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The Senate Committee on Finance has scheduled a public hearing on selected international tax issues on September 26, 2007. This document,1 prepared by the staff of the Joint Committee on Taxation, includes a description of present law and analysis of Federal tax issues relating to offshore reinsurance, offshore entities as investment vehicles for tax-exempt investors, and offshore entities as vehicles for deferral of certain types of compensation.

Part One of this document provides background information about offshore reinsurance and about use of offshore entities by investment funds in connection with tax-exempt investors and for deferral of income of fund managers. Part Two describes present law relating to Federal income tax treatment of insurance companies, the excise tax applicable to premiums paid to foreign insurers and reinsurers covering U.S. risks, applicable international tax rules under U.S. Federal tax law and international tax treaties, unrelated business income tax and debt-financed income, and an overview of ways to defer services income. Part Three provides a description of legislative proposals in recent Congresses relating to offshore reinsurance. Part Four provides a discussion of issues and analysis relating to offshore reinsurance, unrelated business income tax and debt-financed income, and nonqualified deferred compensation.

I. BACKGROUND

Offshore reinsurance

In general

Insurance company reinsurance transactions with offshore reinsurers, particularly affiliated reinsurers, have been characterized as creating the potential for tax avoidance and as causing a competitive disadvantage for U.S. insurance businesses. At the same time, reinsurance is a fundamental component of global risk management techniques.

Insurance transactions are characterized by risk shifting and risk distribution.2 Risk shifting means transferring the risk from one person to another person. Risk distribution means spreading risks among a pool or group of persons.

Insurance is a specific mechanism for transferring the financial consequences associated with the occurrence of identifiable but uncertain ("fortuitous") adverse events (e.g., the risk of damaging one's automobile in an accident, the risk of fire damaging one's home, or the risk of dying prematurely). The concept of risk shifting is best understood from the perspective of the insured: it contemplates that the insured shifts to another person the financial consequences of the adverse fortuitous events, so that (at least to the extent of the insurance) the occurrence of the event has no direct financial impact on the insured. Thus, self-insurance generally is not insurance in the tax sense, because the insured retains the financial consequences that follow from the occurrence of the adverse fortuity.

Many financial contracts - for example, many derivative contracts - shift risk between parties, but that fact does not mean that those contracts necessarily constitute insurance, because the other critical component of true insurance - risk distribution - typically is not present. Just as risk shifting is most easily understood when viewed from the perspective of the insured, risk distribution is a concept that is best visualized from the perspective of the insurer. Risk distribution refers to the fact that, in entering into any one line of the insurance business (such as automobile liability insurance or health insurance), insurers assume or underwrite numerous individual risks that, at least ideally, are independent but homogeneous. Risks are independent when the occurrence of one adverse event in the pool of risks held by the insurer does not increase the likelihood that the other adverse fortuities in the pool will occur. Risks are homogeneous when they are similar in nature. When an issuer has a sufficiently large pool of independent but homogeneous risks, it can rely on the law of large numbers - a statistical tool that enables insurers to model with a relatively high degree of confidence the pattern of actual losses that it can expect in each period. Risk distribution and the associated application of the law of large numbers can be understood in a general sense as the core mechanism by which insurers manage their underwriting risks (i.e., the risk of paying claims arising from insured events), as contrasted with the insurer's investment risks.

When the conditions of risk shifting and risk distribution are satisfied, the insurer can price the premiums it charges to reflect with some precision the total losses it expects from the relevant pool of risks in each period. For example, when an individual buys automobile collision insurance, he shifts from himself to the insurer the risk of paying for damages sustained by his automobile as a result of an accident. The insurer in turn manages that risk by pooling it with other similar automobile insurance contracts that it writes. In this way, each customer (through the premiums that he pays) effectively pays for a portion of the damages sustained by all the automobiles in the pool: because most people are risk averse, they prefer in effect to suffer small but definite losses (the premiums they pay) to unpredictable but much larger losses (the financial consequences of a loss event if one were self-insured).

Insurance covers a variety of types of risks, which are grouped by line of business under current industry practice and regulatory reporting rules. Some lines of business are paid out relatively promptly following the time when the risk is incurred, such as health insurance and automobile liability; these are known as short-tail lines of business. Other lines of business are characterized by longer pay-out periods, such as medical malpractice and workers compensation; these are known as long-tail lines of business.3

Insurance companies are regulated by State insurance regulators in the States in which they do business. State regulators look to the National Association of Insurance Commissioners (the NAIC) for recommendations on regulatory and reporting standards. State insurance rules require annual financial reporting by insurers in accordance with a conservative accounting method known as "statutory accounting," which is designed to maintain insurer solvency.

Types of reinsurance

Reinsurance is a form of further risk shifting and risk distribution. Reinsurance is sometimes characterized as insurance for insurers. A reinsurance transaction is an agreement between insurance companies to pass a risk, or a block of risks, from one company to the other company. Risks can be subdivided and portions reinsured. For example, a portion of the risk may consist of a specific dollar amount such as a layer or band of the total dollar amount, the excess over a dollar amount, or a percentage of the total dollar amount of the risk.

Risks can be reinsured singly or in groups. "Facultative" reinsurance covers a specific risk and is separately negotiated, often because the risk is specialized, high-hazard, or extraordinarily large. A reinsurance "treaty" generally covers a block of risks or type of risks. Under a reinsurance treaty, the primary insurer and the reinsurer agree that all or a specified portion of the primary insurer's business or policies of a particular type or types are covered automatically by the reinsurer until the agreement is terminated.

The portion of a risk covered under a reinsurance agreement can be determined in a variety of ways. Proportional, or pro rata, reinsurance can be on a "quota share" basis, that is, a set percentage of premiums received and losses covered for the applicable risks. Alternatively, proportional reinsurance can be on a "surplus share" basis, that is, an agreed dollar amount of premiums received and losses covered for the applicable risks. Non-proportional reinsurance is known as "excess of loss," representing the reinsurer's coverage for losses above the primary insurer's retention amount. Excess of loss coverage can be on an individual risk basis, on an occurrence basis (relating to the occurrence of a particular event such as a storm or earthquake), or on a aggregate basis (covering losses above a dollar amount per policy or per year).

