Internal Revenue Bulletin: 2008-15 |
April 14, 2008 |
Diversification Requirements for Variable Annuity, Endowment, and Life Insurance Contracts
Table of Contents
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
This document contains final regulations concerning the diversification requirements of section 817(h) of the Internal Revenue Code (Code). The regulations expand the list of holders whose beneficial interests in an investment company, partnership, or trust do not prevent a segregated asset account from looking through to the assets of the investment company, partnership, or trust, to satisfy the requirements of section 817(h). The regulations also remove the sentence in §1.817-5(a)(2) that provides that the payment required to remedy an inadvertent diversification failure must be based on the tax that would have been owed by the policyholders if they were treated as receiving the income on the contract. The regulations affect insurance companies that issue variable contracts and affect policyholders who purchase such contracts.
Section 817(d) defines a variable contract for purposes of part I of subchapter L of the Code (sections 801-818). For a contract to be a variable contract, it must provide for the allocation of all or a part of the amounts received under the contract to an account that, pursuant to state law or regulation, is segregated from the general asset accounts of the issuing insurance company. In addition, for a life insurance contract to be a variable contract, it must qualify as a life insurance contract for Federal income tax purposes, and the amount of the death benefits (or the period of coverage) must be adjusted on the basis of the investment return and the market value of the segregated asset account; for an annuity contract to be a variable contract, it must provide for the payment of annuities, and the amounts paid in, or the amount paid out, must reflect the investment return and the market value of the segregated asset account; for a contract that provides funding of insurance on retired lives to be a variable contract, the amounts paid in, or the amounts paid out, must reflect the investment return and the market value of the segregated asset account.
Section 817(h)(1) provides that a variable contract that is based on a segregated asset account is not treated as an annuity, endowment, or life insurance contract unless the segregated asset account is adequately diversified in accordance with regulations prescribed by the Secretary. If a segregated asset account is not adequately diversified for a calendar quarter, then the contracts supported by that segregated asset account are not treated as annuity, endowment, or life insurance contracts for that period and subsequent periods, even if the segregated asset account is adequately diversified in those subsequent periods. Under §1.817-5(a), if a segregated asset account is not adequately diversified, income earned by that segregated asset account is treated as ordinary income received or accrued by the policyholders. Section 1.817-5(a)(2) provides conditions an issuer of a variable contract must satisfy in order to correct an inadvertent failure to diversify. Rev. Proc. 92-25, 1992-1 C.B. 741, see §601.601(d)(2) of this chapter, sets forth in more detail the procedure by which an issuer may request the relief described in §1.817-5(a)(2).
Congress enacted the diversification requirements of section 817(h) to “discourage the use of tax-preferred variable annuity and variable life insurance primarily as investment vehicles.” H.R. Conf. Rep. No. 98-861, at 1055 (1984). In section 817(h)(1), Congress granted the Secretary broad regulatory authority to develop rules to carry out this intent. Congress directed that these standards be imposed because “by limiting a customer’s ability to select specific investments underlying a variable contract, [adequate diversification] will help ensure that a customer’s primary motivation in purchasing the contract is more likely to be the traditional economic protections provided by annuities and life insurance.” S. Prt. 98-169, Vol. I at 546 (1984). A primary directive from Congress to Treasury in enacting the standards was to “deny annuity or life insurance treatment for investments that are publicly available to investors.” H.R. Conf. Rep. No. 98-861, at 1055 (1984).
Section 817(h)(4) provides a look-through rule under which taxpayers do not treat the interest in a regulated investment company (RIC) or trust as a single asset of the segregated asset account but rather apply the diversification tests by taking into account the assets of the RIC or trust. Section 817(h) further provides that the look-through rule applies only if all of the beneficial interests in a RIC or trust are held by one or more insurance companies (or affiliated companies) in their general account or segregated asset accounts, or by fund managers (or affiliated companies) in connection with the creation or management of the RIC or trust.
