Final Regs on Computation of Mutual Life Insurer's Equity Base

 [4830-01-u]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations relating to the determination of the equity base for purposes of computing the differential earnings amount and recomputed differential earnings amount, which are used in determining the deduction for policyholder dividends of a mutual life insurance company. The final regulations provide that the equity base includes the amount of any asset valuation reserve and the amount of any interest maintenance reserve reported on the annual statement prescribed by the National Association of Insurance Commissioners (NAIC) for filing with the insurance regulatory authorities of a state. The regulations affect life insurance companies.

 DATES: These final regulations are effective September 29, 1994.

 These regulations are applicable to tax years ending after December 31, 1991.

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

 SUPPLEMENTARY INFORMATION:

BACKGROUND

On September 7, 1993, temporary regulations (TD 8484) relating to the determination of the equity base of a life insurance company under section 809 of the Internal Revenue Code (Code) were published in the Federal Register (58 FR 47060). A notice of proposed rulemaking (FI-29-93) cross-referencing the temporary regulations was published in the Federal Register (58 FR 47089) on the same day. The proposed and temporary regulations provide that the equity base includes the amount of any asset valuation reserve and the amount of any interest maintenance reserve reported on the annual statement prescribed by the NAIC for filing with the insurance regulatory authorities of a state.

 Three comments on the proposed regulations were received, and a public hearing on the regulations was held on December 3, 1993. After consideration of the comments, the proposed regulations are adopted without change by this Treasury decision.

EXPLANATION OF PROVISION

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. For purposes of the computations under section 809, a life insurance company must determine its equity base. The equity base of a life insurance company includes the capital and surplus of the company as well as any mandatory securities valuation reserve, deficiency reserve, and voluntary reserve or similar liability. The mandatory securities valuation reserve is the first reserve listed in section 809(b)(5). From the time section 809 was enacted through 1991, the mandatory securities valuation reserve was required to be reported on the NAIC annual statement filed by all life insurance companies. During these years, the NAIC annual statement required insurers to allocate surplus to fund the mandatory securities valuation reserve. Though shown as a liability account on the annual statement, the mandatory securities valuation reserve was not an actual liability in the sense of a debt to another party; rather, it represented a fund of allocated surplus, earmarked as a contingency reserve against fluctuations in the values of a company's investments in stocks and bonds.

 For NAIC annual statements covering 1992 and later years, the NAIC replaced the mandatory securities valuation reserve with the asset valuation reserve and interest maintenance reserve. This change reflected the recognition by the NAIC that life insurance companies need to protect against fluctuations in value in mortgages, real estate, and other investments as well as fluctuations in value in stocks and bonds and that interest-related changes in asset values might appropriately be differentiated from other changes. Accordingly, the new reserves cover an expanded class of assets and differentiate between (1) equity and credit-related capital gains and losses, and (2) interest-related capital gains and losses.

 The asset valuation reserve reflects changes in the value of equity investments and also changes in the value of debt investments where the changes are credit-related. Both realized and unrealized capital gains and losses are reflected in the asset valuation reserve.

 The interest maintenance reserve reflects realized capital gains and losses from bonds, mortgages, and other fixed-income obligations to the extent that they are interest-related. Because the value of U.S. Government securities, together with the value of securities of agencies backed by the full faith and credit of the U.S. Government, are safe from credit-related risks and are subject only to interest- related risks, the capital gains and losses on those securities are allocated solely to the interest maintenance reserve.

 The proposed and temporary regulations provide that the equity base includes the amount of any asset valuation reserve and the amount of any interest maintenance reserve reported on the NAIC annual statement. Three comments were received on the proposed regulations.

 The first commentator agreed that inclusion of the asset valuation reserve and the interest maintenance reserve in the section 809 equity base is consistent with Congress' decision to include the mandatory securities valuation reserve in the equity base. The commentator stated that, by providing in section 809(b)(5)(A) that the equity base includes the amount of the mandatory securities valuation reserve, Congress determined that the allocation of surplus represented by this reserve, which included credit-related capital gains as well as interest-related capital gains, was properly part of the equity base. The commentator concluded that, absent a legislative change, allocated surplus should continue to be included in the equity base notwithstanding the change in the name of the reserve or the method of allocating surplus to the reserve. Alternatively, the commentator stated that the unaccrued market value increase or decrease in an insurer's liabilities as reflected in the interest maintenance reserve should be included in the equity base because the Conference Report underlying section 809 indicates that Congress intended the equity base to include any reserve for potential or unaccrued liabilities. H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 1058 (1984).

