Sections 3401 To 3434: Taxation of Financial Products

In January 2013, Chairman Camp released a discussion draft proposing changes to the tax treatment of financial products and invited comments on the draft. The financial products proposal potentially having the greatest impact on life insurance companies related to the tax treatment of derivatives and required that they be marked to market. The comprehensive Tax Reform Discussion Draft released by Camp on Feb. 26, 2014 incorporated the earlier derivatives proposal, but with a key modification to address concerns raised by the insurance industry in response to the January 2013 draft. Before getting into these and other proposed changes to the taxation of financial products included in the comprehensive Tax Reform Discussion Draft, however, a little background on current tax law as it applies to life insurance company hedges is appropriate.

Current Law

An insurance company’s investments are classified as capital assets for tax purposes, despite the fact that they generate ordinary income while held and are used to support obligations that generate deductions from ordinary income. The capital treatment of these investment assets creates significant timing and character mismatches for insurance companies, which are made worse by current law’s failure to permit tax hedge qualification for insurers’ business hedges of capital assets and the IRS’ position that not all insurers’ hedges can be classified as primarily managing risks with respect to ordinary liabilities.

Hedging Transactions

Qualification for tax hedge accounting is beneficial for several reasons. The taxpayer is entitled to adopt an accounting method that clearly reflects income through matching of the timing of income, deductions, gains and losses, in the hedging transaction and the item(s) hedged. Gains and losses have ordinary character permitting a character match to ordinary liabilities. In addition, tax hedges are excepted from the adverse effects of the straddle and I.R.C. § 1256 mark-to-market rules.

To qualify for tax hedge treatment, a hedging transaction must (1) manage risk of price changes or currency fluctuations with respect to ordinary property, or (2) manage risk of interest rate, price changes or currency fluctuations with respect to ordinary obligations (policy liabilities). Significantly, a transaction that hedges a risk relating only to a capital asset (such as an insurance company’s investment assets) does not qualify for tax hedge treatment. Duration gap hedges (which relate to both capital assets and ordinary liabilities) are particularly problematic under current law because the IRS takes the position that tax hedge qualification applies only if the hedge is more closely related to ordinary liabilities than to capital assets. This standard is difficult to apply because, by definition, a gap hedge relates to both assets and liabilities and closes the duration gap between the two.

A failure to qualify for tax hedge treatment can result in a character mismatch of capital losses on the hedging instrument even though any economic gain from the insurance products is ordinary. There also can be a timing mismatch because the gain or loss on the derivative is not matched to the tax recognition of the hedged item—the capital asset, the policy obligations, or both.