Alternatives to reinsurance

A number of alternatives to reinsurance transactions may also be used to shift and distribute risks. These alternatives comprise the "alternative risk transfer" or ART markets and products. These markets and products can become more attractive when reinsurance prices rise, for example,4 and can serve financing, hedging, or other financial purposes as well as more traditional risk management goals.

There is no generally accepted definition of what constitutes an ART product, and the ART marketplace continues rapidly to evolve. The term has been applied to arrangements as diverse as self-insurance, captive insurance, sidecar reinsurance, finite risk insurance or reinsurance, capital markets financings such as catastrophe ("cat") bonds, and weather derivative contracts.5 Some ART products (e.g., captive insurance and finite risk insurance) typically are structured with a purpose to constitute insurance under State regulatory rules. Others, such as cat bonds, are not treated as insurance for regulatory purposes.

The characterization for Federal income tax purposes of ART products as insurance, or as some other financial product, may not be clear in all cases. Some ART products involve risk shifting, but not necessarily risk distribution. Other ART products, including many that are analyzed as insurance for regulatory purposes, raise questions of whether the product embodies sufficient risk shifting and risk distribution that it should be treated as insurance for Federal income tax purposes.6

Reasons for engaging in reinsurance transactions

Primary insurers have a variety of reasons for reinsuring some of their business. A principal reason is to shift risk, just as any other insured does, because an insurer's pool of risks is too concentrated in some fashion. For example, the primary insurer's risk pool may fall unacceptably short of the goal of homogeneity.

Another reason relates to regulatory compliance. State insurance rules generally require that an insurance company maintain "surplus," and the States limit the amount of new business the company can write based on a ratio of net premiums to surplus. Reinsuring some of the company's risks can lower the ratio of net premiums 7 to surplus and allow the company to write more insurance. Thus, reinsurance can serve in effect as a form of financing for growth in the primary insurance company's business.

A reinsurance transaction can also function as a business acquisition technique for the reinsurer. By reinsuring a block of business, for example, a reinsurer can enter a new line of business more easily than by directly writing policies in that line of business. Similarly, a primary insurer can divest itself of a line of business by reinsuring its entire book of business in that line.8

Several related risk management and financial reporting concerns also motivate the use of reinsurance. A primary insurer can use reinsurance to reduce exposure to extremely large losses from one source such as a catastrophic event (for example, a hurricane) or a particular environmental hazard (for example, asbestos). By reinsuring amounts above a certain level, the primary insurer can smooth loss payments over the year or between years. This can reduce volatility in the company's earnings.

Reinsurance can have U.S. tax benefits as well as book or financial benefits. In general, premiums ceded for reinsurance are deductible in determining a company's Federal income tax.9 If the transaction effects a transfer of reserves and reserve assets to the reinsurer, the tax liability for earnings on those assets generally is shifted to the reinsurer as well. If earnings on these assets are shifted to a reinsurer in a no- or low-tax foreign jurisdiction, generally these earnings are not subject to income taxation.

Federal tax issues relating to offshore reinsurance

The transfer of U.S. risks to foreign reinsurers in low-tax or no-tax jurisdictions, whether by corporate expatriations, foreign acquisitions, or by reinsurance transactions to affiliates and third-party reinsurers, has been criticized as causing a tax-induced competitive disadvantage for U.S. insurers and reinsurers.10 The issue has been publicized repeatedly in recent years 11 despite 2004 changes in the Federal tax law to limit the tax benefit of "inversions"12 - expatriation of a U.S. corporation or partnership to a foreign jurisdiction - and to strengthen the Treasury Department's regulatory authority to reallocate items in reinsurance arrangments.13 Though these changes may have made some types of transactions transferring U.S. risks to foreign reinsurers less attractive to a U.S. insurer from a tax planning standpoint, reinsurance with offshore reinsurers has remained strong.14

Insuring risks with captive insurance affiliates generally can have the effect of reducing U.S. tax on certain earnings. Because of tax accounting rules applicable to insurance companies, under which additions to insurance reserves are deductible, investment earnings on insurance company reserves can be viewed as tax-favored.15 The use of captive insurers as well as the use of affiliated reinsurers are thought to be a means by which U.S. insurance risks migrate to offshore reinsurance markets.

Reinsurance can provide a tax benefit to the primary insurer of U.S. risks principally by shifting to the reinsurer the tax liability for earnings on reserves, that is, on investment assets that fund the future payment of insurance claims.16 In the case of reinsurance with an unrelated or third-party reinsurer, this tax benefit is counterbalanced by the yielding of the business opportunity for profit on the reinsured risks to that unrelated reinsurer.

The tax benefit of reinsurance can be duplicated without yielding the business to a third party, however, if the reinsurer is a foreign affiliate. The corporate structure under which earnings on U.S. risks reinsured with an affiliate are treated as not subject to U.S. tax involves the use of a parent corporation in a low-tax or no-tax foreign jurisdiction. The foreign parent's subsidiaries include both the primary insurer, a U.S. corporation, and the reinsurer, also a foreign corporation in a low-tax or no-tax jurisdiction. The primary insurer of the U.S. risks engages in a reinsurance transaction with the foreign affiliate, shifting the reserve assets to the foreign affiliate. The earnings on the reserve assets associated with the reinsured risks are shifted outside the U.S. tax system. Present-law U.S. tax rules such as the Subpart F rules requiring current inclusion of certain income for U.S. shareholders, the "toll charge" for certain outbound transactions under section 367, and the inversion rules of section 7874,17 generally do not apply to the transaction, although the Treasury Department has the authority to reallocate items under section 482 or section 845, and the one-percent reinsurance excise tax applies.18 The tax benefit of such reinsurance with a foreign affiliate is greater for long-tail lines of business that tend to require reserve assets to be maintained for a longer period of time than for short-tail lines of business.

