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Capital Gains Realizations Unaffected by Mutuals' Deduction Reduction, Attorney Says

FEB. 22, 2000

Capital Gains Realizations Unaffected by Mutuals' Deduction Reduction, Attorney Says

DATED FEB. 22, 2000
DOCUMENT ATTRIBUTES
  • Authors
    Groom, Theodore R.
  • Institutional Authors
    Groom Law Group
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    insurance companies, life, mutual, deduction reductions
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2000-7912 (9 original pages)
  • Tax Analysts Electronic Citation
    2000 TNT 53-22

 

=============== SUMMARY ===============

 

Theodore R. Groom of Groom Law Group, Washington, has sent Treasury a copy of a memo it drafted on the relationship between section 809 and capital. Capital gains realizations by mutual life insurers, says Groom, are not at all motivated by section 809. Under most circumstances, he says, section 809 "actually weighs against capital gains realization."

 

=============== FULL TEXT ===============

 

February 22, 2000

 

 

Louise K. Epstein

 

Department of Treasury

 

Room 1006

 

1500 Pennsylvania Avenue. N.W.

 

Washington, D.C. 20220

 

 

Re: Section 809 and Capital Gains

 

 

Dear Louise:

[1] We recently discussed the relationship between section 809 and capital gains. A memorandum on this subject is enclosed. The memorandum demonstrates that capital gains realizations by mutual life insurers have been the product of normal business considerations and are not motivated -- even in small part -- by section 809. Under most circumstances the presence of section 809 actually weighs against capital gains realization. Repeal of section 809 is most likely to have no effect on capital gains realizations by mutual life insurers.

[2] Please call Matt Zinn (429-6422), John Jonas (457-5624) or me if you have any questions on this subject you wish to discuss.

Sincerely,

 

 

Theodore R. Groom

 

Groom Law Group

 

Washington, D.C.

 

 

cc: John Jonas

 

Matt Zinn

 

 

SECTION 809 AND CAPITAL GAINS

BACKGROUND

[3] Mutual life insurance companies are now seeking the repeal of section 809 of the Internal Revenue Code of 1986. While most knowledgeable tax professionals recognize that "section 809 is not a high-water mark of tax policy" (as one government expert put it), questions have arisen regarding the relation between realized capital gains and section 809. These questions are stimulated by the fact that since the mid-1980's, coincident with the enactment of section 809, mutual life insurance companies have experienced significant increases in realized capital gains. Moreover, realized capital gains have been a larger portion of mutual life insurance company earnings than of stock life insurance company earnings.

[4] These acknowledged facts have led to a number of questions. Why do mutual life insurance companies have significant capital gains? Why are capital gains of mutual life insurance a larger portion of income than capital gains of stock companies? Why were capital gains realizations included in measuring stock and mutual company earnings rates under section 809? Do mutual life insurers realize capital gains in order to reduce section 809 taxes? How will the repeal of section 809 affect capital gains realizations by mutual life insurance companies?

[5] Questions and answers are provided below that address each of these issues in detail. As the answers demonstrate, mutual companies have experienced increases in capital gains realizations for normal reasons involving the investment management of assets, and capital gains have been correctly included in measuring stock and mutual company earnings rates. Moreover, capital gains realizations are not even incidentally motivated by section 809 tax rules. We are not aware of any situation in which a company considering a transaction that would lead to the realization of capital gains has in fact done so motivated -- even in small part -- by section 809. If companies were to consider section 809 effects, however, under most circumstances they would conclude that the presence of section 809 actually weighs AGAINST capital gains realization. In summary, repeal of section 809 is most likely to have no effect on capital gains realizations by mutual life insurers, but could slightly increase such realizations.

QUESTION 1: WHY HAVE MUTUAL LIFE INSURANCE COMPANIES EXPERIENCED INCREASED REALIZATIONS OF CAPITAL GAIN INCOME?

