Rev. Rul. 82-133

Life insurance companies; dividends; "excess interest." Amounts credited by a mutual or stock life insurance company to the account of a policyholder of a single premium deferred annuity contract that are in excess of the assumed rate of interest used in computing the company's life insurance reserves (4 percent) are distributions similar to dividends under sections 811(a) and 809(d)(3) of the Code. Rev. Ruls. 67-180 and 79-260 modified; Rev. Rul. 69-444 supplemented.

ISSUE

Under the circumstances described below, are the amounts credited to deferred annuity contracts distributions similar to dividends to policyholders under section 811(a) of the Internal Revenue Code?

FACTS

Two taxpayers, one a mutual life insurance company and the second a stock life insurance company, are both taxable under section 802 of the Code. Both taxpayers issue a single premium deferred annuity contract. Under the terms of each contract, a portion of the payment received from a policyholder will be credited to his or her account. Interest will be credited annually on this amount and, on the selected annuity commencement date. All amounts credited to a policyholder's account may be applied to purchase an annuity payable, under several options, on a monthly basis.

The full amount to be credited to a policyholder's account is not determinable initially because the rate of interest to be credited to a policyholder's account may vary during the accumulation period of the contract (i.e., prior to annuitization). This is so because, during the accumulation period, the company has agreed to credit interest to a policyholder's account at a variable rate. During the first contract year, the company has agreed to credit interest at an annual rate of 8-1/2 percent. Thereafter, the company has agreed to credit interest at an annual rate of 4 percent. After the first year of the contract, however, the company has the unilateral right to change the guaranteed rate. Such a change must be for at least a one-year period and cannot be to a rate any less than 4 percent per annum. The change must be declared in advance. The contract does not explain on what basis a higher rate will be determined by the company. The assumed rate of interest used in computing the company's life insurance reserves is 4 percent.

Reserves established under this contract are life insurance reserves within the meaning of section 810(c)(1) of the Code.

The taxpayers assert that in calculating the yearly share of investment yield set aside for policyholders under section 809(a) of the Code the term "required interest" should be interpreted to refer to any interest rate guaranteed to policyholders for that year (e.g., 8-1/2 percent during the first year of the contract here under consideration), rather than the assumed rate (here 4 percent). Alternatively, if the term "required interest" is interpreted to refer only to the assumed rate of interest, the taxpayers argue for a deduction pursuant to section 809(d)(2) in computing gain or loss from operations equal to the increase in reserves required because of the crediting of policyholders' accounts of the excess of the guaranteed rate of interest (here 8-1/2 percent for the first policy year) over the assumed rate of interest (here 4 percent). (Such excess in this ruling being referred to as "excess interest".) The taxpayers argue that this increase in reserves arises without the taxpayers necessarily being viewed as having paid a dividend to policyholders and having received back an equal amount of premium income.

The two identical deferred annuity contracts discussed herein are labeled, respectively, a "nonparticipating" contract by the stock life insurance company and a "participating" contract by the mutual life insurance company.

LAW AND ANALYSIS

Section 809(a) of the Code provides that the share of each and every item of investment yield of any life insurance company set aside for policyholders shall not be included in gain or loss from operations. The share of any item set aside for policyholders, the purposes of section 809(a), is the percentage obtained by dividing the required interest by the investment yield. The required interest is the sum of the products obtained by multiplying each rate of interest required or assumed by the taxpayer in calculating the reserves described in section 810(c) by the mean of the amount of the reserves computed at that rate at the beginning and the end of the tax year.

The reserves described in section 810(c) of the Code include life insurance reserves (as defined in section 801(b)).

Section 1.809-2(d)(1) of the Income Tax Regulations provides that, in the case of life insurance reserves (as defined in section 801(b) of the Code), the rate to be used for purposes of the required interest computation under section 809(a)(2) is the same as that used for purposes of section 1.801-5(b), which defines "reserves required by law."

In calculating its reserves required by law, a life insurance company is limited in its calculations to the assumption of a rate of interest no greater than a maximum prescribed by a state regulatory body. Whatever rate the company assumes in these calculations (equal to or lower than the maximum prescribed rate) is its assumed rate of interest. The assumed rate of interest is the only rate that is taken into account in calculating a life insurance company's reserves required by law. Therefore, the only rate of interest that can be used as required interest in determining the policyholders' share of items of investment yield pursuant to section 809(a) of the Code is the assumed rate of interest. No interest in excess of the assumed rate of interest may enter into this calculation.

