LMSB Control No.: LMSB-04-0308-010
Impacted IRM 4.42.4
April 22, 2008
MEMORANDUM FOR INDUSTRY DIRECTORS
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
DIRECTOR, INTERNATIONAL COMPLIANCE STRATEGY AND
POLICY
FROM: Walter L. Harris /s/ Walter L. Harris
Industry Director
Financial Services
SUBJECT: Examination of Dividends Received Deduction on Separate Accounts
of Life Insurance Companies
Introduction:
In an effort to effectively utilize resources, this Directive provides Agents guidance in the examination of the Dividends Received Deduction (DRD) incurred in connection with separate accounts of Life Insurance companies.
Life Insurance companies get a tax deduction for the increase of reserves. Correct determination of the amount of dividends subject to DRD would ensure that a Life Insurance company does not realize double benefits by deducting part of investments earnings credited to the policyholders that have already been deducted through the increase in reserves. Required interest is one of the components of the formula used to determine policyholders’ share of net investment income which is not eligible for the DRD.
Revenue Ruling 2007-54; 2007-38 I.R.B. 604, released on August 16, 2007, in part addressed the interest rate used under § 812(b)(2) to calculate required interest on the reserves held in the separate account of Life Insurance companies. However, the Revenue Ruling was subsequently suspended and taxpayers were informed that the issues considered in the Revenue Ruling would more appropriately be addressed by Regulations (Revenue Ruling 2007- 61; 2007-42 I.R.B. 799). The Regulations project was added to the 2007-2008 Priority Guidance Plan.
The DRD on separate accounts of Life Insurance companies issue is not a mandatory examination item but it should be considered in the auditors’ Risk Analysis. If the Risk Analysis indicates that this issue is material, it should be developed. Although this issue may be raised under existing Code provisions (i.e. §§ 807 and 812(b)(2)), agents may not apply Revenue Ruling 2007-54, which has been suspended. This Directive is intended to provide planning guidance and audit techniques to ensure consistent audit treatment.
This Directive reflects a management decision to balance resources and workload priorities. This Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.
Discussion:
In general, under § 243 through § 246, a corporation is allowed a deduction for all or specified portion of dividends received from other corporations. The same DRD rules apply to Life Insurance companies, however, they are modified under § 805(a)(4). Life Insurance companies might realize double benefits if the company receives the full deduction associated with the reserve increase and a simultaneous tax benefit associated with the policyholder share of the DRD. To prevent the double benefit, § 805(a)(4)(A)(ii) limits the DRD to the Life Insurance Company’s Share of investment income. The policyholders’ share of investment income is not eligible for DRD.
Internal Revenue Code § 812 includes a formula for allocating investment income between the company’s share and the policyholders’ share for the purposes of DRD. This formula is commonly referred to as a proration. The Company’s and the policyholders’ share percentage must be calculated independently for the General and Separate accounts.
A separate (or segregated) account is sponsored by a Life Insurance company and, in substance, is an investment funding mechanism. Assets held in separate accounts are legally segregated for the benefit of particular policyholders. These accounts invest in securities that may be paying dividends eligible for 70% - 80% of DRD for Federal Income tax. A general account represents all assets of the insurer that are available to satisfy its overall obligations. It does not include any Separate account assets.
The Life Insurer’s share of net investment income attributable to assets held in segregated accounts is calculated by subtracting the required interest for such contracts from investment income. Under § 812(b)(2), required interest on reserves generally is determined using the greater of the prevailing State assumed interest rate (PSAIR) or the applicable Federal interest rate (AFR) if such rate is used in determining reserves for the contract. See § 812(b)(2)(A); Rev. Rul. 2003-120; 2003-2 C. B. 1154. The audit techniques discussed below may assist the agent in determining whether the rate used by a particular taxpayer in computing the required interest under § 812 is, in fact, PSAIR or AFR.
Audit Techniques:
In making a decision on whether to pursue the DRD on separate account issue, examiners should consider a number of factors. Materiality is a key factor in making this determination. If the Risk Analysis indicates that this issue is material, it should be developed. An Information Document Request (IDR) may be issued that contains the items listed in Attachment 1. The information should be requested only to the extent it has not been otherwise provided by the taxpayer:
If the responses to the questions listed in Attachment 1 indicate that the applicable reserve method for variable life or variable annuity contracts is the reserve computed under section 807(d)(2) and/or that required interest for separate accounts may need to be recomputed, an additional IDR may be issued requesting the information that is listed in Attachment 2.
Required interest/policy interest may then be recomputed using the formula specified in Revenue Ruling 2003-120. If in the original calculations that support the numbers shown on Form 1120-L as filed, the required interest is understated, the company’s benefits associated with the DRD may have been overstated.
The Field should ensure appropriate communication and collaboration with Local Counsel. The assistance of LMSB Life Insurance actuaries may be beneficial.
Please contact Anna Petinova, LMSB Life Insurance Technical Advisor at (212) 719-6203 and/or Diane Helfgott, LMSB Life Insurance Industry Counsel, at (973) 645-2572, if you have any questions.
Attachments (2)
cc: Commissioner, LMSB
Deputy Commissioner, LMSB
Deputy Commissioner, International
Division Counsel, LMSB
Commissioner, SBSE
Chief, Appeals
Director, Planning, Quality, Analysis and Support
ATTACHMENT TO INDUSTRY DIRECTIVE - EXAMINATION OF DIVIDENDS RECEIVED DEDUCTION ON SEPARATE ACCOUNTS OF LIFE INSURANCE COMPANIES.
ATTACHMENT 1.
Guideline for an Information Document Request (IDR)
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With respect to the separate accounts (green statement blanks) for each year under audit, please provide the statutory reserves and corresponding tax reserves, account values and cash values. Such information should be provided separately for all variable life and variable annuity contracts.
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Please identify the nature, amount, and statement location (general account blue blank or the green blank) of any additional statutory variable contract reserves (i.e., fixed account reserves, reserves in excess of cash values, reserves for a guaranteed minimum death benefit (GMDB), a guaranteed minimum withdrawal benefit (GMWB), a guaranteed income benefit (GIB) or a combination of such benefits) and the corresponding tax reserves that are held for each year under audit.
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Provide a sample reserve computation, separately for a variable life and variable annuity contract, showing all details of how the statutory and tax reserves were computed and the corresponding account values and cash values.
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If not already provided on Forms 1120-L, Schedule F, Line 32, indicate the company share percentages of net investment income separately for the general and separate accounts. Please compute the aggregate company share percentage for the separate accounts if it has not already been computed.
ATTACHMENT TO INDUSTRY DIRECTIVE - EXAMINATION OF DIVIDENDS RECEIVED DEDUCTION ON SEPARATE ACCOUNTS OF LIFE INSURANCE COMPANIES.
ATTACHMENT 2.
Guideline for an Information Document Request (IDR)
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With respect to the separate accounts tax reserve for each year under audit, please provide a listing of tax reserves by issue year showing the corresponding interest rates used under section 807(d) for each issue year.
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