Under §1.817-5(f)(1), if look-through treatment is available, a beneficial interest in a RIC, real estate investment trust, partnership, or trust that is treated under sections 671 through 679 as owned by the grantor or another person (“investment company, partnership or trust”) is not treated as a single investment of a segregated asset account for purposes of testing diversification. Instead, a pro rata portion of each asset of the investment company, partnership, or trust is treated as an asset of the segregated asset account. Section 1.817-5(f)(2)(i) provides that the look-through rule applies to any investment company, partnership, or trust if (1) all the beneficial interests in the investment company, partnership, or trust are held by one or more segregated asset accounts of one or more insurance companies; and (2) public access to the investment company, partnership, or trust is available exclusively through the purchase of a variable contract (except as otherwise permitted in §1.817-5(f)(3)).
Under §1.817-5(f)(3), look-through treatment is not prevented by reason of beneficial interests in an investment company, partnership, or trust that are
(1) Held by the general account of a life insurance company or a corporation related to a life insurance company, but only if the return on such interests is computed in the same manner as the return on an interest held by a segregated asset account is computed, there is no intent to sell such interests to the public, and a segregated asset account of such life insurance company also holds or will hold a beneficial interest in the investment company, partnership, or trust;
(2) Held by the manager, or a corporation related to the manager, of the investment company, partnership or trust, but only if the holding of the interests is in connection with the creation or management of the investment company, partnership or trust, the return on such interest is computed in the same manner as the return on an interest held by a segregated asset account is computed, and there is no intent to sell such interests to the public;
(3) Held by the trustee of a qualified pension or retirement plan; or
(4) Held by the public, or treated as owned by the policyholders pursuant to Rev. Rul. 81-225, see §601.601(d)(2) of this chapter, but only if (A) the investment company, partnership or trust was closed to the public in accordance with Rev. Rul. 82-55, 1982-1 C.B. 12, see §601.601(d)(2) of this chapter, or (B) all the assets of the segregated asset account are attributable to premium payments made by policyholders before September 26, 1981, to premium payments made in connection with a qualified pension or retirement plan, or to any combination of such premium payments.
On July 31, 2007, the Treasury Department and the IRS published a notice of proposed rulemaking (REG-118719-07, 2007-37 I.R.B. 593) under section 817 in the Federal Register (72 FR 41651). The proposed regulations would expand the list of holders whose beneficial interests in an investment company, partnership, or trust do not prevent a segregated asset account from looking through to the assets of the investment company, partnership, or trust, to satisfy the requirements of section 817(h). The proposed regulations also would remove the sentence in §1.817-5(a)(2) that provides that the payment required to remedy an inadvertent diversification failure must be based on the tax that would have been owed by the policyholders if they were treated as receiving the income on the contract. One written comment was received in response to the notice of proposed rulemaking, and no public hearing was requested or held. After consideration of the comment, the proposed regulations are adopted as final regulations with the change discussed below.
The regulations remove the sentence in §1.817-5(a)(2) that provides that the payment required to remedy an inadvertent diversification failure must be based on the tax that would have been owed by the policyholders if they were treated as receiving the income on the contract.
The commentator supports the removal of the sentence. The commentator also suggested that the correction procedures under section 817(h) should be modified to (1) provide flexibility to more appropriately address various fact patterns, (2) encourage taxpayers to establish compliance practices and procedures, (3) promote compliance by providing limited fees for voluntary corrections, (4) provide for fees and sanctions in graduated steps to ensure that there is always an incentive for prompt correction, and (5) provide for sanctions that are reasonable in light of the nature, extent, and severity of the violation. The Treasury Department and the IRS will consider these comments in the course of evaluating what steps, if any, to take in response to submissions received concerning correction procedures more generally under Notice 2007-15, 2007-7 I.R.B. 503 (February 12, 2007).
The regulations expand the list of permitted investors in §1.817-5(f)(3) to include (i) qualified tuition programs as defined in section 529, (ii) trustees of pension or retirement plans established and maintained outside of the United States primarily for the benefit of individuals substantially all of whom are nonresident aliens, and (iii) an account which, pursuant to Puerto Rican law or regulation, is segregated from the general asset accounts of the life insurance company that owns the account, provided the requirements of section 817(d) and (h) are satisfied.
