Neal Bill: US companies use of affiliated reinsurers to avoid taxes

by Linda Beale

Neal Bill: US companies use of affiliated reinsurers to avoid taxes

US insurers are complaining about the Neal Bill, HR 3424, introduced Jul 30, 2009, which would disallow a deduction to a US company for “excess non-taxed reinsurance premiums” with respect to US risks that are “paid to affiliates” (quoted language is from the long title to the bill). The bill amends section 832 of the Code by adding a limitation on the deduction for reinsurance premiums. The limitation only applies for “excess” premiums that are paid to offshore affiliates where the money is not taxed as subpart F income or where the premiums aren’t taxed because of treaty reduction.

The US industry that has benefited from being able to deduct excessive amounts paid to affiliates is up in arms. Quelle surprise, that the corporatist community will claim that all mayhem will ensue if it loses a cherished way to reduce its corporate income tax payments. So much of the time, however, the parade of horribles is a figment of the companies’ (and their lobbyists’) imaginations.

The claim by the “risk and insurance management society (RIMS) is, of course, that the bill will hurt consumers. See Coalition for Competitive INsurance Rates, Letter to Members of Congress, June 7, 2010. The letter claims that the bill will “create a discriminatory reinsurance tax that will harm consumers.”

Funny how things that are good for the fisc and mean less profits for multinational corporations are always cast as harming consumers, as in the financial institutions’ lobbying campaign against any modification of mortgage loans in bankrupcty, which is a way to protect banks’ balance sheets and profits, but is cast as a way to protect homeowners’ ability to get mortgages. Such arguments are usually bunk. Is this one?

The letter argues that the bill will help large US insurers who don’t have overseas affiliates while hurting US insurers that do have international operations, and says that Congress should focus on making the country’s companies “more competitive” rather than taking “punitive” action. This is a typical competitiveness claim. The multinationals are claiming that they will be hurt if they are not able to take advantage of their cross-border entities to cut their federal income tax bill by moving their profits to their offshore affiliates by paying that offshore affiliate an excessive premium for covering risks. Most such “competitiveness” claims are just a different way to make the old “free market uber alles” argument–companies are saying that in order to succeed, they MUST be allowed to arrange their affairs however they see fit, especially if it means moving money offshore and avoiding federal income taxation. This kind of competitiveness argument holds no weight. It reduces to an argument that “competitiveness is important; companies that make more profits are more competitive with other companies that make more profits; since making more profits enhances competitiveness, the government should allow us to avoid taxes so that we can make more profits and enhance competitiveness.”

The companies also argue that the bill would hurt the US ability to manage risk. But look what is happening here. This is a tax imposed only when a US-based company transfers an insurance risk that it has assumed TO AN AFFILIATE that just happens to be offshore. The US company claims a deduction for the reinsurance premium (often perhaps inflated because of the failure of transfer pricing mechanisms to adequately oversee transfer pricing issues); the income of the affiliate doesn’t get taxed in the US. That is most decidedly NOT a risk transferral procedure, since the same affiliated group of companies bears the risk. It is the income that is moved to a position outside US taxation. Tax reduction, not risk reduction, is the primary impetus of the affiliate reinsurance regime.

The letter tries to make the risk reduction argument by implying that the disallowance of this tax reduction technique will keep multinational insurers out of the US market, thereby leaving more of the insurance risk held within the US. In other words, as the release by RIMS puts it, the argument is that the bill will be “a great threat to insurance capacity in the US.” There is a big stretch from disallowance of affiliated deals that reduce US taxes to undoing of the US insurance market. If the US insurers can make profits without the use of the offshore reinsurance gambit, then so can the US companies with multinational affiliates. They can continue to use unaffiliated reinsurers and deduction those premiums, just as US insurers can do. There is nothing in this deal that would stop them from being competitive with US-only insurers, and nothing that would prevent them from remaining in the market. They simply wouldn’t be able to use the extra gambit of affiliated “reinsurance” to increase their profits compared to US insurers by reducing their US tax bills. The purpose of reinsurance is to diversify risks. So while the letter cites a study claiming that the bill would reduce “reinsurance capacity” by 20% (and thus cost consumers billions), that claim is questionable since it relies on treating affiliated “reinsurance” as though it were risk-diversifying reinsurance. So the competitiveness and risk arguments both sink on the same grounds.

The letter claims that the bill is supported by US-only insurers because they “seek to gain via a protected market that would allow them to charge higher prices.” But if US companies have been able to make money even with the “competition” provided by multinationals’ ability to cut their taxes by using offshore affiliates as reinsurers, then so can the multinationals, and the competition should mean that neither increases prices.

Will there be an increase in consumer costs because the insurance multinationals cannot take advantage of offshore affiliates to evade US taxation on their US-based insurance premiums? Perhaps. We do not fully understand the incidence of taxation, so it may be that some of the tax cost will be borne by consumers as the companies attempt to maintain the same profits that were possible with the tax avoidance technique. But maybe not, since the companies, as they themselves note, will be competing with US-only companies that can only reinsure with real unaffiliated reinsurance companies. They’d have to decide that the regular US companies’ profits aren’t high enough to be worth entering the market, which seems a stretch.

The letter also claims that the bill is discriminatory to foreign reinsurers and therefore violates the WTO and treaty commitments. But there is no limitation on deduction just because a US company uses a foreign reinsurer. This bill generally limits the deduction between affiliated companies when a company in the US uses an affiliated foreign reinsurer. Regulating pricing among affiliated companies isn’t discrimination, as evidenced by the transfer pricing “clear reflection of income” standard in section 482.

[hat tip to my colleague Mike McIntyre]

Lifted from comments: As an aside, insurance contracts (as is the case of all financial transactions) are characterised by one party receiving an immediate benefit, and the other party receiving the promise of a future benefit. Allowing the party who receives the immediate benefit to reside in a different jurisdiction from the party who is supposed to receive the delayed benefit raises some interesting questions about compliance and enforcement of contracts.