Transfer of Insurance Policies Taxable

LEGEND:

2. If so, under the principles of Treas. Reg. section 1.817-4(d), is the consideration received by the new target for the assumption of these insurance liabilities measured by the fair market value of the assets transferred or the amount of reserve liabilities assumed?

2. The measure of consideration is the fair market value of the assets transferred in exchange for the assumption of the ceding company's liabilities on its insurance contracts.

[5] Parent decided to terminate its involvement in the property and casualty insurance business. After lengthy negotiations with Group, Parent and Group entered into an agreement whereby Parent would sell its interest in certain investment subsidiaries and Group would acquire an interest in those subsidiaries.

[6] In Year1, Parent formed a wholly owned subsidiary, HoldingSub. Then, in a series of related transactions that constituted a "qualified stock purchase" within the meaning of section 338(d)(3), Parent transferred all its Sub stock to HoldingSub.

[7] At the time of the transaction, the fair market value of Sub's assets exceeded the purchase price of the Sub stock. Because Parent's basis in the Sub stock was significantly less than Sub's basis in its assets, and because Sub had net operating losses Parent could inherit in a liquidation under I.R.C. section 332, Parent required HoldingSub to make a joint election under section 338(h)(10).

[8] At issue in this case is the interplay between the provisions of subchapter C and subchapter L of the Internal Revenue Code of 1986 when a property and casualty insurance company is acquired in a stock purchase that is treated as a deemed sale of assets pursuant to an election under section 338(h)(10). More specifically, you have asked whether it is appropriate for the Service to apply subchapter L rules to a section 338(h)(10) deemed sale or whether the taxpayer instead should be permitted to rely on the general treatment for asset acquisitions under section 338 and I.R.C. section 1060. See, e.g., UNUM Corp. v. United States, 130 F.3d 501 (1st Cir. 1997), aff'g 929 F.Supp. 15 (D.Me. 1996), petition for cert. filed, (Apr. 14, 1998) (holding that the general principles of subchapter C, relating to the nondeductibility of payments made by a corporation to reacquire its stock, override the subchapter L treatment of policyholder dividends in the context of a demutualization of a life insurance company).

[9] Section 338(a) provides that if a purchasing corporation elects under that section, then, in the case of any qualified stock purchase, the target corporation shall be treated as having sold all of its assets at the close of the acquisition date, at fair market value, in a single transaction, and the target corporation shall be treated as a new corporation which purchased all of those assets as of the beginning of the day after the acquisition date.

[10] In the case of a target corporation that was a member of a selling consolidated group at the time of the qualified stock purchase, if an election is made under section 338 and also under section 338(h)(10), any gain or loss recognized by the target corporation on the deemed sale of its assets is treated as having been recognized while the target corporation was a member of the selling group. Further, to the extent provided in regulations, no gain or loss will be recognized on stock sold or exchanged in the transaction by members of the selling consolidated group.

[11] The operation of section 338(h)(10) requires that the new target be treated, for tax purposes, as if it had acquired all of the old target's assets and assumed all of the old target's liabilities (including liabilities on the old target's insurance policies in force) in a taxable transaction for a total purchase price based on the amount paid for the target company stock.

[12] If an insurance company were to acquire the entire business of another insurance company in a cash transaction, the portion of such a transaction providing for the transfer of the selling company's outstanding insurance contract liabilities to the purchasing company would be effected by means of an assumption reinsurance transaction. See, Kentucky Central Life Ins. Co. v. Commissioner, 57 T.C. 482 (1972); Union Bankers Ins Co v. Commissioner, 64 T.C. 807 (1975); Security Benefit Life v. United States, 726 F.2d 1491 (10th Cir. 1984) See also Security Industrial Ins. Co. v. United States, 702 F.2d 1234, 1237 (5th Cir. 1983) (assumption reinsurance is the life insurance industry's functional equivalent of a direct asset acquisition). ²

[13] Furthermore, when the entire insurance business of a life insurance company was acquired pursuant to a stock purchase/liquidation qualifying under former I.R.C. section 334(b)(2), the statutory predecessor of section 338, the transfer of the insurance contracts of the distributor corporation to the acquiring corporation was treated as an assumption reinsurance transaction. See, Southwestern Life Ins. Co. v. United States, 75-1 USTC para. 9321, at 86,750-51 (N.D. Tex. 1975), aff'd, 560 F.2d 627 (5th Cir. 1977), cert. denied, 435 U.S. 995 (1978) (no distinction between a direct acquisition of a block of insurance contracts and the acquisition of the company holding the block of insurance contracts).

