the reserve deduction calculation for life and annuity reserves. As a result, many of the tax issues associated with principle-based reserves have been eliminated, including the use of a prescribed interest rate and accepted actuarial table. The directive provides a clear, elective methodology for taxpayers to resolve the issues associated with the pre-2018 tax years.
For more information contact a KPMG tax professional:
Sheryl Flum | +1 (202) 533-3394 | email@example.com
Fred Campbell-Mohn | +1 (212) 954-8316 | firstname.lastname@example.org
Liz Young | +1 (202) 533-3125 | email@example.com
Rob Nelson | +1 (312) 665-6457 | firstname.lastname@example.org
© 2020 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.KPMG International Cooperative (“KPMG International”) is a Swiss entity.
Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm.
The KPMG logo and name are trademarks of KPMG International. KPMG International is a Swiss cooperative that serves as a coordinating entity for a network of independent member firms. KPMG International provides no audit or other client services. Such services are provided solely by member firms in their respective geographic areas. KPMG International and its member firms are legally distinct and separate entities. They are not and nothing contained herein shall be construed to place these entities in the relationship of parents, subsidiaries, agents, partners, or joint venturers. No member firm has any authority (actual, apparent, implied or otherwise) to obligate or bind KPMG International or any member firm in any manner whatsoever. The information contained in herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG's Federal Tax Legislative and Regulatory Services Group at: + 1 202 533 4366, 1801 K Street NW, Washington, DC 20006.