IRS RELEASES INTERIM RULES FOR MGCs.

Notice 97-32

[1] SUMMARY: This notice provides interim rules with regard to the interest rate to be used in the determinations under sections 807(c)(3), 807(d)(2)(B), and 812 for a "modified guaranteed contract," as defined in section 817A(d). It also describes the manner in which section 811(d) is to be applied to these contracts. Section 817A was added by section 1612 of the Small Business Job Protection Act of 1996, Pub. L. 104-188, 110 Stat. 1755. Section 817A is effective for taxable years beginning after December 31, 1995. See Small Business Job Protection Act section 1612(c)(1). This notice is effective pending the publication of further guidance.

[2] BACKGROUND: Life insurance companies issue modified guaranteed annuity and life insurance contracts. A modified guaranteed contract temporarily guarantees a higher return than the permanently guaranteed crediting rate, in exchange for shifting additional investment risk to the policyholder in the form of a market value adjustment. The temporary guarantee may be a fixed rate or a rate based on bond or equity yields, such as a percentage of an increase in the S&P 500 index. During the temporary guarantee period, the amount paid to the policyholder upon surrender is increased or decreased by the market value adjustment, which is determined by a formula in the modified guaranteed contract. The market value adjustment generally is based on a published bond index. Modified guaranteed contracts can be issued out of a life insurance company's general account or segregated account. Section 817A provides special tax treatment for certain modified guaranteed contracts issued out of a segregated account.

[3] For this purpose, the term "modified guaranteed contract" ("MGC") is defined as an annuity, life insurance, or pension plan contract (other than a variable contract described in section 817) under which all or part of the amounts received under the contract are allocated to a segregated account. Assets in this segregated account must be valued from time to time with reference to market values, and reserves must be valued at market for annual statement purposes. Further, an MGC must provide either for a net surrender value or for a policyholder's fund (as defined in section 807(e)(1)). If only a portion of a contract is not described in section 817, such portion is treated as a separate contract for purposes of applying section 817A.

[4] The tax reserves for an MGC are computed under either section 807(c)(3) or section 807(d). Section 807(c)(3) provides that reserves for obligations under insurance and annuity contracts not involving life, accident, or health contingencies are computed using an appropriate rate of interest. The appropriate rate of interest is the highest (as of the time the obligation first did not involve life, accident, or health contingencies) of the following rates: (1) the "applicable Federal interest rate" (as defined in section 807(d)(2)(B)(i)); (2) the "prevailing State assumed interest rate" (as defined in section 807(d)(2)(B)(ii)); or (3) the rate of interest assumed by the insurance company to determine the contract's guaranteed benefit. Section 807(c) also provides that the reserves computed under section 807(c)(3) are never less than the net surrender value of the contract. ¹

[5] For an MGC that gives rise to life insurance reserves, as defined in section 816(b), reserves are computed under section 807(d). Under section 807(d)(1), the life insurance reserves for a contract cannot exceed the statutory reserves (as defined in section 809(b)(4)(B)) for the contract. Subject to that cap, a contract's life insurance reserves equal the greater of: (1) the contract's net surrender value; or (2) the contract's Federally prescribed reserve determined under section 807(d)(2).

[6] Section 807(d)(2) provides that the Federally prescribed reserves for a contract are determined using: (1) the tax reserve method applicable to the contract; (2) the greater of the applicable Federal interest rate or the prevailing State assumed interest rate in effect on the date of the issuance of the contract; and (3) the prevailing commissioners' standard tables for mortality and morbidity. In the case of a life insurance contract covered by the Commissioners' Reserve Valuation Method ("CRVM") or an annuity contract covered by the Commissioners' Annuities Reserve Valuation Method ("CARVM"), section 807(d)(3) provides that the tax reserve method applicable to a contract is the CRVM or CARVM prescribed by the National Association of Insurance Commissioners ("NAIC"), which is in effect on the date of the issuance of the contract.

[7] Section 811(d) imposes an additional reserve computation restriction for contracts that guarantee beyond the end of the taxable year payment or crediting of amounts in the nature of interest in excess of the greater of the prevailing state assumed interest rate or the applicable Federal interest rate. In those circumstances, section 811(d) requires that the contract's future guaranteed benefits be determined as though the interest in excess of the greater of the prevailing state assumed interest rate or the applicable Federal rate were guaranteed only to the end of the taxable year.

[8] Section 812 prorates the dividends received deduction and the exclusion for tax exempt interest between a life insurance company and its policyholders to prevent the company from receiving a double tax benefit for amounts added to reserves. See also sections 805(a)(4), 807(a) and 807(b). The proration is based on the company's share of "net investment income" (as defined in section 812(c)) for the taxable year. The company's share of net investment income equals the excess, if any, of the net investment income over the sum of the "policy interest" (as defined in section 812(b)(2)) and "gross investment income's proportionate share of policyholder dividends" (as defined in section 812(b)(3)) for the taxable year. Policy interest includes "required interest" (at the greater of the prevailing State assumed rate or the applicable Federal interest rate) on reserves under section 807(c) (other than section 807(c)(2)). See section 812(b)(2)(A). If neither the prevailing State assumed rate nor the applicable Federal interest rate is used, another appropriate rate is used to calculate required interest. Thus, for a contract described in section 807(c)(3), if the rate of interest assumed by an insurance company in determining the contract's guaranteed benefit exceeds the applicable Federal interest rate and the State assumed rate, required interest is computed using the assumed interest rate.

