The Internal Revenue Service has proposed a new rule that it says will limit the use of life insurance and annuity contracts to avoid current taxation of investment earnings.
The rule involves nonregistered partnerships and the application of the “look through” rule under the diversification regulations of Section 817 of the tax code, according to an analysis by the Association for Advanced Life Underwriting, Falls Church, Va.
Under the proposed rule, in order to look through a nonregistered partnership to its underlying assets to determine if any investment in a variable contract is adequately diversified, two conditions must be satisfied.
Under the first condition, all the beneficial interests in the nonregistered partnership must be held by one or more segregated asset accounts of one or more insurers.
Under the second condition, public access to the nonregistered partnership must be available exclusively through the purchase of a variable contract.
AALU notes that under Section 817(h) of the tax code, the inside buildup of a variable contract that is based on a segregated asset account is taxable during any period during which the segregated asset account investments are not adequately diversified.
Section 817(h)(4) of the code provides, however, that in certain situations, the diversification requirements may be met through a “look through” rule.
Under this rule, if all the beneficial interests in a regulated investment company or trust are held by one or more insurance companies, the diversification requirements are applied by taking into account the assets held by the investment company or trust, AALU says.
Without this rule, AALU notes, a segregated asset account that invests all its assets in a regulated investment company would be treated as owning only one asset and would thus fail the diversification requirement.
With the “look through” rule, AALU says, if the assets in the regulated investment company are adequately diversified, then the assets in the segregated asset account are also deemed to be adequately diversified.
In addition, AALU notes, for variable annuity, endowment and life insurance contracts, the “look through” rule applies if the two conditions noted above are met–that is, all the beneficial interests in the investment company are held by one or more insurance companies and public access is available only through the purchase of a variable contract.
However, AALU notes, current regulations imply an exception to these two conditions for nonregistered partnerships. Thus, it is not necessary to have all the beneficial interests held by one or more insurance companies in order for the “look through” rule to apply.
AALU says this exception to the “look through” rule clearly has become an inconvenience to the IRS in its drive to deny tax-deferral treatment to income earned on variable contracts invested in hedge funds.
Most hedge funds, AALU notes, are nonregistered partnerships, many of them offshore. While they are not open to the general public, AALU says, they are open to financially eligible investors who may be holders of variable life insurance or annuity contracts.