Property and casualty insurance industry and reinsurance markets

Property and casualty insurers operating in the U.S. recorded $499 billion in directly written premiums in 2006. Such insurers ceded reinsurance of $340 billion to affiliates, and $64 billion to non-affiliates, while assuming $310 billion of reinsurance from affiliates and $48 billion from non-affiliates. Thus, net premiums written totaled $453 billion.19 Since 1998, net premiums written have increased at an annualized rate of 6.0 percent, compared to an annualized rate of 3.6 percent between 1987 and 1997. Assets of these insurers totaled $1,671 billion in 2006, and grew at an annualized rate of six percent from 1998 to 2006, compared to an annualized rate of eight percent from 1987 to 1997.20

Over the recent past, U.S. property and casualty insurers have increased both the amount of reinsurance assumed and ceded, both in absolute terms and relative to direct premiums written. In 2006 the amount of assumed reinsurance, as noted above, was an amount equal to 71.7 percent of direct premiums. Ceded reinsurance equaled 80.9 percent of direct written premiums. In 1990, in comparison, U.S. property and casualty insurers assumed reinsurance in amounts equal to 60.5 percent of direct written premiums, and ceded reinsurance in amounts equal to 66.0 percent of direct written premiums.21

While there has been growth in both assumed and ceded reinsurance, reinsurance assumed and ceded with respect to non-affiliates has declined relative to direct premiums written. Reinsurance assumed from non-affiliates has fallen from an amount equaling 12.2 percent of direct premiums in 1990 to an amount equal to 9.6 percent of direct premiums in 2006, and reinsurance ceded to non-affiliates has fallen over the same period from an amount equal to 16.5 percent of direct premiums to 12.7 percent of direct premiums. In contrast, reinsurance assumed from affiliates grew over that period from an amount equal to 48.4 percent of direct premiums in 1990 to an amount equal to 62.1 percent in 2006, while insurance ceded to affiliates over the same period grew from an amount equal to 49.5 percent of direct premiums to an amount equal to 68.2 percent of direct premiums.22

With respect to insurance ceded to offshore reinsurers, according to the Reinsurance Association of America, $54.7 billion of U.S. premiums were ceded to offshore reinsurers in 2006, $22.2 billion of which was ceded to unaffiliated offshore reinsurers and $32.5 billion of which was ceded to affiliated offshore reinsurers. These amounts compare to approximately $37.3 billion ceded to offshore reinsurers in 2001, $21.5 billion of which was ceded to unaffiliated offshore reinsurers and $15.9 billion of which was ceded to affiliated offshore reinsurers. Hence from 2001 to 2006, total premiums ceded to offshore reinsurers grew by 46.7 percent, of which premiums ceded to unaffiliated offshore reinsurers grew by 4.7 percent and premiums ceded to affiliated offshore reinsurers grew by 104.4 percent.23

Markets for reinsurance have become global. Historically, London has been an insurance and reinsurance center. Very large reinsurers are also located in Germany and Switzerland. Bermuda is an increasingly large global reinsurance market.24 Between 1983 and 2001, net premiums written in the Bermuda insurance market grew from $4.7 billion to $41.4 billion, and total assets in the Bermuda insurance market grew from $17.1 billion to $172.7 billion.25 It is reported that capital grew 24 percent to $65 billion in 2006 among a group of Bermuda reinsurers, a doubling in their capital since 2002.26 Bermuda is considered to have insurance regulatory rules favorable to insurance companies and products, and does not impose a corporate income tax.27

Use of offshore entities by investment funds

In general

Over the past several decades, private equity funds, venture capital funds, hedge funds, and similar alternative investment vehicles 28 that are managed by U.S. fund managers have attracted large amounts of investment capital. Investors in these funds often include institutional investors such as pension funds and educational and charitable institution endowments, and wealthy individual investors. These investors become limited partners in the funds, which are generally structured as partnerships. Some investment funds are established in offshore jurisdictions,29 particularly those offshore jurisdictions that impose no (or little) income tax. The assets invested in the funds generally are managed by groups of individuals who contribute a relatively small amount of capital to the fund (in relation to amounts of capital contributed by the investors) and who provide investment expertise in selecting, managing, and disposing of fund assets.

Investors in the funds have historically (though not exclusively) been of three general types: high net-worth individuals who are subject to U.S. tax; foreign persons who are not otherwise subject to U.S. tax; and U.S. institutional investors (such as charities and private and government pension funds) that are tax-exempt under U.S. tax rules.30 These types of investors have differing U.S. tax situations, and therefore, confront differing tax issues when they invest in investment funds such as hedge funds and private equity funds.

In general, U.S. high net-worth individuals may be concerned about limitations on deductions, such as the 2-percent floor on miscellaneous itemized deductions, the overall limitation on itemized deductions, and the alternative minimum tax. They may prefer to let the fund manager's carried interest serve to reduce their distributive share of partnership income as it is earned, rather than having a higher share of partnership income along with a deduction for manager compensation that may not be fully or currently usable because of a deduction limitation. These individual investors may also be sensitive to the rate differential between longterm capital gain and qualified dividend income, on the one hand, and other forms of investment returns, on the other hand.

Tax-exempt organizations and foreign persons not subject to U.S. tax may be indifferent to deductions. Instead, tax-exempt organizations may be concerned about becoming subject to unrelated business income tax.

Foreign investors may be concerned about becoming subject to U.S. net income tax or U.S. withholding tax.31 Foreign investors may prefer not to have to file a U.S. income tax return (even if no tax is ultimately due).

Funds have been structured to accommodate these various concerns, and to maximize aggregate tax savings with respect to all the parties (investors and fund managers). These arrangements may be based on the "master-feeder" structure, in which a single fund is held by separate domestic and foreign entities through which different types of investors invest.32 The structure may include the interposition of a foreign corporation - a "blocker" corporation - between the investment fund and certain of its investors, typically the fund's foreign and taxexempt investors, which serves to block types of income received that could be subject to U.S. tax in their hands, and to convert this income into dividends (or interest) when distributed to them.33 The foreign corporation may also serve as an income deferral mechanism for individual fund managers in the case of management fees.

Investment Fund Structure with Foreign Feeder Corporation

Reasons for selecting offshore entities

An initial issue involves identifying which aspects of the structure and business activities of hedge funds and private equity funds and their managers are offshore, and which aspects remain onshore in the United States. Use of intermediate foreign corporations is relatively common. Sometimes the investment fund itself is established offshore.34 Generally the foreign corporation or entity is established in a jurisdiction that does not impose an income tax, or imposes very little tax.

Foreign individuals may find it attractive to invest in an alternative asset fund through an offshore corporation rather than directly because by doing so, the individuals may avoid the direct imposition of U.S. tax on income effectively connected with a U.S. trade or business and the concomitant requirement to file a U.S. tax return. Foreign individuals may also hold the view that it is preferable to invest through a foreign corporation in order to interpose an additional non-U.S. entity between themselves and U.S. tax administration. To the extent, however, that a foreign individual would have effectively connected income if the individual invested in a fund directly rather than through an offshore corporation, the foreign corporation itself has effectively connected income. Investment in a fund through an offshore corporation therefore generally does not reduce the aggregate U.S. tax liability of foreign individual investors.