The commentator supports such an expansion of the list of permitted investors and urged that the list be further expanded to include segregated asset accounts of any foreign insurer that makes an election under section 953(d) to be treated as a domestic corporation for U.S. tax purposes. A general rule to this effect would be beyond the scope of the proposed regulations and may require a more specific examination of the manner in which such accounts are segregated under the applicable foreign law. Accordingly, such an expansion is not provided in these regulations, but the Treasury Department and IRS will consider the issue for possible future published guidance.
The commentator also urged that guidance is needed concerning (1) what steps must be taken to verify that an entity is a permitted investor, and (2) what happens if, despite verification efforts, the entity in question was never a permitted investor or subsequently loses its status as such. The Treasury Department and IRS are aware of this issue, but have concluded it is beyond the scope of the proposed regulations and at this time might better be addressed by Internal Revenue Bulletin guidance or by letter ruling. Accordingly, the issue is not addressed in these final regulations, but the Treasury Department and IRS will consider the issue for possible future published guidance.
Finally, the commentator suggested that the language of the amendment that expands the list of permitted investors to include certain Puerto Rican accounts should be clarified to eliminate confusion. Specifically, in the notice of proposed rulemaking, the proviso clause of the amendment stated that such an account will be a permitted investor “provided the requirements of section 817(d) and (h) are satisfied.” The commentator expressed concern that the language of the amendment as written in the notice of proposed rulemaking could be read to present an issue of circularity (that is, to be a permitted investor, the account must satisfy section 817(h), but to satisfy section 817(h), the account must be a permitted investor.) To eliminate this potential confusion, the final regulations state that, solely for purposes of §1.817-5(f)(3)(vi), the requirement under section 817(d)(1) that the account be segregated pursuant to State law or regulation shall be disregarded and §1.817-5(f)(1) shall be applied without regard to the Puerto Rican segregated asset account.
It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding this regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.
Accordingly, 26 CFR part 1 is amended as follows:
Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.817-5 also issued under 26 U.S.C. 817(h).
Par. 2. Section 1.817-5 is amended as follows:
1. The last sentence of paragraph (a)(2)(iii) is removed.
2. Paragraph (f)(3)(iii) is revised.
3. Paragraph (f)(3)(iv) is redesignated as paragraph (f)(3)(vii).
4. New paragraphs (f)(3)(iv) through (vi) are added.
The revisions and additions read as follows:
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(f) * * *
(3) * * *
(iii) Held by the trustee of a qualified pension or retirement plan;
(iv) Held by a qualified tuition program as defined in section 529;
(v) Held by the trustee of a pension plan established and maintained outside of the United States, as defined in section 7701(a)(9), primarily for the benefit of individuals substantially all of whom are nonresident aliens, as defined in section 7701(b)(1)(B);
(vi) Held by an account which, pursuant to Puerto Rican law or regulation, is segregated from the general asset accounts of the life insurance company that owns the account, provided the requirements of section 817(d) and (h) are satisfied. Solely for purposes of this paragraph (f)(3)(vi), the requirement under section 817(d)(1) that the account be segregated pursuant to State law or regulation shall be disregarded and §1.817-5(f)(1) shall be applied without regard to the Puerto Rican segregated asset account; or
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Linda E. Stiff,
Deputy Commissioner for
Services and Enforcement.
Approved February 29, 2008.
Eric Solomon,
Assistant Secretary of
the Treasury (Tax
Policy).
Note
(Filed by the Office of the Federal Register on March 6, 2008, 8:45 a.m., and published in the issue of the Federal Register for March 7, 2008, 73 F.R. 12263)
The principal author of these final regulations is James Polfer, Office of the Associate Chief Counsel (Financial Institutions and Products), Internal Revenue Service. However, personnel from other offices of the Treasury Department and the IRS participated in their development.
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