Tax Cuts and Jobs Act – Financial reporting implications for insurance companies
Published January 25, 2018
On December 22, 2017, President Trump signed tax bill H.R.1, commonly referred to as the Tax Cuts and Jobs Act (the “Act”), into law. One of the predominant provisions in the Act was the reduction of the corporate tax rate from 35% to 21%. Corporations (which encompasses most insurance companies) are determining the impact of the Act on their 2017 U.S. GAAP and statutory financial statements as part of their year-end closing and reporting process. There are three significant impacts for insurance companies to be aware of and include in their year-end financial statements.
Re-measurement of Deferred Taxes for 2017
FASB ASC 740 requires deferred tax liabilities and assets to be adjusted (re-measured) for the effect of a change in tax rates, with the effect included in income from continuing operations in the reporting period that includes the enactment date of the change. The enactment date of the Tax Cuts and Jobs Act was December 22, 2017, even though most of the provisions in the Act are not effective until January 1, 2018. As of December 31, 2017, companies organized as C-corporations should revalue their existing deferred tax assets or liabilities using the enacted rate of 21%, versus the previous rate of 35%. For companies in a net deferred tax asset position at December 31, 2017, this will generally result in a charge to continuing operations of 14% of the gross deferred tax asset balance (assuming no valuation allowance is recorded or required to be recorded). For companies in a net deferred tax liability position, this will result in a credit to continuing operations. The income statement impact is recorded as tax expense (or benefit).
Generally, the gross amount of deferred items will be based upon the December 31, 2017 book basis (financial statement carrying value) compared to the tax basis (which will be measured utilizing the enacted provisions of tax law in effect at December 31, 2017). Therefore, most companies are in a race to factor in and calculate the impact of the changes on the tax basis of assets and liabilities from the Act as of December 31, 2017 prior to issuing their financial statements.
Once the impact of re-measuring the deferred tax impact of the Act is determined and the change in rate (from 35% to 21%) is calculated, organizations will then need to evaluate whether or not a valuation allowance for any deferred tax assets is required. This will be based upon existing guidance under ASC 740 based upon utilizing a “more likely than not” realization threshold to determine the amount of any deferred tax assets which would require a valuation allowance under the enacted tax law provisions.
A unique consideration – “lodged” taxes in AOCI
Many companies that report financial statements under U.S. GAAP may have components that have accounting impacts which are required to be reported in Accumulated Other Comprehensive Income (“AOCI’) and Comprehensive Income (“CI”). These items currently include:
- Companies with readily marketable debt and equity securities that are classified as available for sale
- Companies with defined benefit pension plans
- Companies with foreign operations who translate those operations to U.S. dollars for financial reporting purposes, with the related translation effect recorded in AOCI
U.S. GAAP requires the above items to be reported, net of tax, in CI and ultimately included in AOCI.
As stated above, ASC 740 requires that the effect of a tax law change on deferred tax assets and liabilities be reflected in continuing operations on enactment date. Under these provisions and the related intraperiod incremental approach of recognizing tax impacts on items in AOCI, subsequent adjustments to deferred tax items originally reflected in AOCI will generally not be reflected in CI or AOCI (but instead are reflected in continuing operations). As a result of these requirements, there will be a tax effect “lodged” in AOCI (i.e. the amount of deferred tax impact included in AOCI will remain at 35%). In other words, under existing guidance, the tax effect on items in AOCI will be at the prior rates (35%), not the newly enacted rate (21%). This is a very unique situation for U.S. GAAP reporting entities. As most insurance companies carry some or all of their investment assets as “available for sale securities,” this unique “lodging effect” of deferred taxes in AOCI occurs.