[14] The courts have also recognized the separate tax treatment of assumption reinsurance transactions involving property and casualty insurance companies, and applied subchapter L rules to such transactions, even where the assumption reinsurance transactions are entered into as part of a broader corporate adjustment.

[15] For example, in Buckeye Union Casualty Co. v. Commissioner 54 T.C. 13 (1970), aff'd, 448 F.2d 228 (6th Cir. 971, the court held that the tax treatment of a ceding commission is to be determined separately from the sale of an insurance company's other tangible and intangible assets even though the reinsurance transaction was a step in a larger plan to dispose of the entire insurance business. In that case, the taxpayer had adopted a plan of complete liquidation and within 12 months transferred its entire insurance business to an acquiring corporation under two separate agreements. Under one agreement (the reinsurance agreement), the acquiring company assumed all liabilities under outstanding policies issued by the petitioner in exchange for a ceding commissioner of 35 percent of the unearned premium liability. Under the other agreement, the acquiring corporation purchased all other assets of the transferor, both tangible and intangible, for a stated consideration. The taxpayer took the position that the entire transaction constituted a sale of assets pursuant to a plan of liquidation under former I.R.C. section 337 and, therefore, that income with respect to the ceding commission was shielded from corporate level tax. The court found, however, that the ceding commission did not constitute proceeds of a section 337 sale and, therefore, was taxable.

[16] Similarly, in Jerome H. Stern et. [sic] al. v. Commissioner, 66 T.C. 91 (1976), the court held that a ceding commission paid by a newly formed stock insurance company for the reinsurance of the outstanding policies of a mutual property and casualty insurance company as part of a cash merger transaction (which did not qualify for tax-free treatment under I.R.C. section 368(a)(1)(A) due to a lack of continuity of interest) could be claimed by the acquiring company as an ordinary deduction for the current year. ³ The court noted that the ceding commission was separately identified and paid for the assumption of the mutual company's outstanding policies, even though the reinsurance transaction was part of a plan to acquire the mutual's entire insurance business and the amounts retained by the mutual as a ceding commission were distributed in liquidation of the policyholders' equity interest.

[17] Finally, Congress also has expressed its views regarding the application of the assumption reinsurance rules to a deemed transfer of insurance policies occurring by reason of a section 338 election during its deliberations relating to the enactment of I.R.C. section 197. Section 197 provides an amortization deduction for certain intangible property, including the value of insurance in force acquired by means of an assumption reinsurance transaction. See, section 197(f)(5). The legislative committee reports accompanying section 197 state that the principles of Treas. Reg. section 1.817-4(d), relating to assumption reinsurance transactions, apply for purposes of determining the amortizable basis of insurance in force acquired in an assumption reinsurance (including any acquisition of an insurance contract occurring by reason of an election under section 338). H. Rep. No. 11, 103d Cong. 1st Sess. 760, 775 fn. 150 (1993), 1993-3 C.B. 167, 351; H.R. Conf. Rep. No. 213, 103d Cong. 1st Sess. 675, 687 fn. 25 (1993), 1993-3 C.B. 393, 565.

[18] Based on the forgoing, we conclude that the portion of the deemed sale created by section 338(h)(10) which involves the transfer of old target's outstanding insurance policies to the new target should be characterized as assumption reinsurance under subchapter L.

[19] The tax consequences of assumption reinsurance transactions involving life insurance companies are clear and well-established and are set forth with specificity in Treas. Reg. section 1.817-4(d). ⁴ Treas. Reg. section 1.817-4(d)(1) provides that the reinsurance of all or a part of the insurance contracts of a particular type by a life insurance company, whereby the reinsuring company assumes all liabilities under such contracts, shall not be treated as the sale or exchange of a capital asset but shall be treated as a transaction producing ordinary income. However if a capital asset is transferred in connection with the assumption reinsurance transaction, the transfer is treated as the sale or exchange of the asset by the transferor.

[20] Although Treas. Reg. section 1.817-4(d) is not directly applicable to property and casualty insurance companies taxable under I.R.C. section 831, it is appropriate, in our view, to apply the principles of this regulation by analogy to a section 338(h)(10) deemed sale of a property and casualty insurance company's outstanding insurance policies.

