At the 2018 P&A Leadership Summit, we presented “The Reinsurance Climate: A Fresh Look at NCFCs, DOWCs, and CFCs.” Each of us spent a substantial portion of 2018 educating our F&I clients on the impact of the Tax Cuts and Jobs Act (TCJA) of 2017 on F&I profit participation structures. The PALS panel gave us the opportunity to share opinions on how the industry climate has changed in a post-TCJA world.
The starting point for the panel was a basic introduction to three common programs and how we understand them today. With that foundation, the panel discussed the TCJA provisions that seem to have pushed parts of the industry to rethink how we implement one of the common programs: the noncontrolled foreign corporation, or NCFC. The panel’s discussion concluded with an assessment of the overall tax risk that exists for reinsurance now that the industry has had a chance to respond to these changes.
Understanding the Common Structures
Regardless of the specific profit participation structure, each has one common element — maximization of tax efficiency via some combination of tax deferral, preferential rate treatment, or tax rate arbitrage. There are generally three common F&I profit participation structures whose design typically requires a dealer have some form of ownership interest in the program — the controlled foreign corporation (CFC) program, the noncontrolled foreign corporation (NCFC), and the dealer-owned warranty company (DOWC).
- Controlled foreign corporations: While it is merely nomenclature whether we refer to CFCs as a producer-owned reinsurance company (PORC), affiliated reinsurance company (ARC), or producer-affiliated reinsurance company (PARC), describing the PORC structure as a CFC is technically inaccurate.
These foreign corporations make an election under IRC § 953(d) to be treated as a U.S. corporation for all federal tax purposes. Because only a foreign corporation can be a CFC, electing for treatment as a domestic company excludes these entities from true CFC treatment.
A PORC achieves its tax efficiency by utilizing the small insurance company election under IRC § 831(b) that excludes underwriting profit from taxation — the result being the taxation of only investment income and other non-insurance income. Importantly, the small insurance company election is only available in those years where the written premium is below $2.3 million (adjusted for inflation).
The insurance aspect of a PORC occurs in the form of “back-end reinsurance” via a fronting arrangement. In a PORC program, state regulators usually require the TPA’s obligor to purchase a contractual liability insurance policy (CLIP). The CLIP typically covers the first dollar of customer risk. The fronting carrier cedes the customer risk to a PORC owned by or affiliated with the dealer that originated the F&I product covered by the CLIP. The PORC earns its underwriting profit and investment income off the risk reserve it assumes from the fronting carrier.
- Noncontrolled foreign corporations: The NCFC structure offers dealers an option that has no limit on written premium, defers taxation on underwriting profit and investment income, and has potential for preferential rate treatment. An NCFC is a foreign corporation, which has diversified ownership such that it is not a controlled foreign corporation.
If an NCFC program does not satisfy these diversified ownership rules, a dealer who is a “U.S. shareholder” would be required to pay current income tax on his program’s underwriting and investment income. Prior to TJCA, a “U.S. shareholder” was a U.S. person who owned 10% or more of the voting shares of the foreign corporation.
Historically, NCFCs avoided CFC status by ensuring that more than 10 people owned voting shares at all times or issued the common voting stock to a foreign program management company. As Irvine noted, some programs also implement voter cut back rules that shift or cut back voting rights attributable to shares of significant economic shareholders to below 10%.
Because an NCFC avoids current taxation of underwriting profit and investment income, shareholders make no special elections and profits sit offshore until the NCFC earns all business. When an NCFC redeems a dealer from his position, the code typically taxes the redemption at capital gain rates.
- Dealer-owned warranty companies: The essential difference between a DOWC and an NCFC or PORC program is the ownership of the obligor by the dealer: A DOWC is an obligor company typically owned by the dealer that offers the contracts with the DOWC’s name on those contracts.
A DOWC allows for tax deferral and tax rate arbitrage because of the surplus strain created by new warranty business. Because a DOWC does not make the small insurance company election, there is no limitation on written premiums.
The surplus strain is the result of the code’s requirement that a DOWC file its tax returns as a non-life insurance company. A non-life insurance company’s starting point for computing taxable income, subject to certain modifications, is the annual statement prepared according to the rules of the National Association of Insurance Commissioners. These statutory basis financials require income deferral and immediate expensing.
A simple illustration of this is a contract with a $2,000 retail cost and $1,000 dealer commission. The DOWC earns the $2,000 written premium over the life of the contract and deducts the $1,000 markup in the initial year. Deferred income inclusion and immediate expensing produce a net operating loss (NOL) in the DOWC’s early years, resulting in no taxation.
