Rev. Rul. 80-117

Advice has been requested concerning the proper tax treatment of life insurance reserves that a transferor life insurance company (M) had elected to revalue under section 818(c)(2) of the Internal Revenue Code prior to the company's merger into another life insurance company (R) that had not made a section 818(c) election for the same type of reserves.

Prior to its merger into R, M elected, for federal income tax purposes, to revalue its life insurance reserves that were computed on a preliminary term basis using the approximate revaluation method under section 818(c)(2) of the Code. The merger, which occurred on October 31, 1976, qualified as a reorganization under section 368(a)(1)(A). Both M and R qualified as a life insurance company taxable under section 802 at the time of the merger. As of October 31, 1976, the life insurance reserves of R, computed on a preliminary term basis, were greater than the life insurance reserves of M. R has never made an election to revalue its preliminary term reserves under section 818(c).

In reliance upon the "principal method of accounting" requirements of section 381(c)(4) of the Code and section 1.381(c)(4)-1 of the Income Tax Regulations, R changed the method used by M in computing its life insurance reserves to conform to R's method of computing life insurance reserves on the preliminary term basis.

The specific issue is what is the proper manner to take into account the difference, as of the date of the merger, between M's life insurance reserves determined on the approximate revaluation basis under section 818(c) of the Code and as computed on a preliminary term basis.

Section 381(c)(22) of the Code provides that if the acquiring corporation is an insurance company taxable under subchapter L, there shall be taken into account (to the extent proper to carry out the purposes of section 381 and of subchapter L, and under such regulations as may be prescribed by the Secretary) the items required to be taken into account for purposes of subchapter L in respect of the distributor or transferor corporation.

Section 1.381(c)(22)-1(a) of the regulations provides that among the items to be taken into account by the acquiring corporation are the reserves described in section 810(c) of the Code 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 (including life insurance reserves) 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 the section 810(c) items at the beginning of the year and the sum of the section 810(c) items at the close of the taxtable 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.

In Rev. Rul. 72-344, 1972-2 C.B. 218, a life insurance company, wholly owned by another life insurance company, was liquidated under section 332 of the Code. The issue there was how the parent should treat the section 810(c) items acquired from the subsidiary for purposes of section 381. Rev. Rul. 72-344 holds that the acquiring life insurance company should add, at the date of transfer, the dollar balances of the transferred section 810(c) items, as of the close of the day of transfer, to the opening balance of its section 810(c) items. It further holds that the difference between the above described 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 section 809(d)(2), as the case may be, in computing its gain or loss for the first taxable year ending after the date of distribution or transfer.

The principles stated in Rev. Rul. 72-344 are applicable in the instant revenue ruling. Thus, R must add the dollar balances of the section 810(c) items acquired from M, as of the close of the day of transfer, to the opening balances of R's own section 810(c) items for purposes of section 810(a) or (b). A problem arises, however, because R valued its life insurance reserves on a preliminary term basis, but prior to the merger M, the acquired corporation, revalued its reserves on the approximate revaluation basis pursuant to a section 818(c)(2) election.

Section 806(b) of the Code provides that, for purposes of subpart B, if the basis for section 810(c) items at the end of the taxable year differs from the basis at the beginning of the taxable year, the old basis shall be used as of the close of the taxable year and the new basis shall be used as of the beginning of the next taxable year.

Thus, for purposes of determining taxable investment income, the old basis will continue to be used for the entire year in which the change in basis occurs. Section 806(b) is applicable in the instant situation because the basis for determining the life insurance reserves of M by R as of December 31, 1976, was preliminary term (as a result of conformance to the principal method of accounting of R), while the basis for determining the life insurance reserves as of January 1, 1976, was the approximate revaluation basis (pursuant to previous election by M under section 818(c)(2)).

In determining a life insurance company's gain from operations, section 809(d)(2) of the Code provides a deduction for the net increase in reserves required by section 810 to be taken into account in the determination of gain from operations. Section 810(b) requires that the excess of section 810(c) items at the close of the taxable year over section 810(c) items at the beginning of the taxable year shall be taken into account as a net increase referred to in section 801(d)(2). Thus, together, section 809(d)(2) and section 810(b) provide the general rule that a net increase in the life insurance reserves shall be taken into account in full in the year the increase occurs.

Section 810(d)(1) of the Code and section 1.810-3(a) of the regulations, however, provide an exception to this general rule. Section 810(d)(1) and section 1.810-3(a) provide that if the basis for determining any item referred to in section 810(c) at the end of the taxable year differs from the basis for such determination at the end of the preceding taxable year, then so much of the difference between the amount of the item at the end of the taxable year, computed on the new basis, and the amount of the item at the end of the taxable year, computed on the old basis, as is attributable to contracts issued before the taxable year, shall not be included in income or be deductible, as the case may be, under section 810(a) or (b), but rather shall be deductible or includible in income, as the case may be, at a rate of one-tenth for each of the 10 succeeding taxable years.

Section 810(d)(2) and (3) of the Code provides the only exceptions to the 10-year spread rule for the change in basis under section 810(d)(1). Section 810(d)(2) states that:

Except as provided in section 381(c)(22) (relating to carryovers in certain corporate readjustments), if for any taxable year the taxpayer is not a life insurance company, the balance of any readjustments under this paragraph shall be taken into account for the preceding taxable year.

Under section 810(d)(3) of the Code an election to revalue preliminary term reserves under section 818(c), is not treated as a change in basis in computing reserves for purposes of section 810(d)(1).

In the instant situation, as a result of the merger and the application of the "principal method of accounting" concept in section 1.381(c)(4)-1 of the regulations, the section 818(c) election previously in effect is revoked. Revocation of the section 818(c) election requires a revaluation of life insurance reserves from the approximate revaluation basis to a preliminary term basis. Such a change in basis comes within the meaning of section 810(d)(1), and thus, is subject to the 10-year spread rule. The section 810(d)(2) exception cannot apply because the merger comes within the carry-over provisions of section 381(c)(22). Similarly, section 810(d)(3) cannot apply because a section 818(c) election is no longer in effect. Thus, the revocation is a change in basis, and the adjustment created thereby is subject to a 10-year spread under section 810(d)(1).

The adjustment created by the change in basis in computing life insurance reserves is controlled by section 810(d)(1) of the Code because it is the result of a change in basis for determining a section 810(c) reserve. Thus, there is no need for section 481 to apply. The distortion that an allocation under section 481 seeks to avoid is likewise avoided under section 810(d). Compare Rev. Rul. 80-116, page 141, this Bulletin, holding that the surviving life insurance company in a statutory merger is not entitled to an adjustment under section 481 by reason of the revaluation of preliminary term reserves of the acquired life insurance company pursuant to an election under section 818(c).

Accordingly, the life insurance reserves acquired by R from M in the merger were properly revalued to a preliminary term basis pursuant to the principal method of accounting requirements of section 1.381(c)(4)-1 of the regulations. Such revaluation to a preliminary term method of computing life insurance reserves is a change in basis in computing reserves within the meaning of section 806(b) and section 810(d) of the Code.