Generally, an entity principally engaged in active trading in securities through agents in the United States would be considered as engaged in a trade or business in the United States. However, under rules referred to as the "securities trading safe harbor," an exception is provided for a range of securities and commodities activities conducted in the United States by or on behalf of foreign persons.35 Investment funds that are organized in offshore jurisdictions may satisfy the securities trading safe harbor and thereby may not be treated as engaged in a U.S. trade or business even if the funds' investment or securities trading activities are managed by individuals working in the United States. As a result, a foreign partner investing in an offshore fund organized as a partnership may not be treated as engaged in a U.S. trade or business solely by reason of that investment, and may not be subject to U.S. net income tax on income from the investment.

A U.S. taxable investor generally obtains no tax advantage from investing in an offshore investment fund rather than a domestic one. If the fund is organized as foreign partnership, the U.S. investor is taxed on its distributive share of partnership income, just as if the fund were a U.S. partnership. If the fund is organized as a foreign corporation, or if the U.S. investor invests through a foreign "feeder" corporation, the passive foreign investment company or subpart F rules may cause the U.S. investor to lose the benefit of deferral of U.S. taxation of that investor's share of the fund's income.36 Thus, neither a foreign investor nor a U.S. taxable investor would generally reduce U.S. net income tax liability by investing through an offshore investment fund, when compared to the U.S. tax liability that would be imposed were the investor to conduct the same activities directly. However, tax-exempt investors can reduce U.S. net income tax liability for unrelated business income tax by investing in an offshore investment fund organized as a corporation, or in offshore "feeder" corporation that is a partner in an offshore investment partnership.

Tax-exempt investors and unrelated business income tax

One reason for investing in alternative investment funds through a foreign corporation relates to the imposition of unrelated business income tax ("UBIT") on tax-exempt organizations under present law. If a tax-exempt organization were to invest directly in the strategies followed by many alternative investment funds, it is likely that the tax-exempt organization's income from that investment would be subject to UBIT, because, for example, the assets are active business assets that are unrelated to the organization's exempt purpose, or the assets are debt-financed.

If tax-exempt organizations hold such investments through a partnership, a lookthrough rule applies, potentially subjecting the tax-exempt investors' returns to UBIT. By contrast, if tax-exempt organizations hold potentially UBIT-producing partnership investments through a corporation, the corporation's separate existence generally is respected for Federal tax purposes so that the lookthrough rule does not apply, and dividends paid by the corporation to the taxexempt investors generally are excluded from the investors' unrelated business taxable income. Tax-exempt organizations thus may have an incentive to invest in alternative investment funds through these "UBIT blockers" or "blocker corporations." Such corporations often are established offshore in low-tax or zero-tax jurisdictions to avoid corporate tax at the blocker corporation level; in turn, the blocker corporation relies on the securities trading safe harbor described earlier to avoid U.S. net income tax on its securities investment/trading strategies.

Deferral of income of managers

A U.S. based manager of an offshore investment fund can agree by contract to take performance-based returns to which the manager may be entitled either in the form of a carried interest, or in the form of contingent compensation. In the latter case, the manager can also negotiate to defer receipt of that income (and likewise to defer the concomitant tax liability) for a period of years.

The typical structure of an offshore hedge fund, in which the underlying fund is organized as a partnership, taxable U.S. investors invest through a "feeder" domestic partnership, and tax-exempt U.S. investors and foreign investors invest through a "feeder" foreign corporation, permits fund managers to optimize their after-tax performance-based returns. Fund managers do so by arranging to take those returns as carried interest where the underlying investment fund is expected to generate long-term capital gain (or where an alternative form might disadvantage taxable U.S. investors), and to take those returns in the form of contingent compensation (which compensation in turn often is subject to a voluntary agreement to defer receipt of the income) when the underlying investment fund generates short-term capital gain or ordinary income (and when doing so does not otherwise disadvantage investors). In a typical structure, managers can combine both approaches, by arranging to take performance-based income, not from the underlying investment fund, but rather from the domestic "feeder" fund, in the form of a carried interest in the domestic "feeder" partnership, and a contingent deferred compensation arrangement with the offshore "feeder" corporation.

In the case of an investor who is subject to U.S. tax, structuring the fund manager's performance based returns as deferred compensation is not desirable as a tax planning matter because the payor's deduction is postponed under U.S. tax law until the amount is included in income by the fund manager. In the case of a U.S. taxpayer, this deferral of the deduction creates a tension which, in theory, may limit the amount of compensation that is deferred. This tension is not present with respect to the relationship between fund managers and offshore "feeder" corporations, because the ultimate investors in these corporations are tax exempt or otherwise not subject to U.S. tax and are indifferent as to the timing of a tax deduction for compensation.

If the carried interest is structured as nonqualified deferred compensation, all amounts received by the fund manager pursuant to the carried interest are taxable as ordinary income. In contrast, if the carried interest is structured as a partnership profits interest in the fund, the fund manager's distributive share of the fund's income and loss items retains the character that those items had at the fund level under present law. Thus, to the extent the fund's income constitutes long-term capital gain or qualifying dividends eligible for the preferential capital gain tax rate, the consensus understanding of current law is that the fund manager's share of that income is eligible for the preferential capital gain tax rate. However, in the case of funds (such as hedge funds) whose investment strategy involves relatively rapid turnover of assets, income generated by the fund is generally not eligible for the long-term capital gain tax rate, but rather, is generally subject to income tax at the same rate as ordinary compensation income.37 In this situation, where preferential long-term capital gains tax rates are not available, the tax benefit of deferred compensation to the recipient may be substantial.