An example of this situation is as follows:
Assume that an entity has a portfolio of available for sale securities comprised of stocks with a cost of $200,000 and a current fair value of $300,000. This entity would have debited the asset (stocks in this case) and credited Comprehensive Income for the unrealized gain of $100,000. This $100,000 unrealized gain would then be reported as a component of CI and ultimately AOCI, a separate component of equity. In addition, existing GAAP requires entities to tax affect the impact of items in AOCI, therefore an entry would be recorded for a deferred tax liability of $35,000 ($100,000 unrealized gain x 35%) by crediting deferred tax liability and debiting CI (which flows into AOCI). Thus the net of tax impact of the unrealized gain in CI (and ultimately AOCI) is $65,000. On December 22, assuming this is the only deferred item reflected in AOCI, an entity would revalue the deferred tax liability recorded to reflect the enacted rate, recording the related impact in continuing operations. Thus, the entity would record an entry to decrease the deferred tax liability by $14,000 (debit deferred tax liability, credit income tax provision in the income statement). As noted under ASC 740, the tax impact of the unrealized gain was not adjusted within AOCI, rather it was required to be adjusted through current operations and reflected in Net Income in the 2017 financial statements. Thus, there remains $14,000 “lodged” as a component of AOCI [$100,000 * (35% – 21%)].
Existing GAAP is silent on when and how to eliminate the tax impact lodged in AOCI. Most guidance available (non-authoritative) believes that the impact of the lodged tax effects must be eliminated when the circumstances on which it is premised cease to exist. If a disproportionate tax effect is lodged in AOCI, a tax effect may remain in AOCI even after the pretax item has been reclassified to income. In this case, the lodged effect would ordinarily clear to income from continuing operations when the circumstances on which it is premised cease to exist (i.e. the security is sold).
Because the lodged effects in AOCI were likely to cause confusion for users of U.S. GAAP financial statements, stakeholders in the banking and insurance industries raised concern with the FASB by submitting unsolicited comment letters. The FASB has responded by exposing for public comment a proposed Accounting Standards Update (“ASU”). The proposed ASU aims to simplify the accounting for lodged effects in AOCI by reclassifying the differential between the historical corporate income tax rate and the newly enacted 21% from AOCI directly to retained earnings. This would result in the elimination of the lodged effects in AOCI and improve the usefulness of the information for financial statement users. In reference to the example above, the $14,000 lodged effect would be reclassified to retained earnings (credit AOCI $14,000, debit Retained Earnings $14,000). Comments on the proposed ASU are due February 2, 2018. If adopted, the ASU would become effective for all entities for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years. Early adoption would be permitted. The amendments would be applied retrospectively to each period (or periods) in which the effect of the change in the corporate income tax rate is recognized.
Statutory Accounting and Reporting
Lastly, insurance companies will also have impacts to their statutory annual statements and audited financial statements. In comparison to the GAAP provisions as describe above, the statutory provisions are simpler. Companies will still need to re-measure their deferred taxes due to the change in enacted rates and other changes in the tax law. The differential, however, will not be recorded to the income statement. Rather, it will be recorded through the change in deferred taxes, which is a component of capital and surplus. Additionally, since CI and AOCI are not recognized by statutory accounting, the “lodging” effect described above will not apply. Under statutory accounting, unrealized capital gains and losses on stocks and certain other investments are included in surplus and shown net of deferred taxes, so any differential related to the revaluation of those items will be included in that same line item (otherwise known as backwards tracing). The Statutory Accounting Principles Working Group (SAPWG) has issued an exposure draft on the impacts and considerations for statutory filers called 2018-01 which is located at http://naic.org/cmte_e_app_sapwg.htm.
There are other unique considerations for statutory filings for Life, Health and P&C companies for 2018 tax returns and some unique considerations for their 2017 DTA admittance calculation under SSAP 101:
- For life companies, the Act no longer allows for carryback NOL’s, thus there are implications for such companies in the non-admittance test for deferred tax assets under SSAP 101.
- Life companies will also have significantly different loss reserve deductible amounts (see article on new tax basis reserve calculations) which will likely have dramatic impacts to life insurance entities’ deferred taxes.
- The small life insurance deduction tax provision was repealed.
- P&C companies will continue to be allowed to carryback their NOL’s (2-year carryback), therefore there will not be a significant impact expected on the SSAP 101 non-admittance calculation.
- AMT is no longer applicable to corporations, however AMT credits are allowed to offset future taxable income and become 100% refundable after 2021 (could have positive implications for your non-admittance test if you have deferred taxes for AMT credits).