Section 809(d)(3) of the Code provides that for purposes of determining gain or loss from operations there shall be allowed a deduction for dividends to policyholders. The deduction for policyholder dividends, however, is limited by section 809(f). That section provides that the amount of the deduction for dividends to policyholders shall not exceed $250,000 plus the excess of gain from operations (computed without regard to the special deductions) over taxable investment income.

When the Life Insurance Company Income Tax Act, Pub. L. 86-69, 1959-2 C.B. 654, was enacted in 1959, Congress was aware that life insurance companies do make distributions to policyholders out of their (the companies') share of investment yield. Congress intended, however, to tax life insurance companies on their full share of investment yield without the allowance of any reduction for policyholder dividend distributions, except to the limited extent provided for in section 809(f) of the Code. S. Rep. No. 291, 86th Cong., 1st Sess. 11 and 22, 1959-2 C. B. 770, 777, 785; H. Rep. No. 34, 86th Cong., 1st Sess. 6, 1959-2 C.B. 736, 740. It was the intent of Congress to prevent life insurance companies from eliminating their federal income tax liability by using the deduction for policyholder dividends to offset both underwriting and investment income. The effect of section 809(f) is to allow the deduction for policyholder dividends to offset underwriting income but to restrict the amount of dividends that can be offset against taxable investment income to $250,000. See S. Rep. No. 291, 86th Cong., 1st Sess. 11 and 22.

Amounts credited to policyholder accounts as excess interest arise out of the company's share of investment yield. Cf. section 809(a) of the Code. These amounts directly benefit policyholders and must be viewed as a distribution of investment earnings equalling [sic] a policyholder dividend. To allow excess interest to be deducted as an increase in reserves would effectively circumvent the legislative purposes underlying section 809(f) to tax life insurance companies on their full share of investment yield regardless of whether such yield is made available to policyholders. It would allow insurance companies to offset both underwriting and investment income by the mere labeling of investment earnings to be diverted to policyholders as excess interest rather than as dividends. Furthermore, the legislative history of the 1959 provisions indicates that to the extent excess interest involves a crediting to policyholders of a portion of the company's share of investment yield, it is within the meaning of dividends to policyholders as that term is defined in section 811.

Section 811(a) of the Code provides that the term "dividends to policyholders" means dividends and similar distributions to policyholders in their capacity as such. The legislative history of the 1959 provisions states that the term dividends to policyholders includes distributions made to policyholders out of the company's share of investment yield. S. Rep. No. 291, 86th Cong., 1st Sess., 11, 22. When a life insurance company credits interest to policyholders at any rate above the assumed rate, the crediting involves a distribution of the company's share of investment yield to the policyholders and, thus, is properly viewed as a dividend to policyholders.

Section 1.811-2(a) of the regulations provides that the term dividends to policyholders means dividends and similar distributions to policyholders in their capacity as such. Included within the meaning of the term are "amounts returned to policyholders where the amount is not fixed in the contract but depends on the experience of the company or the discretion of the management." This language contrasts amounts fixed in the contract with amounts that may be returned to policyholders depending upon the experience of the company or based upon the discretion of management. Under the facts of this ruling the assumed rate is the amount so fixed in the contract. It is required by state insurance regulation, within the rates permitted, to be employed to fund the reserves for the contracts. The additional amounts of interest that are guaranteed to the policyholders change annually depending upon the investment experience of the taxpayers. Under these circumstances, the payment of additional interest becomes discretionary with the taxpayers and in effect the companies are diverting some of their investment yield to the policyholders.

The regulations define a participating contract as a contract containing a right to participate in the divisible surplus of the company and state that amounts paid pursuant to such contracts shall be treated as a dividend to policyholders. Here again the excess interest provisions under consideration provide a right to policyholders to participate in the company's share of investment yield, that is, amounts belonging to the company and inherently a part of its divisible surplus. Consequently, under the regulations, such amounts are properly classified as policyholder dividends. Under the contracts here in question, amounts credited in excess of the assumed rate of interest are not fixed in the contract and may vary every year. Both the amount credited in the first year in excess of the assumed rate and the amounts subsequently declared are (1) subject to the discretion of management, (2) not fixed in the contract, and (3) dependent on the experience (past or future) of the companies. The policyholder is in the same economic position he or she would have been in if the policyholder had received a dividend and immediately paid it to the insurance company as a premium for an additional benefit. These amounts are nothing more than a discretionary mechanism through which an insurance company can provide its policyholders a share of the company's divisible surplus (including earnings) in the form of additional benefits.