Quantifying the tax benefit of deferral of compensation

The principal advantage of deferral is the ability to retain earnings in the foreign corporation and invest them such that they are not subject to tax on an annual basis, i.e., invest them on a pre-tax basis. Suppose that a taxpayer in the 35 percent bracket earns $100 of compensation today and defers it for five years, such that the foreign corporation can invest the money and earn a 10 percent return per year. The taxpayer would then have $161.05 and pay tax of $56.37, for an after-tax income of $104.68. Suppose there is another taxpayer who cannot defer compensation, but has access to the same investment opportunity. This taxpayer receives $100 in compensation today, pays tax of $35, and has only $65 to invest. The taxpayer invests that amount at an after-tax rate of 6.5 percent, i.e. a 10 percent pretax rate less 35 percent tax on the earnings each year. At the end of five years, the taxpayer will only have $89.06. The $15.62 ultimate difference in economic wealth between the taxpayer who could defer the compensation income for five years (whose deferred income in turn compounded at 10 percent per year), compared to the otherwise identically-situated taxpayer who was required to pay tax on the compensation income immediately (whose after-tax income compounded at 6.5 percent per year), can be analyzed as follows.

In the deferral case, the employee can be understood at a conceptual level (by virtue of her agreement with her employer under which her deferred compensation grows at 10 percent per year) as if she also received $100 in cash compensation (but in her case not taxable income) immediately, and then set aside $35 of that $100 to fund her entire tax liability (which $35 in turn also was invested at 10 percent). Of course the employee did not actually receive cash upfront, but the effect of her agreement with her employer was to put her in the same economic position as if she did receive that cash and immediately invested it at a 10 percent rate. Each year the $100 (and therefore the employee's ultimate tax bill) would notionally grow at 10 percent, but so would the $35 component of that amount set aside to fund the employee's future tax bill. As a result, the $35 notionally set aside by the employee in the first period would be sufficient to pay her taxes at the end of the fifth year. This means that the employee's total aftertax wealth at the end of the fifth year would equal $65 (the portion of the $100 notionally received at the start that was not needed to fund her tax liability) compounded at the full pretax rate of 10 percent, or $104.68.

In other words, the incremental value of deferring income in this example is equivalent to the difference between investing $65-the after-tax value of the compensation-at the pre-tax interest rate (10 percent), rather than the after-tax rate (6.5 percent), for the five-year life of the deferral. More generally, any deferral of income can be analyzed in the same way: the value of deferral is equivalent to the value of investing the after-tax amount of the income over the period of the deferral at the pre-tax rate of return.38 It is as if the taxpayer who can defer her income must pay tax currently on the deferred amount, but then can invest the after-tax proceeds on a tax-exempt basis.39

The above example assumed that the employee could earn the normal pre-tax return on her deferred compensation. When the employer is a U.S. taxpayer, that assumption is not necessarily accurate, because the employer itself will be subject to tax on the returns that it earns on the cash attributable to the deferred compensation during the deferral period. This result follows from the fact that U.S. employers in general may not deduct expenses attributable to deferred compensation until that compensation is paid. In theory, therefore, if the employee and the U.S. employer are taxed at the same rate (e.g., 35 percent), and if the employer is not willing to subsidize the employee's deferred compensation (by effectively giving the employee additional compensation), the employer should not be willing to pay more than its after-tax rate of return (6.5 percent, in the above example) to the employee in respect of deferred compensation amounts.40

If these facts were universally the case, there would be no tax disadvantage to the U.S. tax administration system in deferred compensation arrangements. In practice, however, these facts often are not the case: an employer might, for example, be in a lower tax bracket than an employee (for example, by virtue of operating losses or the tax rates then in effect).41 Notwithstanding these (and other) exceptions, the general presumption appears to be that there exists sufficient tension in the tax positions of employees and employers as to serve at least as a partial constraint on compensation deferral arrangements.

This tension in tax positions disappears entirely when the employer is an offshore corporation owned by foreign investors, and U.S. tax-exempt institutions. In that case, the employer never obtains a tax benefit from paying compensation or a tax detriment from deferring the payment of that compensation, because it is not a taxpayer at all. As a result, there is no incremental cost to the employer (or its owners) in permitting an employee to defer compensation, and the employer therefore in theory should be willing to pay to the employee up to the pre-tax return on the cash attributable to the deferred compensation. This result can be extended beyond simple time value of money type returns. For example, the deferred compensation may be treated by contract as if it were invested in the underlying investment fund, and the fund manager's synthetic investment therein would then compound as if it were a taxexempt investment.

II. PRESENT LAW

A. Federal Income Tax Treatment of Insurance Companies

In general

Present law provides special rules for determining the taxable income of insurance companies (subchapter L of the Code). Separate sets of rules apply to life insurance companies and to property and casualty insurance companies. Insurance companies are subject to tax at regular corporate income tax rates.

Life insurance companies

In general

Under the law in effect from 1959 through 1983, a life insurance company was subject to a three-phase taxable income computation under Federal tax law. Under the three-phase system, a company was taxed on the lesser of its gain from operations or its taxable investment income (Phase I) and, if its gain from operations exceeded its taxable investment income, 50 percent of such excess (Phase II). Federal income tax on the other 50 percent of the gain from operations was deferred, and was accounted for as part of a policyholder's surplus account and, subject to certain limitations, taxed only when distributed to stockholders or upon corporate dissolution (Phase III). To determine whether amounts had been distributed, a company maintained a shareholders surplus account, which generally included the company's previously taxed income that would be available for distribution to shareholders. In the Deficit Reduction Act of 1984, the three-phase tax structure was eliminated and the statutory scheme for taxation of life insurance companies was redesigned.

Present law provides rules for taxation of the life insurance company taxable income (LICTI) of a life insurance company. For Federal income tax purposes, a life insurance company means an insurance company that is engaged in the business of issuing life insurance and annuity contracts, or noncancellable health and accident insurance contracts, and that meets a 50-percent test with respect to its reserves (sec. 816(a)). This statutory provision applicable to life insurance companies defines the term "insurance company" to mean any company, more than half of the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies (sec. 816(a)).

LICTI is life insurance gross income reduced by life insurance deductions (sec. 801). An alternative tax applies if a company has a net capital gain for the taxable year, if such tax is less than the tax that would otherwise apply. Life insurance gross income is the sum of (1) premiums, (2) decreases in certain reserves, and (3) other amounts generally includible by a taxapyer in gross income. Life insurance deductions means the general deductions provided in section 805, and the small life insurance company deduction under section 806 (which functions as a reduction in the tax on LICTI equal to 60 percent of tentative LICTI up to $3 million, phasing out for companies with tentative LICTI between $3 and $15 million, provided that assets of the company do not exceed $500 million).

