Rev. Rul. 80-116

Advice has been requested whether S, a life insurance company, as the surviving company in a statutory merger of two stock life insurance companies, is entitled to an adjustment under section 481 of the Internal Revenue Code by reason of the revaluation of reserves of the acquired insurance company under the circumstances described below.

In its Federal income tax return for the taxable year 1961, S, a life insurance company taxable under section 802 of the Code, elected, pursuant to section 818(c), to revalue its life insurance reserves, previously computed on a preliminary term basis, using the approximate revaluation basis prescribed by section 818(c)(2). The taxpayer has computed its life insurance reserves on the approximate revaluation basis since 1961.

R, also a life insurance company taxable under section 802 of the Code, was incorporated and commenced business in 1958. R has made no election under section 818(c) to revalue its reserves that were computed on the preliminary term basis.

On July 1, 1976, R was merged into S, pursuant to the requirements of the state insurance code, in a statutory merger as defined in section 368(a)(1)(A) of the Code. The amount of life insurance reserves of S, computed on the approximate revaluation method, was substantially greater than the amount of life insurance reserves of R, computed on a preliminary term basis. At all times subsequent to the merger, S, the successor life insurance company, has continued to be taxable under section 802.

Section 381(c)(22) of the Code provides, in part, that in the case of a tax-free merger when the surviving corporation is a life insurance company, certain items of the distributor or transferor corporation are required to be taken into account by the transferee in accordance with the Commissioner's regulations. Section 1.381(c)(22)-1(a) of the Income Tax Regulations provides that the acquiring corporation shall take into account the reserves described in section 810(c) distributed or transferred to it as of the close of the date of distribution or transfer by the distributor or transferor corporation in accordance with the provisions of section 381(c)(4) and the regulations thereunder.

Section 810(c) of the Code lists certain items that are to be taken into account under section 810(a) or (b). Section 810(a) and (b) provide that the difference in the sum of section 810(c) items at the beginning of the year and the sum of 810(c) items at the close of the taxable year (reduced by the amount of investment yield not included in gain or loss from operations for the taxable year by reason of section 809(a)(1) shall be taken into account as a net decrease under section 809(c)(2) or a net increase under section 809(d)(2), as the case may be.

Rev. Rul. 72-344, 1972-2 C.B. 218, holds that the acquiring life insurance company should, under section 381(c)(22) of the Code, add at the date of transfer from its subsidiary life insurance company that was liquidated under section 332, the dollar balances of the transferred section 810(c) items, as of the close of the day of transfer, to the opening balances of its own section 810(c) items. Further, the difference between that sum and the acquiring life insurance company's closing balances of all section 810(c) items shall be taken into account by the acquiring company under section 809(c)(2) or (d)(2), as the case may be, in computing its gain or loss for its first taxable year ending after the date of distribution or transfer.

Section 818(c) of the Code permits a life insurance company issuing contracts with respect to which the life insurance reserves are computed on one of the recognized preliminary term bases to elect to revalue such reserves, on a net level premium basis for the purposes of determining the amount that may be taken into account as life insurance reserves for purposes of Part I, Subchapter L, Chapter 1 of the Code, other than section 801. If such an election is made, the basis to be used in making this revaluation of reserves shall be made on either the exact revaluation basis under section 818(c)(1) or the approximate revaluation basis under section 818(c)(2). If an election is made to use either the exact or the approximate basis of revaluing the life insurance reserves, the basis adopted by a life insurance company shall be adhered to in making the computations under Part I, Subchapter L, Chapter 1 of the Code (other than section 801) for the taxable year and all subsequent taxable years unless a change in the basis of computing such reserves is approved by the Commissioner.

Section 1.818-4(d)(2) of the regulations states, in part, that for any taxable year other than the first taxable year for which the election is made under section 818(c) of the Code, a company making such election must revalue all its life insurance reserves held with respect to contracts, for which such reserves are computed on a preliminary term basis at the beginning of the taxable year, on the basis elected under section 818(c). Further, section 1.810-2(c)(3) provides that, for purposes of determining the increase or decrease in reserves under section 810(a) and (b), if a company that computes its life insurance reserves on a preliminary term basis elects to revalue such reserves on a net level premium basis under section 818(c), the sum of such reserves at the beginning and end of all taxable years (including the first taxable year) for which the election applies shall be the sum of such reserves computed on such net level premium basis.