[9] Under section 817A(e)(2), the Service is authorized to determine annually with regard to MGCs the interest rates applicable under sections 807(c)(3), 807(d)(2)(B) and 812. The Service is authorized to exercise this authority by issuing a periodic announcement of the appropriate market interest rates or formula for determining such rates. H.R. Conf. Rept. No. 737, 104th Cong. 2d Sess. 313 (1996). Section 817A(e) also authorizes the Service to modify or waive the application of section 811(d) (relating to interest guaranteed beyond the end of the taxable year), and to prescribe other regulations that are necessary or appropriate to carry out the purposes of section 817A.

[10] The legislative history of section 817A indicates that an appropriate interest rate is a current market rate. H.R. Conf. Rep. No. 737, at 313. The interest rate may be determined, for example, using either a rate that is appropriate for the obligations under the contract to which the reserve relates or the yield on the assets underlying the MGCs. Id.

[11] INTERIM RULES FOR MGCs: Pending the publication of further guidance, an insurance company is required to determine under sections 807(c)(3) or 807(d)(2) the reserves for a MGC using, with regard to the contract's temporary guarantee period, an annual interest rate equal to the greater of--

(a) the interest rate assumed by the insurance company to determine future guaranteed benefits under the applicable tax reserve method for the contract or, for reserves computed under section 807(c)(3), the interest rate assumed by the company to determine the contract's guaranteed benefit; or

(b) the Moody's Corporate Bond Yield Average-Monthly Average Corporates ("Moody's rate") as published by Moody's Investors Service, Inc., or any successor thereto, for the month that includes the last day of the taxable year, multiplied by:

(i) 1.1 if the MGC provides for a market value adjustment or a guaranteed return based in whole or in part on the performance of stocks, other equity instruments or equity-based derivatives, including but not limited to a contract which guarantees a return based on the S&P 500 index; and

(ii) 1.0 for all other MGCs.

[12] With respect to an MGC's temporary guarantee period, section 811(d) shall be applied by substituting the rate of interest applicable to the contract's temporary guarantee period under this notice for the applicable Federal interest rate and the prevailing State assumed interest rate. During the temporary guarantee period, the interest rate to be used to determine required interest under section 812(b)(2)(A) is the rate that applies with regard to that period for purposes of sections 807(c)(3) or 807(d)(2)(B).

[13] For periods outside the temporary guarantee period, sections 807(c)(3), 807(d)(2), 811(d) and 812(b)(2)(A) continue to apply without modification.

EXAMPLE 1

[14] IC, a life insurance company as defined in section 816, issued an MGC on July 1, 1996. The MGC is an annuity contract that gives rise to life insurance reserves, as defined in section 816(b). IC is a calendar year taxpayer. The MGC guarantees that interest will be credited at 8% per year for the first 5 contract years and 4% per year thereafter. During the 5 year temporary guarantee period, the MGC provides for a market value adjustment based on changes in a published bond index and not on the performance of stocks, other equity instruments or equity based derivatives. The Moody's rate for December 1996 is 7.5%. The applicable Federal interest rate and the prevailing State assumed interest rate for 1996 are 6.63% and 5.75%, respectively.

[15] To determine under section 807(d)(2) the end of year 1996 reserves for the MGC, IC must use a discount interest rate of 8% (the interest rate assumed by the insurance company to determine future guaranteed benefits during the 5 year temporary guarantee period) with regard to the unexpired portion of the temporary guarantee period. The discount rate applicable to periods outside the 5 year temporary guarantee period is 6.63%. The interest rate to be used in computing required interest under section 812(b)(2)(A) for 1996 is 8%.

EXAMPLE 2

[16] The facts are the same as in Example 1, except that the MGC guarantees that interest will be credited at 7% per year for the first 5 contract years. To determine under section 807(d)(2) the end of year 1996 reserves for the MGC, IC must use a discount interest rate of 7.5% (Moody's rate multiplied by 1.0) with regard to the unexpired portion of the 5 year temporary guarantee period. The discount rate applicable to periods outside the 5 year temporary guarantee period is 6.63%. The interest rate to be used in computing required interest under a section 812(b)(2)(A) for 1996 is 7.5% (Moody's rate multiplied by 1.0).

[17] COMMENTS REQUESTED: The Internal Revenue Service invites comments concerning the application of new section 817A and the application of this notice to various types of MGCs, including equity indexed annuities and life insurance contracts. Specifically, comments are requested regarding whether different interest rates should apply to equity indexed contracts based upon the different participation rates, guarantees, market value adjustments, or other pertinent factors under the contracts. Written comments should be sent to Internal Revenue Service, P. O. Box 7604, Ben Franklin Station, Washington, D.C. 20044. Alternatively, submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (Notice 97-32), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. Finally, taxpayers may submit comments electronically via the Internal Revenue Service INTERNET site at http://www.irs.ustreas.gov/prod/tax_regs/comments.html. All submitted comments will be available for public inspection and copying.

[18] FURTHER INFORMATION: For further information regarding this notice, contact Ms. Katherine A. Hossofsky at (202) 622-3970 (not a toll-free call).

[19] PROCEDURAL INFORMATION: This document serves as an "administrative pronouncement" as that term is defined in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure.