SECTION 2. BACKGROUND

.01 CAMT under the Inflation Reduc- tion Act .

(1) Overview . Section 10101 of the IRA amended § 55 to impose the new CAMT based on the “adjusted financial statement income” (AFSI) of an applicable corpora­ tion for taxable years beginning after De­ cember 31, 2022. In general, a corporation is an applicable corporation subject to the CAMT for a taxable year if it meets an average annual AFSI test for one or more taxable years that (i) are before that tax­ able year and (ii) end after December 31, 2021. See section 2.01 of Notice 2023-7 for a general description of the CAMT.

(2) AFSI under § 56A . (a) General definition of AFSI . For pur­ poses of §§ 55 through 59, the term AFSI

1 Unless otherwise specified, all “section” or “§” references are to sections of the Code.

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(15) authorizes the Secretary to issue reg­ ulations or other guidance to provide for such adjustments to AFSI as the Secretary determines necessary to carry out the pur­ poses of § 56A, including adjustments to AFSI to prevent the omission or duplica­ tion of any item.

(g) General authority of the Secretary . Section 56A(e) authorizes the Secretary to provide such regulations and other guidance as necessary to carry out the purposes of § 56A, including regulations and other guidance relating to the effect of the rules of § 56A on partnerships with in­ come taken into account by an applicable corporation.

.02 Variable Contracts under § 817 and Similar Contracts .

(1) Variable contracts accounted for under § 817 . Some insurance companies issue variable contracts (as defined in § 817(d)). In general, variable contracts are life insurance and annuity contracts under which the amount of the insur­ ance company’s obligation depends, at least in part, on the value of the assets held in a separate account that is segre­ gated from the general asset accounts of the insurance company. Provided certain requirements are met, under § 817(c), an insurance company that issues variable contracts (as defined in § 817(d)) must separately account for the various income, exclusion, deduction, asset, reserve, and other liability items properly attributable to such variable contracts. As a general matter, § 807 provides that increases in the life insurance reserves of a life insurance company are deductible and decreases in the life insurance reserves are includible in income. However, § 817(a) provides that for purposes of determining the net decrease or increase in reserves under § 807(a) or (b), amounts subtracted from or added to separate account reserves by reason of the depreciation or appreciation of separate account assets (whether or not realized) are disregarded. Under § 817(a), deductions for items described in § 805(a) (1) and (6), which include claims and ben­ efits accrued and losses incurred during the taxable year on insurance and annui­ ty contracts, are similarly adjusted for the depreciation or appreciation of separate account assets. Additionally, § 817(b) pro­ vides that the basis of each separate ac­ count asset is decreased by the amount of

depreciation, or increased by the amount of appreciation, of separate account assets (whether or not realized), to the extent separate account reserves are adjusted for such depreciation or appreciation under § 817(a). Generally, the result is a perma­ nent elimination of any effects on compa­ ny-level taxable income that would other­ wise result from the change in the value of the separate account assets.

(2) Contracts similar to variable con- tracts . Like variable contracts accounted for under § 817, the value of certain oth­ er contracts similarly depends directly, at least in part, on the value of the assets supporting those contracts.

(a) Closed block contracts . When a mutual insurance company engages in a “demutualization” process to convert to a stock insurance company, the company may create a “closed block” for the benefit of holders of certain insurance contracts issued by the mutual insurance company. Generally, when a closed block is creat­ ed, the company allocates assets to the closed block in an amount such that the assets, together with future revenue from the closed block, are expected to provide sufficient cash flow for future policy ben­ efits, certain expenses, and policyholder dividends determined in a manner consis­ tent with the manner in which they were determined prior to the demutualization. The closed block assets and the revenue from the closed block benefit only holders of the policies in the closed block.

(b) Other similar contracts . A for­ eign insurance company may issue con­ tracts that are regulated as life insurance or annuity contracts in the jurisdiction in which they are issued and for which the insurance company’s obligations to the contract holders (and the company’s corresponding reserves) must reflect (in whole or in part) the change in the value of a designated pool of investments sup­ porting the contract.

(3) U.S. GAAP and IFRS accounting for variable contracts and similar con- tracts . The contracts described in sections 2.02(1), 2.02(2)(a), and 2.02(2)(b) of this notice generally have the same accounting treatment under U.S. generally accepted accounting principles (U.S. GAAP) and international financial reporting standards (IFRS). For example, under an AFS pre­ pared according to either U.S. GAAP or

IFRS, unrealized gain or loss on the sup­ porting assets is included in the net income or loss set forth on the AFS, and there is an offsetting adjustment to certain liabil­ ities to reflect the resulting change in the company’s contractual obligations to con­ tract holders, which is also included in the net income or loss set forth on the AFS. However, unrealized gain or loss on some categories of the supporting assets, but not the offsetting adjustment to liabilities, is required to be disregarded under § 56A(c) (2)(C) or (D)(i) for purposes of determin­ ing AFSI, resulting in a mismatch that could significantly overstate or understate AFSI relative to taxable income.

.03 Funds Withheld Reinsurance and Modified Coinsurance Agreements .

(1) Overview . Insurance companies regularly engage in reinsurance transac­ tions in which one insurance company transfers all or part of its risk under an insurance contract to another insurance company. The insurance company that issues the underlying insurance contract and transfers the risk is called the ceding company, and the insurance company to which the risk is transferred is called the reinsurer. If the reinsurer in turn transfers all or part of the reinsured risk to another reinsurer, the transaction is called a retro­ cession.

(2) Funds withheld reinsurance and modified coinsurance agreements . In a conventional reinsurance transaction, the ceding company transfers to the reinsur­ er both the risk of the reinsured business (represented by the reserves) and the assets supporting the reserves. In funds withheld reinsurance and modified co­ insurance agreements, from a legal title and financial accounting perspective, the ceding company retains the supporting assets (Withheld Assets) as security for the reinsurer’s obligations under the re­ insurance agreement. See Credit for Re­ insurance Model Law (MO-785), NAIC Model Laws, Regulations, Guidelines, & Other Resources, § 3 (2019). The ceding company records a liability (Withheld As­ sets Payable) to the reinsurer to reflect the assets it has retained. Under U.S. GAAP and IFRS, the unrealized gains and losses from certain of the Withheld Assets are generally accounted for as part of the ced­ ing company’s OCI. However, any relat­ ed change in the Withheld Assets Payable,

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which is generally equal to the unrealized gains and losses included in OCI, is ac­ counted for as part of the net income or loss of the ceding company, as set forth in the ceding company’s AFS, and is not off­ set by the unrealized gains and losses that are included in OCI. The reinsurer has a corresponding asset (Withheld Assets Receivable) and the unrealized gains and losses on the Withheld Assets are general­ ly accounted for as part of the net income or loss of the reinsurer that is set forth on the reinsurer’s AFS. Financial accounting guidance states that the ceding company’s Withheld Assets Payable and the reinsur­ er’s Withheld Assets Receivable include an embedded derivative. See, for example, FASB ASC paragraphs 815-15-55-107 to 109. The Treasury Department and the IRS understand that, in some circumstances, each of the ceding company and the rein­ surer may be able to make certain types of “fair value” elections for AFS purpos­ es to change the accounting treatment of one or more items relevant to its funds withheld reinsurance or modified coinsur­ ance agreement such that both offsetting items related to the unrealized change in Withheld Assets value run through OCI or both run through the net income or loss set forth on the AFS. For example, under U.S. GAAP, the ceding company may be able to make a “fair value option” election that would move the unrealized gains or losses on certain of the Withheld Assets into the net income or loss set forth on its AFS, which would offset the changes in its Withheld Assets Payable to the rein­ surer that are reflected in the net income or loss set forth on the ceding company’s AFS. However, such fair value elections may be made only at the time a relevant asset is acquired or when the reinsurance agreement is entered into and also may be undesirable for business reasons.

.04 Respecting Congressional “Fresh Start” Basis Rules .