Section 1.381(c)(4)-1 of the regulation provides, in part, that the acquiring corporation shall use the method of accounting used by the distributor or transferor corporation on the date of distribution or transfer unless different methods of accounting were used by the distributor or transferor corporation and the acquiring corporation. If different methods of accounting were used, the acquiring corporation shall use the principal method of accounting. The principal method of accounting can be determined by comparing the dollar balances in each corporation's reserve account. The method of accounting of the party having the largest amount is, under section 1.381(c)(4)-1(c)(2)(iv), deemed to be the principal method. Section 1.381(c)(4)-1(a)(1)(ii) provides, in part, that if adjustments are necessary to reflect a change in accounting method, pursuant to section 381 of the Code, the manner in which they are to be taken into account and the tax attributable thereto shall be determined and computed under section 481 of the Code and regulations thereunder subject to the rules provided in section 1.381(c)(4)-1(c) and (d).

Section 481(a) of the Code provides, in part, that in computing the taxpayer's taxable income for the taxable year, if the computation is under a method of accounting different from the method under which the taxpayer's taxable income for the preceding taxable year was computed, then there shall be taken into account those adjustments that are determined to be necessary solely by reason of the change in order to prevent amounts from being duplicated or omitted.

Since the amount of life insurance reserves of S computed on the approximate revaluation method at the time of the statutory merger was substantially greater than the life insurance reserves of R, S's basis of computing life insurance reserves is considered the principal method of accounting for computing such reserves. Thus, S was correct to continue such basis with respect to its life insurance reserves and also to use such basis in computing the life insurance reserves acquired from R in the merger.

In view of the above, S is required to revalue, as of July 1, 1976, the preliminary term reserves acquired from R in the merger to the net level premium basis under section 818(c) of the Code, using the approximate method of valuation prescribed in section 818(c)(2). For purposes of its section 810(a) or (b) adjustments for the increase or decrease in section 810(c) items, S must add to its own opening reserves the revalued life insurance reserves attributable to those contracts acquired from R as of July 1. The difference between the sum of S's opening life insurance reserve balance, which includes those reserves attributable to R's contracts, and the opening balances of all other section 810(c) items, and S's closing balances of all section 810(c) items shall be taken into account by S under section 809(c)(2) or (d)(2), as the case may be, in computing its gain or loss for the taxable year 1976, the first taxable year ending after the date of distribution or transfer.

Further, S is not allowed to make a section 481 adjustment because the duplication or omission section 481 of the Code is designed to correct is not present under a section 818(c) election. Section 810(d)(3) and section 1.810-3(e)(1) of the regulations specifically provide that an election pursuant to section 818(c) is not to be considered a change in basis within the meaning of section 810(d)(1) that would require a 10-year spread of any adjusting item, similar to the 10-year spread set forth in Rev. Proc. 70-27, 1970-2 C.B. 509. The only adjustment required by reason of an election under section 818(c) is that provided by section 1.810-2(c)(3), which provides that for purposes of determining the increase or decrease in reserves, all reserves at both the beginning and the end of the taxable year in which the election under section 818(c) is made shall be computed on the net level premium basis. The difference between the reserves at the end of the previous taxable year, which were valued on the preliminary term basis, and the reserves at the beginning of the taxable year of the election, which were revalued on the net level premium basis pursuant to the section 818(c) election, is not reflected as a deduction in the year of the election or any subsequent taxable year. See example (1) of section 1.813-3(f) of the regulations. Thus, by revaluing reserves acquired in the merger under section 818(c) election, there is no duplication or omission of income or deductions of the type that would require a section 481 adjustment.

Accordingly, S is not entitled to an adjustment under section 481 of the Code by reason of the revaluation of reserves of the acquired insurance company pursuant to an election under section 818(c).