Deduction for increases in reserves

A life insurance company includes in gross income any net decrease in reserves, and deducts a net increase in reserves (sec. 807). Methods for determining reserves for tax purposes generally are based on reserves prescribed by the National Association of Insurance Commissioners for purposes of financial reporting under State regulatory rules. Special rules are provided, eliminating unrealized gains and losses from reserve increases and decreases, in the case of reserves based on separate accounts with respect to variable contracts (sec. 817).

Proration of deductions relating to untaxed income

Because deductible reserves might be viewed as being funded proportionately out of taxable and tax-exempt income, the net increase and net decrease in reserves are computed by reducing the ending balance of the reserve items by a portion 42 of tax-exempt interest (sec. 807(b)(2)(B) and (b)(1)(B)). Similarly, a life insurance company is allowed a dividends-received deduction for intercorporate dividends from nonaffiliates only in proportion to the company's share of such dividends (secs. 805(a)(4), 812). Fully deductible dividends from affiliates are excluded from the application of this proration formula (so long as such dividends are not themselves distributions from tax-exempt interest or from dividend income that would not be fully deductible if received directly by the taxpayer). In addition, the proration rule includes in prorated amounts the increase for the taxable year in policy cash values of life insurance policies and annuity and endowment contracts owned by the company (the inside buildup on which is not taxed).

Property and casualty insurance companies

In general

Under the law prior to 1986, a variety of special rates, deductions, and exempts applied to mutual property and casualty insurance companies, distinguishing their Federal income tax treatment from stock property and casualty companies. The Tax Reform Act of 1986 repealed the special rates, deductions, and most of the exemptions,43 and consolidated and modified the tax rules applicable to property and casualty companies.

Under present law, the taxable income of a property and casualty insurance company is determined as the sum of its gross income from underwriting income and investment income (as well as gains and other income items), reduced by allowable deductions (sec. 832). For purposes of determining the company's gross income, underwriting income and investment income are computed on the basis of the underwriting and investment exhibit of the annual statement approved by the National Association of Insurance Commissioners (sec. 832(b)(1)(A)).

Deduction for unpaid loss reserves

Underwriting income means premiums earned during the taxable year less losses incurred and expenses incurred (sec. 832(b)(3)). Losses incurred include certain unpaid losses (reported losses that have not been paid, estimates of losses incurred but not reported, resisted claims, unpaid loss adjustment expenses). Present law provides for the discounting of the deduction for loss reserves to take account partially of the time value of money (sec. 846). Thus, present law limits the deduction for unpaid losses to the amount of discounted unpaid losses. Any net decrease in the amount of unpaid losses results in income inclusion, and the amount in included is computed on a discounted basis.

The discounted reserves for unpaid losses are calculated using a prescribed interest rate which is based on the applicable Federal mid-term rate ("mid-term AFR"). The discount rate is the average of the mid-term AFRs effective at the beginning of each month over the 60-month period preceding the calendar year for which the determination is made.

To determine the period over which the reserves are discounted, a prescribed loss payment pattern applies. The prescribed length of time is either the accident year and the following three calendar years, or the accident year and the following 10 calendar years, depending on the line of business. In the case of certain "long-tail" lines of business, the 10-year period is extended, but not by more than 5 additional years. Thus, present law limits the maximum duration of any loss payment pattern to the accident year and the following 15 years. The Treasury Department is directed to determine a loss payment pattern for each line of business by reference to the historical loss payment pattern for that line of business using aggregate experience reported on the annual statements of insurance companies, and is required to make this determination every five years, starting with 1987.

Under the discounting rules, an election is provided permitting a taxpayer to use its own (rather than an industry-wide) historical loss payment pattern with respect to all lines of business, provided that applicable requirements are met.

Reinsurance premiums deductible

In determining premiums earned for the taxable year, a property and casualty company company deducts from gross premiums written on insurance contracts during the taxable year the amount of premiums paid for reinsurance (sec. 832(b)(4)(A)).

Unearned premiums

Further, the company deducts from gross premiums the increase in unearned premiums for the year (sec. 832(b)(4)(B)). The company is required to reduce the deduction for increases in unearned premiums by 20 percent. This amount serves to represent the allocable portion of expenses incurred in generating the unearned premiums, so as to provide a degree of matching of the timing of inclusion of income and deduction of associated expenses.

Proration of deductions relating to untaxed income

In calculating its reserve for losses incurred, a property and casualty insurance company must reduce the amount of losses incurred by 15 percent of (1) the insurer's tax-exempt interest, (2) the deductible portion of dividends received (with special rules for dividends from affiliates), and (3) the increase for the taxable year in the cash value of life insurance, endowment or annuity contracts the company owns (sec. 832(b)(5)). This rule reflects the fact that reserves are generally funded in part from tax-exempt interest, from wholly or partially deductible dividends, or from other untaxed amounts.

Treatment of reinsurance

Present law includes a rule enacted in 1984 providing authority to the Treasury Department to reallocate items and make adjustments in reinsurance transactions to prevent tax avoidance or evasion (sec. 845).44

The rule generally permits the Treasury Department to make reallocations in related party reinsurance transactions and in reinsurance transactions between unrelated parties. The legislative history of the provision states that "the operative standards for both of the reinsurance adjustment provisions are objective tests of (1) whether adjustments are necessary to more properly reflect income or (2) whether the transaction has a significant tax avoidance effect."45 The legislative history further provides that in determining whether a reinsurance agreement between unrelated parties has a significant tax avoidance effect with respect to one or both of the parties, appropriate factors for the Treasury Department to take into account are (1) the duration or age of the business reinsured, which bears on the issue of whether significant economic risk is transferred between the parties, (2) the character of the business (as long-term or not), (3) the structure for determining potential profits, (4) the duration of the reinsurance agreement, (5) the parties rights to terminate and the consequences of termination, such as the existence of a payback provision; (6) the relative tax positions of the parties, and (7) the financial situations of the parties.46

The provision was amended in 2004 to provide the Treasury Department with authority to allocate among the parties to a reinsurance agreement or recharacterize income (whether investment income, premium or otherwise), deductions, assets, reserves, credits and any other items related to the reinsurance agreement, or make any other adjustment in order to reflect the proper source, character, or amount of the item.47 In expanding this authority to the amount (not just the source and character) of any such item, Congress expressed the concern that "reinsurance transactions were being used to allocate income, deductions, or other items inappropriately among U.S. and foreign related persons," and that "foreign related party reinsurance arrangements may be a technique for eroding the U.S. tax base."48

B. Reinsurance Excise Tax

An excise tax applies to premiums paid to foreign insurers and reinsurers covering U.S. risks (secs. 4371-4374). Under this rule, a gross-basis excise tax is imposed at the rate of 1 percent on reinsurance and life insurance premiums. The excise tax is imposed at the rate of 4 percent on property and casualty insurance premiums. The excise tax does not apply to premiums that are effectively connected with the conduct of a U.S. trade or business or if an applicable income tax treaty provides an exemption from the tax.49 The excise tax does not provide a credit with respect to the excise tax paid by one party if, for example, the risk is reinsured with a second party in a transaction that is also subject to the excise tax.