[21] Both the courts and the Service have recognized that the principles of Treas. Reg. section 1.817-4(d) are applicable in the case of assumption reinsurance transactions involving blocks of nonlife business. In Union Bankers Ins. Co. v. Commission, 64 T.C. 807 (1975), acq. 1976-2 C.B. 3, the court concluded based on the facts in that case, that the cost of acquiring cancellable accident and health insurance accident policies could be amortized over the reasonably estimated life of the acquired policies, in accordance with the treatment provided in Treas. Reg. section 1.817-4(d). The court rejected the Service's contention that Treas. Reg. section 1.817-4(d) could not apply to commissions paid for blocks of cancellable accident and health policies (or other nonlife business) because such policies do not have a determinable future useful life. See, Rev. Rul. 65-175, 1965-2 C.B. 41 (allowance paid by a property and casualty insurance company to assume cancellable accident and health insurance policies is not subject to amortization under Treas. Reg. section 1.817-4(d) because such business does not have a determinable future useful life); Rev. Rul. 69-375, 1969-2 C.B. 146, revoked by Rev. Rul. 76-411, 1-976-2 C.B. 208 (same result for life insurance company). Subsequent to Union Bankers, the Service issued Rev. Rul. 76-411, 1976-2 C.B. 208, which, in addition to revoking Rev. Rul. 69-375, modifies Rev. Rul. 65-175 as regards the inability of a nonlife insurance company to amortize commissions paid for the assumption of a block of cancellable accident and health insurance business.

[22] In addition, the Service has been successful in extending the amortization requirement of Treas. Reg. section 1.817-4(d) to other areas, such as indemnity reinsurance of life insurance companies. Most notably, in Colonial American Life Ins. Co. v. Commissioner, 491 U.S. 244 (1989), the Supreme Court applied the principles of Treas. Reg. section 1.817-4(d) by analogy to the treatment of indemnity reinsurance ceding commissions. The Court stated that the effect of Treas. Reg. section 1.817-4(d) of treating the reinsurer as having invested in an income producing asset is consistent with general tax principles. The ceding commission paid by the reinsurer, the Court noted:

[23] Finally, as noted above, Congress' treatment of assumption reinsurance transactions under section 197(f)(5), and the statement in the legislative committee reports that the amount paid by the acquirer/reinsurer for insurance in force should be determined in conformity with Treas. Reg. section 1.817-4(d), do not distinguish between life and property and casualty insurance companies. The legislative committee reports, therefore, would seem to imply that the same rule will apply to both types of insurers.

Measure of Consideration for the Assumption Reinsurance (Issue 2)

[24] An area of tension between the subchapter C and subchapter L approaches to insurance company acquisitions under section 338 is the calculation of the target's liabilities in determining the deemed purchase price. In our view, the amount of liabilities taken into account by new target as a result of the deemed assumption reinsurance transaction created by section 338(h)(10) should be based on tax rather than statutory reserves.

[25] In 1984, Congress concluded with respect to life insurance companies that statutory reserves represented "a significant overstatement of liabilities in comparison to those measured under realistic economic assumptions." H. Rep. No. 432, Pt. 2, 98th Cong., 2d Sess. 1396 (1984); S. Prt. No. 169, Vol. 1, 98th Cong., 2d Sess. 521 (1984). Congress enacted I.R.C. section 807(d) to ensure that the amount of life insurance reserves taken into account for tax purposes represented a more realistic measure of a life insurance company's liabilities. Under section 807(d), the reserve for any contract is the greater of the net surrender value or a Federally prescribed reserve. The rules for computing the Federally prescribed reserve require the use of a particular reserve method depending on the type of contract involved, the higher of the prevailing State assumed interest rate or the applicable rate for the year in which the contract is issued, and the prevailing Commissioners' standard mortality or morbidity table for the year in which the contract is issued.

[26] As the provisions of section 807(d) apply for all purposes of Part I of subchapter L (other than qualification as a life insurance company under I.R.C. section 816), the Service has taken the position that the amount paid by an acquirer/reinsurer for life insurance and annuity contracts in an actual assumption or indemnity reinsurance transaction is determined using tax reserves rather than statutory reserves. See, Rev. Proc. 90-36, 1990-2 C.B. 357, which applies the principles of Treas. Reg. section 1.817-4(d) by stating "the amount of the up-front ceding commission paid by the reinsurer is equal to the excess of the increase in the reinsurer's tax reserve liabilities (computed in accordance with section 807 of the Code) over the net assets received. See also, Rev. Rul. 94-45, 1994-2 C.B. 39 (liabilities for purposes of I.R.C. sections 357(c) and 358(d) based on tax reserves).

