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.
A number of taxpayers, AALU says, have relied on the nonregistered partnership exception to the diversification rules to justify the deferral of income earned on their investment in hedge funds via an insurance or annuity “wrapper.”
The proposed rule, AALU says, removes the exception.
Written comments on the proposed rule must be filed with IRS by Dec. 3, 2003.
AALU says it will continue to monitor the issue.
In other tax news, AALU, along with the National Association of Insurance and Financial Advisors, the American Council of Life Insurers, and 25 other insurance firms, have formally asked the Treasury Department for a one-year extension of the effective date for proposed new rules on split-dollar life insurance arrangements.
If the groups succeed, the new effective date would be Jan. 1, 2005.
“This continuance for taxpayer decision-making is needed because of the complexity of the numerous issues to which attention must be given, the enormous effort that will be required of the persons and advisors involved (e.g., employers, employees, assignors of employees such as life insurance trusts, issuing life insurance companies, life insurance agents and consulted lawyers and accountants), and the restricted time in which decisions must be made.”
The letter notes that full information about the applicable rules will not be available until the final regulations are issued, which is expected to happen later this year.
Finally, ACLI is applauding legislation introduced in the Senate that would eliminate the current restrictions on consolidated tax returns filed by life insurance companies.
Under current law, life insurers must be part of an affiliated group for five years before they can join in the groups consolidated returns.
In addition, nonlife companies must be members of the affiliated group before any of their net operating losses can be used to offset life insurer income.
Moreover, the nonlife affiliates net operating losses can offset only 35% of the life insurers taxable income.
The legislation, S. 1495, would eliminate all these restrictions.
ACLI President Frank Keating says the current restrictions create an unfair playing field for life insurers in the financial services marketplace.
Reproduced from National Underwriter Life & Health/Financial Services Edition, August 11, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.