2012 Washington Prod Tax Butler

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Product Tax Seminar

September 20 – 21, 2012

Washington, DC

Managing Product Tax Compliance Risk

ChairBrian King

FacilitatorsBryan Keene

Cecile Butler

David Remus


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2012 Product Tax Seminar Session 4 – Managing Product Tax Risk

2012 Product Tax Seminar Session 4 – Managing Product Tax Risk

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Marriott Metro Center Washington, DC

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Marriott Metro Center Washington, DC

PresentersPresenters

Moderator: Brian King, Ernst & Young LLP

Faculty: Bryan Keene, Davis & Harman LLPCecile Butler, John HancockDavid Remus, Office of Chief Counsel, IRS

Moderator: Brian King, Ernst & Young LLP

Faculty: Bryan Keene, Davis & Harman LLPCecile Butler, John HancockDavid Remus, Office of Chief Counsel, IRS

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The opinions expressed hereare the presenters’ alone andThe opinions expressed hereare the presenters’ alone and

the views of Ernst & YoungLLP, Davis & Harman LLP or

John Hancock.

the views of Ernst & Young

LLP, Davis & Harman LLP orJohn Hancock.

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Session Overview

Present an overview of the IRC qualification, -

care contracts

Discuss sources of noncompliance

Highlight the implications for noncompliance

Discuss strategies to mitigate the risk for

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noncomp ance


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Managing Product Tax Risk

Insurance companies are charged with administeringproducts within the requirements of the Internal Revenue

An effective Product Tax Compliance operation requires:• An understanding of the qualification rules applicable to each

type of insurance contract

• Insurance products be properly designed to conform to thequalification requirements

• Policyholder administration assist in the ongoing monitoring of

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compliance

Includes the proper withholding and reporting of income

Managing Product Tax Risk How are qualification failures detected?

Generally no IRS audit program

Short answer -- someone goes looking for them

Sale due diligence (subsidiary, block of business)

System conversion, new personnel, other

Why do qualifications failures occur? Complexity of rules

Misunderstanding of the qualification requirements

Lack of tax professional oversight

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a e aw n erpre a on ac uar a prac ce vs. ax aw n erpre a on,(e.g., no “tolerances”)

Product design errors

Administrative errors in the ongoing monitoring for compliance

IRS issuance of new guidance


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Managing Product Tax Risk

Implication of qualification failures• Cost of remediation (contracts and systems) can be

• Exposes insurer’s tax reporting errors and penalties

• Reputational risk & policyholder dissatisfaction

• FIN 48 reserve

• Disclosure to auditor

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Products to be Discussed

Non-qualified annuities (deferred or immediate)

Individual retirement annuities

Variable contracts (life or annuity)

Long-term care insurance & accelerated deathbenefits

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Non-qualified annuit ies

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NQ Annuities – Deferred or Immediate

Qualification rules:

• Section 72(s) – contract must include specific provisions for

primary annuitant when the holder is not a living person.

• Section 72(u) – tax-deferral on inside build-up available toowners who are living persons. “Non-natural” owners areallowed tax-deferral under limited circumstances.

• The contract must provide for annuitization.

•

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.regulations to qualify for exclusion ratio treatment.

Need to track investment in contract for annuitization,withdrawals, death benefits & surrenders.


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NQ Annuities - Immediate

Section 72(u)(4) – additional qualificationrequirements for immediate annuities:

• on rac purc ase w s ng e prem um or annu yconsideration;

• Annuity starting date no later than 1 year from the date ofpurchase of the annuity; and,

• Contract must provide a series of substantially equalperiodic payments – paid not less frequently than annually

–

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.

Less favorable treatment for contracts purchased by

1035 exchange from a deferred annuity.

NQ Annuit ies, cont.

Consequences/costs of non-compliance:• Loss of tax-deferral on undistributed gains

• Loss of exclusion ratio for annuitization

• Loss of exception from 10% penalty tax

• Insurance department complaints and lawsuits

• Damage to brand name and agent relations

• Detailed tax reporting obligations (sec. 6047(d))

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• VAs are securities subject to additional disclosure andpenalties


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NQ Annuit ies, cont.

How to avoid compliance problems

• Alwa s include tax rofessionals in roductdesign and administration

• Sensitize senior management to tax risks andthe high costs of non-compliance

• Education and training, and repeat every 2 to3 ears

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• If it can be systematized, it should be

(overrides are the devil’s playthings)

NQ Annuities - Remediation

Offer replacement contracts, reimburse owner fortaxes & accountant’s fees, and gross-up for thetaxes attributable to the reimbursement.

OR

Seek IRS closing agreement to fix contracts

• No formal program to correct annuity failures

• Compile extensive data and negotiate a compliance

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fee, which could be based on number of contracts• Communicate fix to contract owners and agents

• Self-correcting not an option (see, PLR 201021042)


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Life Insurance

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Life Insurance - Qualification rules: Section 101(f) and 7702

• Defines a life insurance contact for purposes of the IRC• Limits the allowable cash value and/or premiums paid• Compliance allows for:

Tax deferral of “inside build-up” Tax free receipt of death benefit

Section 7702A• Imposes a premium limitation on contracts to avoid

becoming a MEC• Implications of becoming a MEC

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Still a qualifying life insurance contract under section 7702 Subjects pre-death distributions (including loans) to taxation

under the annuity rules

Actuarial qualification requirements are complex!