Although the mutual company herein described designates its policy as participating and the stock company herein described designates its policy as nonparticipating, both contracts are in fact participating and the excess interest is a policyholder dividend or similar distribution within the meaning of sections 809(d)(3) and 811(a) of the Code. A participating contract results from a policyholder benefit defined in section 1.811-2 of the regulations and is not dependent upon the labeling employed.

Once it is determined that excess interest is a dividend to policyholders, deductible additions to reserves (other than at the assumed rate) can arise only if such dividends are viewed as payments from the policyholder to the company in the form of premium income. This follows from an understanding of the role reserves play in determining a life insurance company's income subject to tax. Moreover, the policyholder, in agreeing to the terms of such excess interest provision, is effectively agreeing to have such distributions applied directly to the policy to increase cash surrender value and policy benefits.

Each year reserves are increased to reflect net premium payments received, if any, and interest credited at the assumed rate. An amount equal to interest credited at the assumed rate is treated as the policyholders' share of total investment yield and is simply eliminated from the insurance company's tax base. See section 809(a) and (b)(1)(A) of the Code. Premium income is included in gain from operations. Section 809(b)(1)(C) and (c)(1). An offsetting deduction is allowed to the extent reserves are increased. Section 809(d)(2). The policyholders' share of investment yield is deducted from the section 809(d)(2) deduction under section 810(b). The 809(d)(2) deduction is necessary in computing gain or loss from operations in order to reflect the fact that some or all of the premium income received from policyholders should not currently be considered "gain" from operations because it must be held ready (as a reserve) to meet future policy commitments. Thus viewing the function of the section 809(d)(2) deduction for an increase in reserves, it would be inappropriate to allow such a deduction if the company did not receive, actually or constructively, premium income.

This interpretation is supported by the legislative history of section 809 of the Code. In discussing changes made from the House of Representatives' method of calculating gain or loss from operations, the Senate Committee on Finance outlined the treatment of interest and premiums discussed above and stated that additions to reserves [under section 809(d)(2)] relate only to premium additions to reserves. S. Rep. 291, 86th Cong., 1st Sess. 24, 1959-2 C.B. 770, 787.

HOLDING

Amounts in excess of the assumed rate of interest that are credited under the contracts are distributions similar to dividends to policyholders under sections 811(a) and 809(d)(3) of the Code.

Under the authority of section 7805(b) of the Code, life insurance companies may continue in certain limited circumstances to credit excess interest amounts to life insurance reserves without such amounts being considered either as dividends to policyholders or as premiums received. This treatment will be allowed for such interest attributable to reserve accumulations existing on June 21, 1982, and subsequent reserve accumulations resulting from excess interest that are allocable to the June 21, 1982, reserve accumulations. Such treatment will not be allowed for any excess interest amounts credited to reserves after June 30, 1987.

In addition, life insurance reserve additions resulting from scheduled premiums falling due prior to October 1, 1982, in amounts specified in and required by provisions of the contract in force on June 21, 1982, will be treated the same as reserve accumulations existing on June 21, 1982. Reserve additions resulting from premiums paid before July 1, 1987, on contracts used to fund employee plans described in section 401 or 403(a) of the Code, tax-sheltered annuities described in section 403(b), and individual retirement accounts or annuities described in section 408, and on contracts purchased to provide the necessary funds to make payments pursuant to eligible state deferred compensation plans defined in section 457, will also be treated the same as reserve accumulations existing on June 21, 1982.

The section 7805(b) relief granted in this revenue ruling is also applicable to excess interest credited on life insurance contracts.

The section 7805(b) relief granted in this revenue ruling sham not apply from the effective date of any subsequent legislation enacted by Congress specifically providing treatment of policyholder dividends or excess interest different from that set forth in this revenue ruling.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 67-180, 1967-1 C.B. 172, and Rev. Rul. 79-260, 1979-2 C.B. 262, which describe policyholder dividends and divisible surplus as being determined solely on the basis of experience factors which have already occurred, are hereby modified.

Rev. Rul. 69-444,1969-2 C.B. 145, which concludes that the addition of a double indemnity benefit to lie insurance policies is not a change in basis in computing reserves, is hereby supplemented by the following holdings:

(1) The additional benefits announced during the taxable year are distributions similar to policyholder dividends under sections 809(d)(3) and 811 of the Code.

(2) Such distributions should also be included in the "gross amount of premiums and other consideration" under section 809(c)(1) of the Code.

¹ Also released as News Release IR-82-78, dated June 21, 1982.