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AALU INSIGHTS

Obama Budget Targets Coli And Drd

Key life insurance tax provisions are again included in President Barack Obama's budget. The AALU has and continues to oppose these proposals-namely the COLI interest deduction and life insurance dividends received deduction (DRD) provisions.

Expansion of Interest Expense Disallowance for COLI Policies

Treasury Department Description/ Reasons for Proposal: Interest on policy loans or other indebtedness with respect to life insurance, endowment or annuity contracts generally is not deductible, unless the insurance contract insures the life of a key person of the business (defined to include a 20 percent owner of the business, as well as a limited number of the business' officers or employees). This interest disallowance rule applies to businesses only to the extent that the indebtedness can be traced to a life insurance, endowment or annuity contract. Because of Treasury Department concerns that highly leveraged businesses can find ways to circumvent these rules, the proposal would repeal the exception from the pro rata interest expense disallowance rule for contracts covering employees, officers or directors, other than 20 percent owners of a business who are the owners or beneficiaries of the contracts.

AALU/Industry Analysis: As the AALU and the broader life insurance industry have pointed out, Congress reviewed the use and tax treatment of COLI extensively between 2003 and 2006. The result was a bipartisan codification of COLI Best Practices in the Pension Protection Act of 2006, which reaffirmed that COLI is an important tool for American businesses and that the tax treatment of COLI is appropriate so long as businesses comply with the provisions in the law. Under current rules, such interest is generally not deductible if the business borrows directly from a policy, pledges the policy as collateral, or if there is any demonstrable connection between the decision to purchase life insurance and the decision to borrow and deduct interest and there is no information that would suggest that businesses are evading current rules.

Most businesses do not have any incentive to place more in life insurance than they need for protection and financing of employee benefits because every dollar they place in life insurance is not available to invest in business operations. Under interagency rules set forth in "OCC Bulletin 2004-56," the OCC, FDIC, Federal Reserve and the OTS specifically provide that national banks and federal savings associations "may not purchase life insurance… for speculation or… to generate funds for normal operating expenses other than employee compensation and benefits" and "may not hold life insurance in excess of their risk of loss or cost to be covered."

Finally, the Treasury proposal would even disallow interest where it is very clear that the borrowing has no relationship to the life insurance. For example, if a life insurance policy was taken out today by a corporation to fund employee benefits and 15 years from now the corporation took out a loan to build a new business facility, the pro rata interest disallowance proposal would still impose a tax penalty due to the unrelated life insurance holdings.

Proposal to Modify Dividends Received Deduction for Life Insurance Company Separate Accounts

Treasury Department Description and Reasons for Proposal: Corporate taxpayers, including life insurance companies, generally qualify for a dividends received deduction (DRD) from dividends received from other domestic corporations, in order to prevent or limit double taxation of the same income by more than one corporation. However, for life insurance companies, the DRD is permitted only for the "company's share" of dividends received, because some portion of the company's dividend income is used to fund tax-deductible reserves for its obligations to policyholders. The Treasury is concerned that there may be some circumstances in which a company's share of the DRD greatly exceeds the company's economic interest in the net investment income earned by its separate account assets, which, in turn, generates controversy between life insurance companies and the IRS.

Under the proposal, the general account DRD, tax-exempt interest and increases in certain policy cash values of a life insurance company would be subject to a fixed 15 percent proration in a manner similar to that which applies under current law to non-life insurance companies. The limitations on the DRD that apply to other corporate taxpayers would be expanded to apply explicitly to life insurance company separate account dividends in the same proportion as the mean of reserves bears to the mean of total assets of the account.

AALU/Industry Analysis: The AALU, in conjunction with the broader life insurance industry, has pointed out that many families, especially among the farming and small business communities, turn to annuities, variable annuities and variable life insurance products as a means to protect their retirement security. There are already restrictions on the DRD, and the industry opposes the proposal because changing the longestablished rules for the DRD would result in additional costs due to higher taxes being passed on to policyholders, depressing the value of their retirement security products.

In Hunt for Revenue, Congress Targets GRATs [email protected].


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