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Life Insurance, cont.

Consequences and costs of non-compliance:• Section 7702 failure –

Loss of tax deferral or exemption on inside buildup

Tax on prior and future “income on the contract”

• Section 7702A failure – unfavorable treatment ofloans and withdrawals, penalty tax application

• Potential claims, lawsuits by policyholders

• Dama e to brand name and a ent relations

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• Reporting and withholding (Rev. Rul. 91-17)

Life Insurance, cont.

A program for avoiding non-compliance:

• Educate senior officers about risks and costs of non-compliance

• Include tax professionals in product and systemdesign, oversight

• Upgrade – and verify – compliance software

• Improve staff training

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• Documentation of existing methodology,

assumptions, interpretations, opinions, etc.

• Assigning ownership of tax compliance


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Life Insurance – Remediation

Policy remediation• Rev. Proc. 2008-39

Closing agreement to “un-MEC” an inadvertent MEC

• ev. roc. - Closing agreement to remediate failed contracts Limited section 7702 relief at limited cost

• Rev. Proc. 2008-42 Section 7702(f)(8) auto waiver

• Full section 7702(g) closing agreement

Administrative system remediation

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Costs can be substantial

Discussion with IRS audit team? What about “self help”?

Individual retirement annuities

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Individual Retirement Annuities

Section 408(b):• Contract is not transferable

’• wner s en re n eres s non or e a e

• Contract complies with minimum distribution andincidental death benefit rules

• Under the contract: –

Premiums are not fixed

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sec. 219(b)(1)(A)

Sec. 408(e)(3): no borrowing under or by use ofcontract

Individual Retirement Annuities, cont.

Common sources of non-compliance• Not including tax professionals in product design

and administration

• Very complex rules – RMD, SEPP, APV

• Conflict between base contract and IRAendorsement, outdated endorsements

• Stretch programs/enhanced benefits

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• Not monitoring contributions, distributions,rollovers, conversions, recharacterizations


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Consequences/costs of non-compliance• 6% excise tax on excess contributions not timely

refunded

• 10% penalty tax on premature distributions

• 50% excise tax for not taking RMD

• Lost deductions

• Owner taxed on fair market value if contract

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ceases to qualify as IRA

• Insurance department complaints and lawsuits• Damage to brand and agent relations


Remediating errors:

• SEP and SIMPLE IRAs covered b EPCRS

• Affidavit of company error might help acontract owner avoid penalty on a late RMD

• Reimburse owner for taxes and accountant’sfees, with gross-up. This will not requalify thecontract as an IRA.

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• To restore IRA qualification or for errorscovering multiple contracts, seek closingagreement with IRS.


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Variable contracts

(life or annuity)

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Variable Contracts

Qualification rules:

rules of section 817(h) and Reg. sec. 1.817-5

Percentage limits on investments by “issuer”

Special rules for U.S. Treasury and othergovernment agency securities

Look-through rule

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Tested quarterly

Investor control doctrine (e.g., Rev. Rul. 2003-91 and Rev. Rul. 2003-92)


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Variable Contracts, cont.

Sources of non-compliance:

•

• Mistaken application of Treasury / governmentagency investment rules – see, e.g., Notice 2000-9

• Legal uncertainty (derivatives, stable value wraps,etc.)

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• Mistakes in understanding rules or in assessing

risk in connection with the investor control doctrine(e.g., Rev. Rul. 2003-92)


Consequences and costs of non-compliance: Variable life and annuity contracts based on a non-diversified

segregated asset account will no longer constitute life,

7702 and Subchapter L. Inside build-up taxable as ordinaryincome

Upon an investor control failure, the policyholder is treated asowning the assets of the account and is taxable on any incomeor gains derived from those assets

Tax reporting obligation (Rev. Rul. 91-17)

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Also, if there is an investor control failure, look-throughtreatment under Reg. sec. 1.817-5(f) might be lost – “infection”issue

Variable contracts are securities – disclosure requirements,potential for actions


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Avoiding non-compliance and remediating failures• Ask for diversification reports

• nvo ve ax pro ess ona s n n erpre ng eg. sec. - - ,investor control doctrine

• Rev. Proc. 2008-41 for inadvertent diversification failure

Toll charge based on income on contract for the period orperiods of non-diversification, or

Toll charge based on highest amount by which thesegregated asset account was non-diversified, or

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Toll charge based on the lesser of $5 million or 5% of the totalvalue of the segregated asset account

IRS user fee (currently $18,000)

• Closing agreement for investor control violation?

Long-term care insurance &

accelerated death benefits

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Qualified Long-Term Care Insurance and Code

Sec. 101(g) Accelerated Death Benefits

“Qualified” long-term care insurance (“LTC”) must meetsection 7702B requirements, including consumer

through section 4980C penalties• Qualified LTC insurance can be provided under a stand-alone

contract, as part of an LTC-life combination contract (which mayor may not accelerate the death benefit) or as part of an LTC-annuity combination contract

Code section 101(g) accelerated death benefits must

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meet similar requirements, although they differ in a

number of respects Non-compliance risks

Addressing non-compliance problems

Any Questions?

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Documents

2012 Washington Prod Tax Butler