Final Regs on Mutual Insurers Differential Earnings Rates

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations relating to the differential earnings rate and the recomputed differential earnings rate, which are used in determining the deduction for policyholder dividends of a mutual life insurance company. The final regulations provide that these rates cannot be negative. The applicable law was enacted as part of the Tax Reform Act of 1984. The final regulations provide guidance to mutual life insurance companies.

 DATES: These regulations are effective December 10, 1993. For dates of applicability, see section 1.809-9(c) of these regulations.

 FOR FURTHER INFORMATION CONTACT: Katherine Ann Hossofsky, (202) 622-3477 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

This document contains amendments to the Income Tax Regulations (26 CFR part 1) to provide guidance relating to the differential earnings rate and the recomputed differential earnings rate under section 809 of the Internal Revenue Code (Code). The final regulations reflect the addition of section 809 to the Code by section 211(a) of the Tax Reform Act of 1984 (Pub. L. 98-369, 98 Stat. 733).

 Proposed regulations under section 809 (FI-159-84) were published in the Federal Register on August 19, 1992 (57 FR 37495). Written comments were received from the public, and a public hearing was held on December 7, 1992.

 After consideration of all of the comments, the regulations proposed by FI-159-84 are adopted without substantive change by this Treasury decision.

STATUTORY FORMULA FOR REDUCING POLICYHOLDER DIVIDENDS

 Section 809(a) of the Code provides that, in the case of any mutual life insurance company, the amount of the deduction allowable under section 808 for policyholder dividends is reduced (but not below zero) by the differential earnings amount. The differential earnings amount is the portion of policyholder dividends deemed to be a distribution of a mutual company's profits to policyholders in their capacity as owners of the company. See H.R. Rep. No. 432 (Part 2), 98th Cong., 2d Sess., 1422 (1984). In effect, otherwise deductible policyholder dividends equal in amount to the differential earnings amount are not deductible. Any excess of the differential earnings amount over the policyholder dividends deduction allowable under section 808 is taken into account as an adjustment to reserves under subsections (a) and (b) of section 807.

 A mutual life insurance company's differential earnings amount for any taxable year is an amount equal to the product of the company's average equity base for the year multiplied by the differential earnings rate for the year.

 The differential earnings rate is the excess of (a) the imputed earnings rate for the taxable year over (b) the average mutual earnings rate for the second calendar year preceding the calendar year in which the taxable year begins. The imputed earnings rate for any taxable year is an amount which bears the same ratio to 16.5 percent as the current stock earnings rate for the taxable year bears to the base period stock earnings rate.

 To correct for the difference between the average mutual earnings rate for the calendar year in which the taxable year begins and the average mutual earnings rate for the second preceding calendar year, section 809(f) provides a mechanism under which the differential earnings amount for the taxable year is recomputed in the following taxable year. This amount is known as the recomputed differential earnings amount. The recomputed differential earnings amount for any taxable year is calculated in the same manner as the differential earnings amount for the taxable year, except that the average mutual earnings rate for the calendar year in which the taxable year begins is substituted for the average mutual earnings rate for the second calendar year preceding the calendar year in which the taxable year begins. The revised rate is known as the recomputed differential earnings rate. If the recomputed differential earnings amount for any taxable year exceeds the differential earnings amount for the taxable year, the excess is included in life insurance gross income for the succeeding taxable year. Conversely, if the differential earnings amount exceeds the recomputed differential earnings amount, the excess is allowed as a life insurance deduction for the succeeding taxable year.

EXPLANATION OF PROVISION

 The IRS publishes both the tentative and final differential earnings rate and recomputed differential earnings rate. These rates are used by mutual life insurance companies in calculating their federal income tax liability. Announcement 88-47, 1988-12 I.R.B. 56, stated that the tentative recomputed differential earnings rate for 1986 was -1.700. However, both the differential earnings rate and the recomputed differential earnings rate are determined based on "the excess of" the imputed earnings rate over the average mutual earnings rate. Whenever the average mutual earnings rate is greater than the imputed earnings rate, there is no "excess of" the imputed rate over the average mutual earnings rate. By referring to the excess of the imputed earnings rate over the average mutual earnings rate, the statutory formula does not permit the differential earnings rate to be negative. Accordingly, the Internal Revenue Service subsequently issued Notice 88-106, 1988-2 C.B. 444, which stated that regulations under section 809 would provide that the differential earnings rate may not be a negative rate. See also Rev. Rul. 88-80, 1988-2 C.B. 129; Rev. Rul. 89-106, 1989-2 C.B. 108; Rev. Rul. 91-52, 1991-2 C.B. 331; and Rev. Rul. 92-78, 1992-2 C.B. 143.

 Congress added section 809 to limit the deductibility of dividends paid by mutual life insurance companies to their policyholders in recognition of the fact that these dividends are, to some extent, distributions of the companies' earnings to the policyholders as owners. Section 809(a) states that the deduction allowed under section 808 "shall be reduced (but not below zero) by the differential earnings amount." The use of the term reduce reflects Congress's intention that the purpose of section 809 is to limit an otherwise deductible amount, not to create a new deduction. A negative differential earnings rate or a negative recomputed differential earnings rate would allow mutual life insurance companies to deduct an amount in excess of dividends paid to policyholders. This would be contrary to the intent of section 809.