As the DOWC writes more business, the NOL grows and continues to postpone taxation until a later tax year. Absent continued growth of the DOWC’s book of business, profits of the DOWC will eventually become taxable at 21% (the new lower corporate tax rate). Although a Section 831(b) election could defer or eliminate the “turnaround” of the DOWC earnout, advisors may not recommend DOWC planning with a preplanned Section 831(b) election.
Because a DOWC is a “front-end” program, the required CLIP will provide excess-of-loss coverage instead of the typical first-dollar coverage in the PORC context. Essentially, this means the DOWC retains the risk and the dealers can have more access to the reserves.
TCJA Provisions Cause Alarm
The brunt of the TCJA’s force was taken by NCFC programs that have historically assumed almost exclusively F&I business. The first significant revision discussed was the active insurance company exception to the passive foreign investment company (PFIC) rules. The second item considered by the panel was the addition of a value component to the definition of “U.S. shareholder” for purposes of the CFC rules.
PFIC modification: Shareholders subject to the PFIC rules are either taxed currently on their pro rata share of the PFIC’s net ordinary income and net capital gains (generally small or nonexistent) or subject to taxation at the highest ordinary income rates (rather than capital gains rate) and subject to special interest charges on deferred taxes at the time of sale or distribution of profits to the shareholder.
- A PFIC is a foreign corporation, which meets either of the two of the following tests:
- More than 75% of the gross income is from passive sources (income test).
- More than 50% of the gross assets give rise to passive income (asset test).
In applying the income test and asset test, a foreign insurance corporation could treat reasonable levels of passive assets and passive income as “active” if the foreign insurance corporation was:
- Predominantly engaged in the active conduct of an insurance business and
- More than half of the business conducted is insurance or reinsurance.
- This is commonly referred to as the “active insurance exception.”
The TCJA revisions added a ‘threshold’ test for a foreign insurance corporation to qualify for the active insurance exception: the qualifying insurance corporation (QIC) test. A foreign corporation is a QIC if:
- Its “applicable insurance liabilities” are more than 25% of its total assets on its year-end “applicable financial statement” and
- More than half of the business of the foreign corporation is insurance or reinsurance.
- For these purposes, applicable insurance liabilities are:
- Loss and loss adjustment expense.
- Reserves that are not deficiency, contingency, or unearned premium reserves.
The applicable financial statement used to determine QIC status depends on the first available financial statement available based on a hierarchy drafted into the statute’s definition of applicable financial statement. The statutory order requires a foreign insurer to utilize the first financial statement available that it prepares on the basis of generally accepted financial principles (GAAP). If there are no GAAP financials, international financial reporting standards (IFRS) apply. If there are no GAAP or IFRS statements, a foreign insurer will rely on rules promulgated by the applicable insurance regulatory body for purposes of filing the annual statement.
The TCJA’s new PFIC insurance exception attempted to provide a more “bright-line” rule to what has historically been a very subjective determination. The new law is particularly tricky for NCFCs conducting substantial F&I business and using GAAP. These NCFCs typically book significant unearned premium reserves and minimal loss reserves and would most likely fail the new QIC test.
CFC modification: As previously noted, the industry has historically only concerned itself with the voting rights issued by an NCFC because U.S. taxation essentially turned on the voting rights of U.S. shareholders. However, the TCJA changed this and added a value component to the definition of “U.S. shareholder.”
The new test for controlled foreign corporation status begins with whether any U.S. person (individual or entity) owns at least 10% of the vote or value of the foreign corporation. Thus, the new law has expanded the realm of possible U.S. shareholders placed into the proverbial “bucket” for determining if those U.S. shareholders, together, own more than 25% of the vote or value of the foreign corporation.
The prior law also permitted a 30-day “curing period” during which a foreign corporation could cure any issues related to 10% voting owners triggering the more-than-25% test, i.e. permitting usage of a voting cutback provision. TJCA changed the “30-day period” to “any”; as such, if U.S. shareholders reach the more-than-25% threshold, those U.S. shareholders are allocated a pro rata share of income for the period the U.S. shareholder exceeds that threshold.
Responding to the Changes
There have been two common immediate responses: NCFCs have taken steps to manage their immediate capital situation with forced distributions and redemptions, and NCFCs have revisited their respective methods of accounting. These steps are not necessarily knee-jerk reactions to the TCJA, but bought time for NCFC sponsors to plan for the future of their programs.
For sponsors who do not intend to withdraw from their NCFC operations, we have typically discussed two common items: The first is the potential for adopting financial reporting that demonstrates, to the satisfaction of the IRS, that the NCFC is eligible for the PFIC insurance exception. Second is whether the NCFC can manage its capital position to avoid PFIC or CFC classification. Underlying each of these discussions is whether the NCFC can remain a competitive structure in a post-TCJA world.