C. International Taxation

General U.S. tax rules applicable to business operations

The United States employs a worldwide tax system under which U.S. persons (including U.S. citizens, U.S. resident individuals, and domestic corporations) generally are taxed on all income, whether derived in the United States or abroad. In contrast, foreign persons (including nonresident alien individuals and foreign corporations) are taxed in the United States only on income that has a sufficient nexus to the United States.

Foreign persons are subject to U.S. tax on income that is effectively connected with the conduct of a trade or business in the United States. Such income may be derived from U.S. or foreign sources. This income generally is taxed in the same manner and at the same rates as income of a U.S. person. In addition, foreign persons generally are subject to U.S. tax at a 30-percent rate on certain gross income (such as interest, dividends, rents, royalties, and premiums) derived from U.S. sources.

An income tax treaty between the United States and a foreign country may reduce or eliminate the 30-percent gross-basis withholding tax on certain payments. A tax treaty also may permit the United States to tax a foreign person's income from business operations only to the extent the income is attributable to that person's permanent establishment in the United States. Finally, a tax treaty may eliminate the insurance premiums excise tax described above.

U.S. persons --income from a foreign business

Section 367

If a U.S. corporation reincorporates in a foreign jurisdiction, seeking to replace the U.S. parent corporation of a multinational corporate group with a foreign parent corporation, several provisions of the tax law apply to the transaction. In certain outbound stock transactions, the U.S. shareholders generally recognize gain (but not loss) under section 367(a), based on the difference between the fair market value of the foreign corporation shares received and the adjusted basis of the domestic corporation stock exchanged. To the extent that a corporation's share value has declined, and/or it has many foreign or tax-exempt shareholders, the impact of this section 367(a) "toll charge" is reduced. The transfer of foreign subsidiaries or other assets to the foreign parent corporation also may give rise to U.S. tax consequences at the corporate level (e.g., gain recognition and earnings and profits inclusions under secs. 1001, 311(b), 304, 367, 1248 or other provisions). The tax on any income recognized as a result of these restructurings may be reduced or eliminated through the use of net operating losses, foreign tax credits, and other tax attributes.

In asset inversions, the U.S. corporation generally recognizes gain (but not loss) under section 367(a) as though it had sold all of its assets, but the shareholders generally do not recognize gain or loss, assuming the transaction meets the requirements of a reorganization under section 368.

Inversions

Rules limiting the tax benefits of certain corporate and partnership inversion transactions were added to the Code in 2004.50 Present law defines two different types of corporate inversion transactions and establishes a different set of consequences for each type. Certain partnership transactions also are covered.

The first type of inversion is a transaction in which, pursuant to a plan or a series of related transactions: (1) a U.S. corporation becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity in a transaction completed after March 4, 2003; (2) the former shareholders of the U.S. corporation hold (by reason of holding stock in the U.S. corporation) 80 percent or more (by vote or value) of the stock of the foreign-incorporated entity after the transaction; and (3) the foreign-incorporated entity, considered together with all companies connected to it by a chain of greater than 50 percent ownership (i.e., the "expanded affiliated group"), does not have substantial business activities in the entity's country of incorporation, compared to the total worldwide business activities of the expanded affiliated group. The provision denies the intended tax benefits of this type of inversion by deeming the top-tier foreign corporation to be a domestic corporation for all purposes of the Code.

In determining whether a transaction meets the definition of an inversion under the provision, stock held by members of the expanded affiliated group that includes the foreign incorporated entity is disregarded. For example, if the former top-tier U.S. corporation receives stock of the foreign incorporated entity (e.g., so-called "hook" stock), that stock would not be considered in determining whether the transaction meets the definition. Similarly, if a U.S. parent corporation converts an existing wholly owned U.S. subsidiary into a new wholly owned controlled foreign corporation, all stock of the new foreign corporation would be disregarded, with the result that the transaction would not meet the definition of an inversion under the provision. Stock sold in a public offering related to the transaction also is disregarded for these purposes.

Transfers of properties or liabilities as part of a plan a principal purpose of which is to avoid the purposes of the provision are disregarded. In addition, the Treasury Secretary is to provide regulations to carry out the provision, including regulations to prevent the avoidance of the purposes of the provision, including avoidance through the use of related persons, passthrough or other noncorporate entities, or other intermediaries, and through transactions designed to qualify or disqualify a person as a related person or a member of an expanded affiliated group. Similarly, the Treasury Secretary is granted authority to treat certain non-stock instruments as stock, and certain stock as not stock, where necessary to carry out the purposes of the provision.

The second type of inversion is a transaction that would meet the definition of an inversion transaction described above, except that the 80-percent ownership threshold is not met. In such a case, if at least a 60-percent ownership threshold is met, then a second set of rules applies to the inversion. Under these rules, the inversion transaction is respected (i.e., the foreign corporation is treated as foreign), but any applicable corporate-level "toll charges" for establishing the inverted structure are not offset by tax attributes such as net operating losses or foreign tax credits. Specifically, any applicable corporate-level income or gain required to be recognized under sections 304, 311(b), 367, 1001, 1248, or any other provision with respect to the transfer of controlled foreign corporation stock or the transfer or license of other assets by a U.S. corporation as part of the inversion transaction or after such transaction to a related foreign person is taxable, without offset by any tax attributes (e.g., net operating losses or foreign tax credits). This rule does not apply to certain transfers of inventory and similar property. These measures generally apply for a 10-year period following the inversion transaction.

