IRS ADDRESSES WHETHER ASSETS RETAINED BY TARGET STOCK LIFE INSURANCE COMPANY IN A REORG. ARE DISTRIBUTIONS.

Rev. Rul. 95-19

ISSUE

If substantially all of the assets of a target stock life insurance company are transferred in a transaction qualifying as a reorganization under section 368(a)(1)(D) of the Internal Revenue Code, is there a direct or indirect distribution, within the meaning of section 815(a), of an amount equal to the fair market value of any retained assets?

FACTS

SITUATION 1. P owns all of the outstanding stock of S-1 and S-2. P, S-1, and S-2 are incorporated in state X and are taxable as life insurance companies under section 801. S-1, a life insurance company since 1957, has a balance in its existing policyholders surplus account. P, S-1, and S-2 are calendar year taxpayers.

Pursuant to a plan of reorganization, on December 31, 1993, S-2, the acquiring company, assumed all of the outstanding insurance contracts and related liabilities of S-1, the target stock life insurance company, and also received substantially all of the assets of S-1 other than its state charter, its insurance license, and the assets needed to satisfy X's minimum capital requirements in order to remain in existence, in an exchange qualifying as a reorganization under section 368(a)(1)(D). See, e.g., Rev. Proc. 89-50, 1989-2 C.B. 631, which describes conditions under which the Internal Revenue Service will ordinarily rule that the distribution requirement applicable to reorganizations under section 368(a)(1)(D) will be satisfied where the transferor corporation does not dissolve under state law so that the value of its corporate charter can be realized through a sale of the transferor's stock.

The purpose for having S-1 maintain its corporate existence under state law was to isolate S-1's charter and license for resale by P, parent of both S-1 and S-2, to an unrelated purchaser through the sale of S-1's stock. P intended either to sell S-1 to an unrelated purchaser or, if an unrelated purchaser could not be located within one year, to dissolve S-1 under state law, extinguishing its charter and insurance license and transferring to P assets representing S-1's minimum capital. After the receipt by P of either the proceeds from the sale of S-1's stock or the minimum capital of S-1 upon its liquidation, P may contribute those funds to S-2.

S-1 and S-2 filed the statements referred to in section 1.381(b)-1(b)(3) of the Income Tax Regulations. Under that statement, December 31, 1993, the date that substantially all of the assets were transferred to S-2, is the "date of transfer" of the reorganization for purposes of section 381.

The reorganization did not result in any taxable distributions under subchapter C in the 1993 tax year.

SITUATION 2. The facts are the same as set forth in Situation 1 except that all of S-1's assets (other than the charter and license) were transferred to S-2. Simultaneously with the transfer of all of S-1's assets, P contributed to S-1 an amount sufficient to meet S-1's minimum capital requirements under state X law.

Situation 3. The facts are the same as set forth in Situation 1 except that all of S-1's assets (other than the charter and license) were transferred to S-2. Simultaneously with the transfer of all of S-1's assets, S-2 loaned P an amount sufficient to meet S-1's minimum capital requirements under state X law and P contributed a similar amount to S-1. The loan is evidenced by a note and bears interest at the federal short-term rate (as defined in section 1274(d)), compounded semiannually, in effect on the December 31, 1993, transfer date. If S-1's stock is sold to an unrelated purchaser, P may use the sales proceeds to repay its loan from S-2.

LAW AND ANALYSIS

Section 801(a) imposes a tax on life insurance company taxable income. Section 801(c) provides that section 815 governs the taxation of distributions to shareholders from a pre-1984 policyholders surplus account.

Under section 815(a), the amount of any direct or indirect distribution from an "existing policyholders surplus account" during a taxable year is added to life insurance company taxable income for that year for purposes of the tax imposed by section 801(a). If the life insurance company's taxable income is less than zero, the company still must pay the tax imposed by section 801(a) on the amount of any direct or indirect distribution from an existing policyholders surplus account. For this purpose, an indirect distribution does not include any bona fide loan with arms-length terms and conditions.

Section 815(e) defines the term "existing policyholders surplus account" as any policyholders surplus account that has a balance as of the close of December 31, 1983. Section 815(d) directs each stock life insurance company that has such an account to continue the account and forbids any additions to the account for any taxable year beginning after December 31, 1983.

Section 815(b) provides that any distribution to shareholders is treated as made -- (1) first out of the shareholders surplus account, to the extent thereof, (2) then out of the policyholder's surplus account, to the extent thereof, and (3) finally, out of other accounts.

Section 815(f) applies subsections (d), (e), (f), and (g) of section 815 (as in effect before the enactment of the Tax Reform Act of 1984 (the "1984 Act")) to any existing policyholders surplus account, except to the extent inconsistent with the provisions of part 1 of subchapter L. Section 815(f) as in effect at that time (with certain exceptions not pertinent here) defined the term "distribution" as any distribution in redemption of stock or in partial or complete liquidation of the corporation.