 The proposed regulations provided that neither the differential earnings rate under section 809(c) nor the recomputed differential earnings rate that is used in computing the recomputed differential earnings amount under section 809(f)(3) may be less than zero.

 Two comments were received concerning the proposed regulations.

 The first commentator states that the adoption of the proposed regulations in final form is necessary to preserve the integrity of section 809. The comment contends that section 809 is simply the mechanism to determine the amount of the reduction to a mutual life insurance company's policyholder dividend deductions to reflect distributions to policyholders in their role as owners of the company. The differential earnings rate is based on Congress' belief that "the average pre-tax return on equity of mutual companies falls below that for a comparable group of stock companies" and that "this difference is attributable to distribution by mutual companies of earnings to their owners." See H.R. Rep. 432 (Part 2), 98th Cong., 2nd Sess. 1422 (1984). Thus, the commentator concludes that the only difference in stock and mutual earnings rates that Congress intended to utilize is the positive difference by which the stock companies' (or imputed) earnings rate exceeds the mutual companies' earnings rate.

 The first commentator further states that section 809(f)(2) does not support recognition of a negative recomputed differential earnings rate to permit a deduction for policyholder dividends in excess of the dividends actually paid or accrued during the taxable year to which the recomputed rate relates. Rather, the deduction provided by section 809(f)(2) merely compensates the taxpayer for what more current data indicate to have been an excessive disallowance in an earlier year.

 Finally, the first commentator states that section 809 should not be interpreted merely to limit over an extended period of time mutual life insurance companies' deductions for policyholder dividends. The comment points out that sections 808(c) and 809 expressly require computation of a deduction limit separately for each taxable year.

 The second commentator states that there is no need for any regulations to be issued regarding negative differential earnings rates and that the proposed regulations represent an erroneous interpretation of section 809. Specifically, the comment points out that the Internal Revenue Service on five occasions has expressed its view that neither the differential rate nor the recomputed differential earnings rate may be negative. See Notice 88-106, Rev. Rul. 88-80, Rev. Rul. 89-106, Rev. Rul. 91-52, Rev. Rul. 92-78. In addition, the comment contends that adoption of the proposed regulations would result in inappropriate and excessive taxation of mutual life insurance companies.

 In American Mutual Life Insurance Company v. United States, Civil No. 4-92-70347 (S.D. Iowa, November 2, 1993), the court held that the taxpayer could deduct an amount equal to the excess of the differential earnings amount for the 1986 taxable year over the negative recomputed differential earnings amount for 1986. In its opinion, the court stated that the parties agreed that the statutory formula produced a 1986 recomputed differential earnings rate of - 1.695. The court also noted that in its briefs in the case, and at oral argument, the government had conceded that the statutory formula produced a negative 1986 recomputed differential earnings rate. Thus, the issue of whether the statutory formula can produce a negative rate was not before the court.

 The final regulations clarify that the statute provides that the differential earnings rate and the recomputed differential earnings rate cannot be negative.

EFFECTIVE DATE

 Notice 88-106 set forth guidance that would be contained in forthcoming regulations. The notice stated that regulations would be issued that would provide that neither the differential earnings rate nor the recomputed differential earnings rate may be negative. Rev. Rul. 88-80 stated that the final recomputed differential earnings rate for 1986 was zero even though the calculated rate was negative, and indicated that when the regulations were issued they may be effective prior to the date of issuance. As the final regulations involve the application of the guidance provided in Rev. Rul. 88-80, concerning the 1987 taxable year, the final regulations provide an effective date of taxable years beginning after December 31, 1986.

SPECIAL ANALYSES

 It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these final regulations is Katherine Ann Hossofsky of the Office of the Assistant Chief Counsel (Financial Institutions and Products). However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR part 1

 Income taxes, Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

Part 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.809-9 is added to read as follows:

SECTION 1.809-9 COMPUTATION OF THE DIFFERENTIAL EARNINGS RATE AND THE RECOMPUTED DIFFERENTIAL EARNINGS RATE.

(a) IN GENERAL. Neither the differential earnings rate under section 809(c) nor the recomputed differential earnings rate that is used in computing the recomputed differential earnings amount under section 809(f)(3) may be less than zero.

(b) DEFINITIONS -- (1) RECOMPUTED DIFFERENTIAL EARNINGS AMOUNT. The recomputed differential earnings amount, with respect to any taxable year, is the amount equal to the product of --

(i) The life insurance company's average equity base for the taxable year; multiplied by

(ii) The recomputed differential earnings rate for that taxable year.

(2) RECOMPUTED DIFFERENTIAL EARNINGS RATE. The recomputed differential earnings rate for any taxable year equals the excess of --

(i) The imputed earnings rate for the taxable year; over

(ii) The average mutual earning rate for the calendar year in which the taxable year begins.

(c) EFFECTIVE DATE. The regulations are effective for all taxable years beginning after December 31, 1986.