[27] Similarly, we believe that in a section 338(h)(10) deemed sale involving a property and casualty insurance company taxable under section 831, the amount of liabilities taken into account by the acquirer/reinsurer should be based on tax rather than statutory reserve liabilities. Thus, in accounting for the deemed reinsurance transaction, the new target should take into account reserve increases based on old target's unearned premiums on outstanding business, computed in accordance with I.R.C. section 832(b)(4)(B), and discounted unpaid losses, computed in accordance with I.R.C. section 846. Otherwise, the tax consequences of the section 338(h)(10) deemed sale would not parallel the results of an actual sale of the target company's insurance business in a cash transaction. Moreover, the use of statutory reserves to determine the purchaser's available basis would create a discrepancy between the amount of liabilities used for purchase price calculations and the tax reserves used to determine new target's operating income in post-sale periods.

[28] If applying the principles of Treas. Reg. section 1.817-4(d) to an insurance company acquisition under section 338(h)(10), a major issue affecting the tax treatment of the acquirer/reinsurer arises if the fair market value of old target's assets exceeds the sum of old target's liabilities (including tax reserves) plus the amount paid for target stock.

[29] In an arm's length transaction, the consideration paid by one party should be considered as equal to the value received by the other party. See, United States v. Davis, 370 U.S. 65 (1962). This basic tax principle is applied in a reinsurance context by the part of Treas. Reg. section 1.817-4(d) requiring capitalization of a ceding commission. Thus, the regulations specify that if the assuming company receives from the ceding company a net amount of consideration that is less than the increase in the assuming company's reserves resulting from the transaction, the assuming company is treated (a) as having received from the ceding company consideration equal in total to the increase in its reserves, and (b) as having paid to the ceding company for the purchase of the contracts an amount equal to the excess of the increase in reserves over the net amount actually received from the ceding company. See, Treas. Reg. 1.817-4(d)(2)(ii)(B).

[30] Treas. Reg. section 1.817-4(d) recognizes that the arm's length consideration received by the reinsurer to assume the policy obligations, however, is not necessarily limited to the increase in the reinsurer's reserves. For example, if the business acquired by the reinsurer has inherent problems, the reinsurer may require an amount of consideration from the ceding company to assume the liabilities on the outstanding policies which is in excess of the amount of the ceding company's existing reserves on such policies. In these circumstances, the regulations treat the ceding company as having paid consideration for the assumption of liability on the transferred policies equal to the fair market value of the assets transferred to the reinsurer, and treats the reinsurer as having received gross income equal to the fair market value of the assets received from the ceding company. See, e.g., Treas. Reg. section 1.817-4(d)(3), Example 4. ⁵

[31] Arguably, the result in this example of the regulations is inconsistent with the usual treatment of the buyer of assets and liabilities of a business. Under general tax principles, a purchaser of assets would normally not recognize income based on a disparity between the fair market value of assets acquired and an arm's length purchase price for those assets prior to the actual disposition of the underlying assets. See, Palmer v. Commissioner, 302 U.S. 63, 69 (1937) ("[O]ne does not subject himself to income tax by the mere purchase of property, even if at less than true value, and taxable gain does not accrue to him before he sells or otherwise disposes of it.")

[32] However, if the disparity between the fair market value of the assets transferred to the buyer and the agreed-upon purchase price reflects the existence of a contingent liability connected with the business, so that the assets represent the value placed on the expected payment of the contingent liability, the general rules under sections 338 and 1060 would require the buyer to recognize income (with a corresponding increase in basis) when the contingent liabilities assumed as part of the asset purchase become fixed and determinable. Accordingly, the buyer of the business would not be entitled to a deduction upon payment of any contingent liabilities assumed as part of the purchase of the business, even though these liabilities would otherwise have constituted a deductible expense if the business had not changed hands. See, Pacific Transport Co. v. Commissioner, 483 F.2d 209 (9th Cir. 1973), cert. denied, 415 U.S. 948 (1974) (payment of a liability which had been assumed in a liquidation of a recently acquired subsidiary under former section 334(b)(2) did not give rise to a deductible expenses, since the assumption of the liability was a cost of acquiring the assets of the liquidated corporation).