The legislative history of the 1984 Act indicates that the term "direct or indirect distributions" in section 815(a) includes both actual and constructive distributions. H.R. Rep. No. 432, Part 2, 98th Cong., 2d Sess. 1411 (1984) (House of Representatives Report); 1 Senate Committee on Finance, 98th Cong., 2d Sess., Deficit Reduction Act of 1984: Explanation of Provisions Approved By the Committee on March 31, 1984, at 536 (S. Print 98-169, 1984) (Senate Print).

The Tax Reform Act of 1986 amended section 815 to clarify that an indirect distribution does not include a bona fide loan with arms- length terms and conditions. The legislative history accompanying the amendment also makes clear that an indirect distribution occurs whenever policyholder surplus account funds are used to benefit shareholders indirectly. That legislative history emphasizes that, regardless of whether a distribution occurs under general corporate tax provisions, what causes a direct or indirect use or distribution of policyholders surplus account funds is to be construed broadly. H.R. Rep. 426, 99th Cong., 1st Sess. 955 (1985), 1986-3 C.B. (Vol. 2) 955 (House of Representatives Report); S. Rep. 313, 99th Cong., 2d Sess. 974 (1986), 1986-3 C.B. (Vol. 3) 974 (Senate Report).

Section 381 provides that a corporation which acquires the assets of another corporation in certain liquidations and reorganizations succeeds to, and takes into account, as of the close of the date of distribution or transfer, the items described in section 381(c) of the distributor or transferor corporation. In addition, if the acquiring and transferor corporations are life insurance companies, section 381(c)(22) provides that certain items must be taken into account to carry out the purposes of subchapter L. Section 1.381(c)(22)-1 requires the acquiring corporation to take into account the dollar balances in the shareholders surplus account, the policyholders surplus account, and other accounts of the target corporation (provided that the acquiring corporation is a stock life insurance company).

Under the Life Insurance Company Income Tax Act of 1959 (sections 801-820 as they existed prior to the 1984 Act), a life insurance company was taxed on the lesser of its taxable investment income or its gain from operations (phase I). If a company's gain from operations exceeded its taxable investment income, the company was also taxed on 50 percent of that excess (phase II). The other 50 percent of that excess was accounted for as part of a policyholders surplus account and, subject to certain limitations, was taxed pursuant to section 815 only when distributed to stockholders or upon corporate dissolution (phase III).

As set forth above, section 815(a) provides that any direct or indirect distribution to shareholders from an existing policyholders surplus account of a stock life insurance company is subject to tax in the taxable year of the distribution. The legislative history provides that an indirect distribution occurs whenever policyholder surplus account funds are used to benefit the shareholders indirectly. An indirect distribution, for purposes of section 815, occurs in a reorganization within the meaning of section 368(a)(1)(D) whenever the target stock life insurance company's shareholders directly or indirectly hold assets of the target company free of any direct or indirect bona fide obligation (with arms-length terms and conditions) to the policyholders or former policyholders of the company.

Thus, at the time that substantially all of the assets of S-1 were transferred to S-2, the assets retained by S-1 are treated as having been indirectly distributed to P (because these assets indirectly benefit S-1's shareholder, P, as the assets can be used by P and are no longer required to benefit S-1's policyholders) and then contributed back by P to S-1. (In Situation 1, these retained assets were the license, charter, and minimum capital; in Situation 2 and Situation 3, they were the license and the charter.)

The balance in S-1's shareholders surplus account, policyholders surplus account, and any other account is reduced, in the order required by section 815, by the indirect distribution prior to being taken into account by S-2 under section 381.

HOLDINGS

Situation 1

In Situation 1, at the time of the transfer of substantially all of the assets of the target stock life insurance company, there is an indirect distribution under section 815(a) equal to the fair market value of the charter, license and minimum capital retained by the company.

Situation 2

In Situation 2, at the time of the transfer of substantially all of the assets of the target stock life insurance company, there is an indirect distribution under section 815(a) equal to the fair market value of the charter and license retained by the company.

Situation 3

In Situation 3, at the time of the transfer of substantially all of the assets of the target stock life insurance company, there is an indirect distribution under section 815(a) equal to the fair market value of the charter and license retained by the company.

There are no tax consequences under section 815 in the subsequent tax year (1994) if the common parent corporation (P) sells the stock of the target stock life insurance company (S-1); nor, in Situation 3, are there any tax consequences under section 815 if the common parent repays the loan from the acquiring company (S-2) with a portion of the proceeds from the sale of the stock of S-1.

DRAFTING INFORMATION

The principal author of this revenue ruling is William T. Sullivan of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Mr. Sullivan on (202) 622-3970 (not a toll- free call).