[6] Over the last sixteen years, both stock and mutual life insurance companies have had significant capital gains income. For example, for the period 1993 - 1998, stock life insurers and mutual life insurers had net capital gains of over $20 billion and $26 billion, respectively. While these gains have been significant, their importance is frequently exaggerated by a comparison of capital gains income, undiminished by any share of corporate expenses, to net gain from operations after policyholder dividends, as shown on the annual statement. Nevertheless, as a percentage of net investment income, these gains are still significant, about 10% of investment income during recent years for mutual life insurers and about 5% for stock life insurers.

[7] There are several reasons why mutual life insurers began having significant capital gains income during the periods since section 809 was enacted. In the 1960's and 1970's, the United States experienced long periods of rising interest rates, and, consequently, the portfolios of most insurers reflected net unrealized losses, rather than gains. Since 1984, the United States has experienced a long period of generally declining interest rates that has resulted in substantial appreciation in the value of fixed income securities that are the core investment for life insurers. Also, the sustained bull market produced gains in stock and real estate holdings. In many cases, gains have been realized because life insurance company investment personnel believe that they can take advantage of inefficiencies in the bond market or that changes in stock or real estate holdings will be economically advantageous to the company. In other words, some companies pursue an active investment strategy which results naturally in the realization of accrued gains. ADDITIONALLY, A SUBSTANTIAL PORTION OF THE CAPITAL GAINS OF MANY COMPANIES HAVE BEEN REALIZED INVOLUNTARILY -- BONDS CONTAIN CALL PROVISIONS WHICH HAVE BEEN EXERCISED BY THE LENDER.

[8] There have been substantial pressures on mutual companies also to improve their capital position. Prior to 1992, bonds and mortgages were valued on annual statements at book value, and sales of these appreciated securities would strengthen the company's capital position as reported for financial purposes. While the accounting rules for fixed income securities were changed to neutralize the effects of gains realization on capital, real estate equities continue to be carried at cost, and sales of appreciated realty may improve the company's reported capital position. 1

[9] Other factors may also result in realizations. In the Tax Reform Act of 1986, Congress eliminated favorable capital gains rates for corporations effective in 1987, and this lead to substantial realizations in 1986 to take advantage of the lower rates then applicable.

[10] AN ADVANTAGE OF THE MUTUAL FORM IS THE ABILITY TO TAKE A LONGER VIEWPOINT WHICH IS REQUIRED BY INVESTMENTS IN THE EQUITY MARKET. MUTUALS HAVE BEEN REWARDED BY INVESTMENTS IN EQUITIES WHICH HAVE HISTORICALLY HAD MUCH HIGHER RETURNS THAN FIXED INCOME INVESTMENTS. A NUMBER OF THE BETTER CAPITALIZED MUTUALS HAVE INVESTED SIGNIFICANT PORTIONS OF THEIR SURPLUS IN EQUITIES, AND HAVE BEEN REWARDED BY DOING SO.

QUESTION 2: HAVE STOCK LIFE INSURERS HAD FEWER INCENTIVES TO REALIZE CAPITAL GAINS?

[11] Yes. As indicated above, stock companies have also experienced rising asset values, so that sales of securities for normal investment reasons also tend to produce gains. Nevertheless, stock companies have realized a smaller proportion of gains because they do not have the same incentives to do so and, in fact, actually have disincentives. Generally, financial analysts that evaluate market prices of investor owned stock companies do not consider capital gains and losses in evaluating earnings because of their discretionary nature. In a declining interest rate market, where bond values increase, stock company financial earnings will be improved by retaining higher yielding securities instead of realizing capital gains and reinvesting in lower yielding securities. In a rising interest rate market, the opposite is true. Stock companies are treated more favorably by financial analysts when they sell low- yielding fixed income securities at a loss, and reinvest in securities that pay higher current yields.

[12] Like mutual companies, stock companies have been concerned with improving their capital positions. However, stock companies have had less need to realize gains to improve their capital positions because they have had superior access to capital markets. Finally, the proration rules applicable to dividend income also result in smaller holdings of stock by stock life insurance companies, although not necessarily by their affiliates. 2 All of these factors combine to discourage capital gains realizations by stock companies.

QUESTION 3: WHY ARE CAPITAL GAINS REALIZATIONS INCLUDED IN MEASUREMENT OF EARNINGS RATES UNDER SECTION 809?

[13] The basic theory of section 809 was that differences between stock and mutual earnings rates could be used to measure the extent to which mutual companies were paying returns on equity to their policyholders. Mutuals were thought to have lower earnings rates because a portion of their policyholder dividends or policy benefits included a return on equity. The application of this theory required an accurate measure of stock and mutual company earnings.

[14] Accuracy requires that capital gains be included in earnings. Capital gains are not fundamentally different from other investment earnings of life insurance companies. Capital gains generally result when an asset of the company appreciates because the future earnings capacity of the asset is enhanced. Capital gains on portfolios of insurance companies occur most frequently when there is a decline in interest rates and the value of a bond in the company's portfolio rises inversely with the decline in interest rates. The company may realize the gain by selling the bond and capture immediately the value of the enhanced return, or it may retain the bond and capture the value of the retained return over time. The income from selling the bond is capital, the income from receiving the yield is ordinary income. In either case the company has received earnings, and the earnings should be included in income consistent with the underlying theory of section 809. IN SUMMARY, CAPITAL GAINS ARE PART OF THE TOTAL RETURN ON INVESTMENT, AND IT IS GENERALLY RECOGNIZED THAT TOTAL RETURN IS THE BEST MEASURE OF INVESTMENT PERFORMANCE.

[15] To this end, section 809 requires that the earnings rates be based on annual statement earnings "properly adjusted for realized capital gains. . . ." In 1985, the Treasury Department specifically ruled that realized capital gains should be included in earnings under section 809 and that has been the governing rule during the entire fifteen year history of the statute.

QUESTION 4: HOW DO CAPITAL GAINS REALIZATIONS IMPACT THE TAX LIABILITY OF A MUTUAL LIFE INSURER?

[16] For a number of reasons, a mutual life insurance company is usually worse off for tax purposes when it realizes a capital gain than if it had not done so. First, the mutual life insurance company that realizes the gain must pay a tax at the full corporate rate on the gain, whereas if the gain had not been realized, tax recognition would be deferred. Second, if the gain involves fixed income securities or real estate, the realization increases the company's equity base, thereby increasing the company's current and future section 809 tax liability. Realization of appreciated stock values tend to have more neutral effects since unrealized appreciation in stocks is already reflected in equity.

[17] Third, since the mutual earnings rate is based on weighted average earnings of all mutual companies (rather than the company's own rate), the company realizing the gain only enjoys the benefit of the increased earnings rate for purposes of section 809 to the extent of its proportionate part of tax equity of the mutual life sector. Most of the section 809 benefit from the realization will accrue to the benefit of the company's mutual company competitors. Fourth, large capital gains by the mutual sector have resulted frequently in negative recomputed differential earnings rates, and no company gets any offsetting benefit from inclusion of the gain in mutual earnings to the extent that the inclusion merely increases the negative recomputed differential earnings rate.

[18] It is sometimes suggested that mutual companies act collaboratively to reduce section 809 liabilities for the whole sector by realizing capital gains en masse. This suggestion has no foundation in fact, and is fully contradicted by economic theory. 3 However, it is demonstrable that, even if there were only a single mutual life insurance company, capital gains realizations would increase rather than decrease the company's tax liability. In such circumstances, while the increase in capital gains and the decrease in section 809 earnings would be largely offsetting, the increase in the equity base would increase mutual tax liability both in the year of sale and future years. The net effect is that the company would be better off for tax purposes if it had not realized the gain.

[19] This is illustrated by an example set forth in an attachment.

QUESTION 5: WHAT EFFECT WILL REPEAL OF SECTION 809 HAVE ON CAPITAL GAINS REALIZATIONS BY MUTUAL LIFE INSURERS?

[20] Repeal of section 809 should have no significant effect on capital gains realizations by mutual life insurers. Any possible effect will be to INCREASE capital gains realizations because the inhibiting effect of increasing the section 809 equity base will be removed.

ATTACHMENT A: EXAMPLE

[21] The relation between capital gains realization and section 809 is illustrated by the example set forth below which assumes that the universe of mutual companies consists of a single company.

BASE CASE

 

 

                      Year 1  Year 2  Year 3  Year 4  Year 5  Year 6

 

 

Statement Gains        1,500   1,500   1,500   1,500   1,500   1,500

 

Mean Equity           10,000  10,000  10,000  10,000  10,000  10,000

 

Mutual Rate           15.00%  15.00%  15.00%  15.00%  15.00%  15.00%

 

Imputed Rate          25.00%  15.00%  15.00%  15.00%  15.00%  15.00%

 

RDER                  10.00%   0.00%   0.00%   0.00%   0.00%   0.00%

 

Section 809 income     1,000       0       0       0       0       0

 

Capital gain income        0       0       0       0       0       0

 

 

ADDITIONAL

 

CAPITAL GAIN

 

 

                      Year 1  Year 2  Year 3  Year 4  Year 5  Year 6

 

 

Statement Gains        2,500   1,500   1,500   1,500   1,500   1,500

 

Mean Equity           10,500  11,000  11,000  11,000  11,000  11,000

 

Mutual Rate           23.81%  13.64%  13.64%  13.64%  13.64%  13.64%

 

Imputed Rate          25.00%  15.00%  15.00%  15.00%  15.00%  15.00%

 

RDER                   1.19%   1.36%   1.36%   1.36%   1.36%   1.36%

 

Section 809 income       125     150     150     150     150     150

 

Capital gain income    1,000

 

Additional income        125     150     150     150     150     150

 

 

[22] The example shows a Base Case and the effect on the Base Case of capital gains realization. In the Base Case, the earnings of the mutual company in the first year are 15% of its $10,000 mean equity, and the imputed rate for the first year is 25%. There is a resulting recomputed differential earnings rate of 10% and additional income under section 809 of $1,000. In subsequent years of the Base Case, the imputed and mutual company rate are the same, and there is no additional section 809 income.

[23] The example then shows what happens if the company realizes a capital gain of $1000. The capital gain is included in its taxable income, but it also increases its equity in year one and in all subsequent years. The increased equity reduces the average mutual earnings rate and results in the company reporting section 809 income in the first year and in all subsequent years. The net effect is that the company reports more income as the result of the realization than if no capital gains had been realized.

[24] It may be observed that the example does show that the marginal tax rate on the capital gains is reduced. That is, however, one of the perverse effects of section 809, which is dramatized by the assumption that there is a single mutual life insurance company. All additional items of income have reduced marginal tax rates because they reduce the imputation under section 809. Conversely, additional expenses only marginally reduce taxable income because expenses increase the section 809 imputation.

 

FOOTNOTES

 

 

1 Common stocks are valued at market on the annual statement, and, consequently, capital gains realization does not affect statement capital.

2 The proration rules that apply to affiliates of stock companies, particularly property and casualty insurance affiliates, are more favorable than mutual life insurance company proration rules. As a result, an affiliated group of stock companies is more likely to hold common stock investments in a property and casualty affiliate, rather than in a life insurance company. While a particular stock life insurance company may have few capital gains, an examination of its affiliated property and casualty company may reveal very substantial capital gains realized by the affiliate. Thus, the allocation of stock investments within fleets of companies that include life insurance companies classified as stock for tax purposes will differ from the allocation of investments among related companies with a mutual life insurance parent company. This distinction holds, not only for investor owned stock companies, but for life insurance companies owned by mutual property and casualty and mutual holding companies also.

3 Economic history and theory holds that collaborative behavior is inherently unstable, and unlikely to exist at all in competitive industries involving complex and multiple products.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Groom, Theodore R.
  • Institutional Authors
    Groom Law Group
  • Code Sections
  • Subject Area/Tax Topics
  • Index Terms
    insurance companies, life, mutual, deduction reductions
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2000-7912 (9 original pages)
  • Tax Analysts Electronic Citation
    2000 TNT 53-22
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