[33] As noted above, Treas. Reg. section 1.817-4(d) adopts a different approach. Under the accounting rules for reinsurance transactions in subchapter L, the assuming company is treated as not only purchasing assets but also taking over the ceding company's insurance risk on the transferred policies. Thus, the assuming company includes the fair market value of the assets received from the ceding company as an item of premium income under I.R.C. section 803(a)(1). Correspondingly, the assuming company recognizes an increase in reserves based on the amount of insurance liabilities transferred in the transaction.

[34] Accordingly, under subchapter L reinsurance rules, there is no delay placed on the assuming company in creating basis if the assets received from the ceding company represent the expected payment of contingent liabilities. Similarly, there is no tension between contingent liabilities assumed by the buyer as part of the purchase of the business and post-sale liabilities incurred by the buyer. Thus, for example, if the assuming company were to determine that it was necessary to strengthen the unpaid loss reserves on the assumed business in a post-sales year to properly reflect the amount of liabilities assumed, the assuming company would be permitted to include the additional reserves (after discounting these amounts in accordance with section 846) in computing its deduction for losses incurred in the year in which the reserves are increased.

[35] The application of the subchapter L assumption reinsurance rules to an insurance company acquisition under section 338(h)(10) does not produce an anomalous tax result. Subchapter L does not create artificial income to the buyer in a section 338(h)(10) transaction. To the contrary, the subchapter L approach may more clearly reflect the economics of the transaction than a rule requiring the capitalization of the buyer's payments of contingent liabilities assumed as part of the asset purchase. See, D. Halperin, Assumption of Contingent Liabilities on Sale of a Business, in Florida Tax Review, Vol. 2, No. 12 (1996).

[37] If you have further questions, please call (202) 622-7870.

² "Assumption reinsurance" is defined in Treas. Reg. section 1.809-5(a)(7)(ii) as an arrangement whereby another person (the reinsurer) becomes solely liable to the policyholders on the contracts transferred by the taxpayer (ceding company) . Assumption reinsurance is usually used in a life insurance company context. For property and casualty insurance companies, these transactions are generally referred to as portfolio reinsurance transactions. See Huebner, Black, and Cline, Property and Liability Insurance 567 (1982 ed.).

³ There is no indication in the Jerome H. Stern opinion that the Commissioner had argued for the capitalization and amortization of the ceding commission by the acquiring company. Thus, the court did not have to decide whether the general capitalization requirements of I.R.C. section 263 were applicable to the assuming company. Compare, Colonial American Life Ins. Co. v. Commissioner, 491 U.S. 244 (1989) (holding that I.R.C. section 809 did not expressly provide for deductibility of ceding commissions and that section 263 should apply to this expenditure in the absence of a specific provision to the contrary).

⁴ Treas. Reg. section 1.817-4(d) was originally issued under former I.R.C. section 817, as enacted by the Life Insurance Company Tax Act of 1959. In 1984, the provisions of the 1959 Act were repealed and replaced with any entirely new Part I of subchapter L. Former section 817 is now found in I.R.C. sections 818(b) and (c). Although former section 817 was repealed, Congress indicated that the prior law regulations for assumption reinsurance transactions would continue under present law. H. Rep. No. 432 (Part 2), 98th Cong. 2d Sess. 1438-39 (1984); see also, Staff of the Joint Committee on Taxation, General Explanation of the Deficit Reduction Act of 1984, 633 (1984).

⁵ The example involves an assumption reinsurance transaction in which the reinsurer's reserve liability with respect to the transferred policies was $100,000. However, the parties agreed that the consideration paid by the ceding company for the reinsurer's assumption of liability on the contracts was $130,000. Under the example, the ceding company has income from a decrease in reserves of $100,000, but is allowed a deduction of $130,000 for the consideration paid to the reinsurer. Correspondingly, the reinsurer has premium income of $130,000 as a result of the consideration received from the ceding company, and a deduction of $100,000 for the net increase in its reserves. When the amount of a life insurance company's reserves was based on reserves established under State law, the reinsurer could have avoided the recognition of $30,000 of additional income in the example by increasing its state law reserves. However, if the target's reserves were properly computed under the Code, or if the purchasing corporation is concerned about the effect which such a reserve increase would have the target company's credit rating, an immediate strengthening of the target company's reserves may not be feasible.