(1) Section 177 of the Deficit Re­ duction Act of 1984 (1984 Act), Public Law 98-369, 98 Stat. 494, 709 (1984), amended § 303(d) of the Federal Home Loan Mortgage Corporation Act (then 12 U.S.C. 1452(d)) to repeal the exemp­ tion “from all taxation now or hereafter imposed by the United States” (includ­ ing taxation under subtitle A of the Code

(subtitle A)) for the Federal Home Loan Mortgage Corporation, effective January 1, 1985. Section 177(d)(2)(A) of the 1984 Act provides special rules for determining the adjusted basis of any asset of the Fed­ eral Home Loan Mortgage Corporation held on January 1, 1985, for purposes of determining any gain or loss under sub­ title A. Section 177(d)(2)(B) of the 1984 Act provides special rules for determining the adjusted basis of certain tangible de­ preciable property held by Federal Home Loan Mortgage Corporation on January 1, 1985. (2) Section 1012(a) of the Tax Reform Act of 1986 (1986 Act), Public Law 99514, 100 Stat. 2085, 2390-94 (1986), add­ ed § 501(m) to the Code, which generally provides that an organization described in § 501(c)(3) or (4) is exempt under § 501(a) from taxation under subtitle A only if no substantial part of its activities consists of providing “commercial-type insurance” (as defined in § 501(m)(3)). As a result of § 1012(a), “existing Blue Cross or Blue Shield organizations” (as defined in § 833(c)(2)) lost their Federal income tax exemption (subtitle A exemp­ tion). Section 1012(c)(1) provides that the amendments made by § 1012 of the 1986 Act were effective for taxable years begin­ ning after December 31, 1986. In the case of any existing Blue Cross or Blue Shield organization, § 1012(c)(3) of the 1986 Act provided that for purposes of determining gain or loss under subtitle A, the adjusted basis of any asset held on the first day of its first taxable year beginning after De­ cember 31, 1986, was treated as equal to the asset’s fair market value on such day.

In addition, § 1012(c)(4)(A) and (B) of the 1986 Act provided that the amend­ ments made by § 1012 of the 1986 Act did not apply to repeal the subtitle A exemp­ tion with respect to the pension businesses of Mutual of America and the Teachers Insurance Annuity Association-College Retirement Equities Fund (pension busi­ ness entities). For this purpose, “pension business” was defined as the administra­ tion of any plan described in § 401(a) that includes a trust exempt from tax under § 501(a), any plan under which amounts are contributed by an individual’s em­ ployer for an annuity contract described in § 403(b), any individual retirement plan described in § 408, and any eligi­

ble deferred compensation plan to which § 457(a) applies.

(3) Section 1042(a) of the Taxpayer Relief Act of 1997 (1997 Act), Public Law 105-34, 111 Stat. 788, 939 (1997), termi­ nated the subtitle A exemption provided under § 1012(c)(4)(A) and (B) of the 1986 Act for the pension business of each pen­ sion business entity for any taxable year beginning after December 31, 1997. In the case of a pension business entity that, under § 501(m), became subject to taxa­ tion under subtitle A solely by reason of § 1042(a) of the 1997 Act, § 1042(b)(2) of the 1997 Act provided that for purposes of determining gain or loss under subtitle A, the adjusted basis of any asset held on the first day of its first taxable year beginning after December 31, 1997, was treated as equal to its fair market value on such day.

.05 Additional Defined Terms . For pur­ poses of this notice:

(1) Covered Insurance Company . The term Covered Insurance Company means (i) a company subject to tax under sub­ chapter L of the Code or (ii) a foreign company that is subject to regulation as an insurance (or reinsurance) company by its home country and is licensed, authorized, or regulated by the applicable insurance regulatory body for its home country to sell insurance, reinsurance or annuity con­ tracts.

(2) Covered Variable Contract . The term Covered Variable Contract means a contract described in section 2.02(1), sec­ tion 2.02(2)(a), or section 2.02(2)(b) of this notice.

(3) Covered Investment Pool . The term Covered Investment Pool means a pool of investment assets designated to support one or more Covered Variable Contracts.

(4) Covered Obligations . The term Covered Obligations means the financial accounting liabilities, including contract reserves and claims or benefits payable, that reflect a Covered Insurance Compa­ ny’s obligations under one or more Cov­ ered Variable Contracts and are taken into account in determining Net Income.

(5) Covered Reinsurance Agreement . The term Covered Reinsurance Agree- ment means a funds withheld reinsurance or modified coinsurance agreement de­ scribed in section 2.03(2) of this notice and any retrocession of all or part of the risk under such agreement.

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(6) Fresh Start Entity . The term Fresh Start Entity means any formerly tax-ex­ empt entity the repeal of whose subtitle A exemption is described in section 2.04(1) through (3) of this notice.

(7) Net Income . The term Net Income means the net income or loss as set forth on the AFS.