Actuary/Accountant/Tax Attorney Dialogue on Internal Revenue Code Deference to the NAIC Part I: Tax Reserves

Editor’s Note: For our 10th anniversary year of Taxing Times, we are reviving a popular format that we have used several times over the years: a dialogue among tax professionals of various backgrounds (actuarial, legal and accounting) exploring federal income tax issues applicable to life insurance companies. This dialogue will examine the important and evolving topic of the extent to which the tax law defers to the NAIC in taxing life insurance companies. It is our most ambitious dialogue yet and will be published as a three-part series in this, and the next two editions of Taxing Times. The first part of the dialogue that follows focuses on tax reserves. The next part will continue with a discussion of product taxation, and the last in the series will be a catch-all of other life insurance tax provisions where deference to the NAIC may be relevant.

I am grateful to Peter Winslow of Scribner, Hall & Thompson, LLP, for developing the concept for this dialogue and for volunteering to serve as moderator. A core group of panelists will join Peter in this series: Mark Smith of PricewaterhouseCoopers, LLP and Sheryl Flum of KPMG LLP (both of whom have previously headed the IRS Chief Counsel’s Insurance Branch), along with Susan Hotine of Scribner, Hall & Thompson, LLP and John T. Adney of Davis & Harman, LLP. Susan, John and Peter were all active in the legislative process “in the beginning”—during the enactment of the Tax Reform Act of 1984.

Peter Winslow: I am pleased to serve as a moderator of this dialogue on the general topic of deference to the NAIC in the federal income taxation of life insurance companies. This first part will focus on tax reserves. It seems to me that there are two major issues on tax reserves for our panelists to discuss. The first is the basic question of what types of liabilities are deductible on a reserve basis, and what role NAIC guidance has in answering that question. Once we determine what type of liability is deductible as a tax reserve, the second issue becomes how much is deductible. And, who gets to decide—the taxpayer, the NAIC, the state regulator, or the IRS? What I would like to do is organize our discussion into three sections. First, we can set the general rules by describing how the Tax Reform Act of 1984 dealt with tax reserves and deference to the NAIC. Then, we can move into a discussion of how the case law and IRS rulings have dealt with the deference issue since 1984. And, finally, we can speculate on where we may be heading on the NAIC deference issue in the future.

Before I turn it over to the panelists, I want to take a few minutes to set the stage on the state of the tax law before the 1984 Tax Act. Under the Life Insurance Company Income Tax Act of 1959, there were two Code sections that were most relevant on the question of what type of reserve was deductible. Former section 810(c) was much like current section 807(c) and listed the deductible tax reserves.

On the NAIC deference question, the pre-1984 law was somewhat of a mixed bag. On the one hand, the deductible reserve items could be considered terms of art used in NAIC accounting—so, to the extent Congress intended the NAIC’s understanding of these terms of art to apply, there was some deference to how the NAIC characterized a particular reserve. On the other hand, the case law and IRS rulings placed a gloss on the statute to permit a deduction for only “insurance reserves,” as opposed to surplus or contingency reserves.