NCFC programs need to move away from GAAP. NCFC programs will likely need to utilize a basis of accounting that incorporates, at least in part, a “gross method” or economic balance sheet (EBS) framework for valuing the balance sheet of the insurance company. A fundamental premise of the gross method/EBS framework is the establishment of a NCFC’s balance sheet items on a “day one” economic outlook.
In short, a NCFC adopting an EBS framework would record the expected results of a contract of reinsurance as if the contract was fully earned on day one with a liability also booked for unamortized profits. This would result in establishing the expected ultimate loss reserve for a multiyear service contract on day one along with liabilities for expected return premiums and unamortized profits.
We agree that NCFC programs have historically utilized GAAP reporting, or the “net method” as a matter of convenience because the underwriters ceding into these programs have typically reported on a GAAP basis. We might also note that U.S. insurers reporting on a statutory basis have booked their UPR in a method similar to what insurers would show on a GAAP basis. Based on discussions with a number of industry experts, the EBS method of reporting tends to be a more accurate reflection of the economics of the NCFC programs.
However, the code authorizes the usage of EBS financials for PFIC purposes in the case of IFRS statements prepared using the new IFRS 17 basis. Under IFRS 17, insurers accrue an “insurance contract liability” on the balance sheet. The insurance contract liability is composed of future expected losses and future return premiums on a net present value basis, unamortized profits and a risk factor. While insurers are not required to use IFRS 17 until 2022, early adoption is allowed.
It also bears mentioning that NCFCs in Bermuda, under the regulatory oversight of the Bermuda Monetary Authority, have had discussions with the BMA to confirm that the EBS method is consistent with that nation’s statutory accounting principles. The BMA currently requires the use of the EBS for certain classes of reinsurers in Bermuda. For Bermuda statutory accounting, the “gross method” earns premiums at inception and accrues ultimate expected losses and return premiums without the net present value factor contained under IFRS 17.
It seems that there is a possibility that using an EBS method may permit an NCFC to present its balance sheet with a reserve liability that potentially meets the definition of a loss or loss adjustment expense. These reserves are then compared to total assets to determine if the foreign insurer is a QIC that may avail itself of the new PFIC insurance exception — as opposed to those amounts booked as UPR and not treated as an applicable insurance liability.
NCFC sponsors will need to take a more active management role. Undoubtedly, many dealers with positions in NCFCs became U.S. shareholders in controlled foreign corporations on Jan. 1, 2018, due to holding significant economic positions which resulted in owning 10% or more of the value of these foreign corporations. These U.S. shareholders should be working with their sponsors and tax advisors to address any additional U.S. tax return filing requirements created under TJCA.
Additionally, we agree that U.S. persons owning shares in a NCFC should consider making a “protective” qualified electing fund (QEF) election with the shareholders 2018 tax returns, as there is a lack of administrative guidance from the IRS on the new QIC test.
On a go-forward basis, the sponsors will likely need to monitor and manage capital levels to avoid U.S. shareholder status for participants and ensure QIC treatment. NCFCs will need to work with ceding companies to provide timely data that allows enough time to make the appropriate adjustments.
The industry has not experienced a mass exodus of NCFC programs to domestic programs, but smaller NCFC programs are likely to seek options that attempt to both diversify its book of business and dilute economic ownership. Some NCFCs, especially those with positions that have exercised voting cut back provisions in the past, will need to work with the dealers to discuss taking current distributions or even redemption of their current position to avoid the new CFC “value” component.
NCFC programs will likely begin to implement policies that will cater to the needs of participants. Policies that ensure NCFC sponsors are better equipped to monitor PFIC and controlled foreign corporation issues will likely become a critical part of the NCFC’s business model. This type of proactive tax planning could potentially be a differentiating factor for NCFCs taking these issues seriously.
As an industry, the best response is to ensure that providers, administrators, and dealers are making informed decisions regarding their programs. Assessment of the risk associated with the tax positions taken by program sponsors will prove critical as the industry finishes adjusting to the TCJA and begin marketing their programs to dealers.
In the end, the TCJA did appear to significantly highlight the tax risk that exists for NCFC programs and Kaseff believes that the changes increase the task risk by their very nature. Irvine contends that the tax risk associated with a NCFC and possible PFIC status has always been present and that the days of unlimited deferral are gone, as mathematically a NCFC, which has a 50% loss ratio, will most likely fail the QIC test within four to five years.
Overcapitalized PORCs also present tax risks to shareholders. It has come to the attention of the authors that the IRS has imposed the accumulated earnings tax on purportedly overcapitalized PORCs which have not paid dividends. Tax risk has always existed in the world of profit participation programs. The dust is still settling, but the panel believes the industry will move forward and continue to adjust and provide value to dealers who seek it.