 This commentator also requested that the final regulations clarify that both positive and negative interest maintenance reserves are included in computing the equity base. Finally, while noting that the proposed regulations do not address the treatment of interest-related capital gains and losses in computing the section 809 earnings of a life insurance company, the commentator indicated that for calendar years prior to 1992 interest-related capital gains or losses have been included in section 809 earnings no later than the year in which the gains or losses were realized for tax purposes. The commentator stated that this treatment should be continued in the absence of a legislative change.

 The second commentator did not take a position regarding the inclusion of the amount of any interest maintenance reserve in the section 809 equity base. Rather, this commentator noted that the regulations deal with the determination of the equity base but are silent on the extent to which interest-related capital gains are to be included in section 809 earnings. If the current inclusion approach of the proposed and temporary regulations is adopted in the final regulations, then this commentator indicated that interest- related capital gains and losses should be included currently in section 809 earnings. In addition, the commentator stated that there should be consistency between the calculations of the equity base made on Form 1120L, U.S. Life Insurance Income Tax Return, and on Form 8390, Information Return for Determination of Life Insurance Company Earnings Rate Under Section 809.

 The third commentator agreed that the interest maintenance reserve must be treated consistently for equity base and earnings purposes. However, this commentator urged that the interest maintenance reserve not be included in the section 809 equity base. Instead, interest-related capital gains and losses would be amortized into equity and earnings over the remaining life of the asset sold. The commentator stated that inclusion of the interest maintenance reserve in equity: (1) is inconsistent with the substance and theory of the interest maintenance reserve, which is to treat interest- related realized capital gains and losses as a substitute for future unearned income; (2) fails to reduce the volatility of the life insurance companies' earnings rates; (3) is inconsistent with the requirement under section 809 that all determinations generally be made on the basis of the amounts required to be set forth on the annual statement; and (4) is inconsistent with section 1.809-9(a), which provides that neither the differential earnings rate nor the recomputed differential earnings rate may be negative.

 No changes are being made to the regulations in response to these comments. Inclusion of the interest maintenance reserve in the equity base is consistent with the historical treatment of interest- related capital gains and losses under section 809. By providing in section 809(b)(5)(A) that the equity base includes the amount of the mandatory securities valuation reserve, Congress demonstrated its intent to include interest-related capital gains and losses in the equity base. Modification of the annual statement by the NAIC to eliminate and replace the mandatory securities valuation reserve cannot override the specific inclusion that Congress required for these gains and losses. Section 809(g)(3) provides the regulatory authority to adjust under section 809(b)(5) amounts set forth on the annual statement to continue the inclusion of these gains and losses in the equity base. Since the interest maintenance reserve represents an allocation of surplus from interest-related capital gains and losses for which Congress made clear its intentions and provided regulatory authority to preserve its intentions, the inclusion of the interest maintenance reserve in the equity base is appropriate.

 The final regulations require any interest maintenance reserve (whether positive or negative) to be included in an insurer's equity base. The reduction of the equity base for any interest-related capital losses reflected in a negative interest maintenance reserve is consistent with the treatment of those losses prior to the replacement of the mandatory securities valuation reserve with the asset valuation reserve and the interest maintenance reserve. Before the change, any interest-related capital losses reduced the amount of net income added to capital and surplus. Thus, any negative interest maintenance reserve should be included as a reduction to the equity base, consistent with the treatment of interest-related capital losses prior to the change.

 Under the final regulations, the asset valuation reserve and the interest maintenance reserve must be included in the calculation of the equity base for purposes of section 809. This requirement is reflected on both Form 1120L and Form 8390. See Announcement 93-117, 1993-29 I.R.B. 85. Thus, there is consistency between the calculations of the equity base on Form 1120L and on Form 8390. Finally, although the final regulations do not specifically address this issue, interest-related capital gains and losses continue to be included in section 809 earnings by virtue of section 809(g)(1)(C).

SPECIAL ANALYSES It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 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) 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 preceding these regulations was submitted to the Small Business Administration for comment on its impact of small business.

DRAFTING INFORMATION The principal author of these 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 IN 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 is amended by adding an entry in numerical order to read as follows:

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

Section 1.809-10 also issued under 26 U.S.C. 809(b)(2) and (g)(3). * * *

Section 1.809-10T [Redesignated as section 1.809-10]

Par. 2. Section 1.809-10T is redesignated as section 1.809-10 and the word "(temporary)" is removed from the section heading.