Inversion transactions include certain partnership transactions. Specifically, the provision applies to transactions in which a foreign-incorporated entity acquires substantially all of the properties constituting a trade or business of a domestic partnership, if after the acquisition at least 60 percent of the stock of the entity is held by former partners of the partnership (by reason of holding their partnership interests), provided that the other terms of the basic definition are met. For purposes of applying this test, all partnerships that are under common control within the meaning of section 482 are treated as one partnership, except as provided otherwise in regulations. In addition, the modified "toll charge" proposals apply at the partner level.

A transaction otherwise meeting the definition of an inversion transaction is not treated as an inversion transaction if, on or before March 4, 2003, the foreign-incorporated entity had acquired directly or indirectly more than half of the properties held directly or indirectly by the domestic corporation, or more than half of the properties constituting the partnership trade or business, as the case may be.

Passive foreign investment companies

The Tax Reform Act of 1986 established an anti-deferral regime for passive foreign investment companies. A passive foreign investment company generally is defined as any foreign corporation if 75 percent or more of its gross income for the taxable year consists of passive income, or 50 percent or more of its assets consists of assets that produce, or are held for the production of, passive income.51 Alternative sets of income inclusion rules apply to U.S. persons that are shareholders in a passive foreign investment company, regardless of their percentage ownership in the company. One set of rules applies to passive foreign investment companies that are "qualified electing funds," under which electing U.S. shareholders currently include in gross income their respective shares of the company's earnings, with a separate election to defer payment of tax, subject to an interest charge, on income not currently received.52 A second set of rules applies to passive foreign investment companies that are not qualified electing funds, under which U.S. shareholders pay tax on certain income or gain realized through the company, plus an interest charge that is attributable to the value of deferral.53 A third set of rules applies to passive foreign investment company stock that is marketable, under which electing U.S. shareholders currently take into account as income (or loss) the difference between the fair market value of the stock as of the close of the taxable year and their adjusted basis in such stock (subject to certain limitations), often referred to as "marking to market."54

Subpart F

Under the subpart F rules, 10-percent U.S. shareholders of a controlled foreign corporation ("CFC") are subject to U.S. tax currently on certain income earned by the CFC, whether or not such income is distributed to the shareholders. The income subject to current inclusion under the subpart F rules includes, among other things, insurance income and foreign base company income. Foreign base company income includes, among other things, foreign personal holding company income and foreign base company services income (i.e., income derived from services performed for or on behalf of a related person outside the country in which the CFC is organized).

Foreign personal holding company income generally consists of the following: (1) dividends, interest, royalties, rents, and annuities; (2) net gains from the sale or exchange of (a) property that gives rise to the preceding types of income, (b) property that does not give rise to income, and (c) interests in trusts, partnerships, and REMICs; (3) net gains from commodities transactions; (4) net gains from certain foreign currency transactions; (5) income that is equivalent to interest; (6) income from notional principal contracts; (7) payments in lieu of dividends; and (8) amounts received under personal service contracts.

Insurance income subject to current inclusion under the subpart F rules includes any income of a CFC attributable to the issuing or reinsuring of any insurance or annuity contract in connection with risks located in a country other than the CFC's country of organization. Subpart F insurance income also includes income attributable to an insurance contract in connection with risks located within the CFC's country of organization, as the result of an arrangement under which another corporation receives a substantially equal amount of consideration for insurance of other country risks. Investment income of a CFC that is allocable to any insurance or annuity contract related to risks located outside the CFC's country of organization is taxable as subpart F insurance income.

Temporary exceptions from foreign personal holding company income, foreign base company services income, and insurance income apply for subpart F purposes for certain income that is derived in the active conduct of a banking, financing, or similar business, or in the conduct of an insurance business (so-called "active financing income").

In the case of insurance, in addition to a temporary exception from foreign personal holding company income for certain income of a qualifying insurance company with respect to risks located within the CFC's country of creation or organization, certain temporary exceptions from insurance income and from foreign personal holding company income apply for certain income of a qualifying branch of a qualifying insurance company with respect to risks located within the home country of the branch, provided certain requirements are met under each of the exceptions. Further, additional temporary exceptions from insurance income and from foreign personal holding company income apply for certain income of certain CFCs or branches with respect to risks located in a country other than the United States, provided that the requirements for these exceptions are met.

In the case of a life insurance or annuity contract, reserves for such contracts are determined as follows for purposes of these provisions. The reserves equal the greater of: (1) the net surrender value of the contract (as defined in section 807(e)(1)(A)), including in the case of pension plan contracts; or (2) the amount determined by applying the tax reserve method that would apply if the qualifying life insurance company were subject to tax under Subchapter L of the Code, with the following modifications. First, there is substituted for the applicable Federal interest rate an interest rate determined for the functional currency of the qualifying insurance company's home country, calculated (except as provided by the Treasury Secretary in order to address insufficient data and similar problems) in the same manner as the mid-term applicable Federal interest rate (within the meaning of section 1274(d)). Second, there is substituted for the prevailing State assumed rate the highest assumed interest rate permitted to be used for purposes of determining statement reserves in the foreign country for the contract. Third, in lieu of U.S. mortality and morbidity tables, mortality and morbidity tables are applied that reasonably reflect the current mortality and morbidity risks in the foreign country. Fourth, the Treasury Secretary may provide that the interest rate and mortality and morbidity tables of a qualifying insurance company may be used for one or more of its branches when appropriate. In no event may the reserve for any contract at any time exceed the foreign statement reserve for the contract, reduced by any catastrophe, equalization, or deficiency reserve or any similar reserve.

Present law permits a taxpayer in certain circumstances, subject to approval by the Internal Revenue Service ("IRS") through the ruling process or in published guidance, to establish that the reserve of a life insurance company for life insurance and annuity contracts is the amount taken into account in determining the foreign statement reserve for the contract (reduced by catastrophe, equalization, or deficiency reserve or any similar reserve). IRS approval is to be based on whether the method, the interest rate, the mortality and morbidity assumptions, and any other factors taken into account in determining foreign statement reserves (taken together or separately) provide an appropriate means of measuring income for Federal income tax purposes. In seeking a ruling, the taxpayer is required to provide the IRS with necessary and appropriate information as to the method, interest rate, mortality and morbidity assumptions and other assumptions under the foreign reserve rules so that a comparison can be made to the reserve amount determined by applying the tax reserve method that woul