Part I. Rulings — Internal Revenue Bulletin 2003-33

Section 21.—Expenses for adoption assistance benefits), and 151 Low-income housing credit; satis- Household and Dependent (dependency exemptions). factory bond; “bond factor” amounts Care Services Necessary for for the period July through September Gainful Employment Rev. Rul. 2003–72 2003. This ruling announces the monthly

adoption assistance benefits), and 151 (dependency exemptions).

Rev. Rul. 2003–72

Low-income housing credit; satis- factory bond; “bond factor” amounts for the period July through September 2003. This ruling announces the monthly bond factor amounts to be used by taxpayers who dispose of qualified low-income buildings or interests therein during the period July through September 2003.

Rev. Rul. 2003–93

In Rev. Rul. 90–60, 1990–2 C.B. 3, the Internal Revenue Service provided guidance to taxpayers concerning the general methodology used by the Treasury Department in computing the bond factor amounts used in calculating the amount of bond considered satisfactory by the Secretary under § 42(j)(6) of the Internal Revenue Code. It further announced that the Secretary would publish in the Internal Revenue Bulletin a table of bond factor amounts for dispositions occurring during each calendar month.

Rev. Proc. 99–11, 1999–1 C.B. 275, established a collateral program as an alternative to providing a surety bond for taxpayers to avoid or defer recapture of the low-income housing tax credits under § 42(j)(6). Under this program, taxpayers may establish a Treasury Direct Account and pledge certain United States Treasury securities to the Internal Revenue Service as security.

This revenue ruling provides in Table 1 the bond factor amounts for calculating the amount of bond considered satisfactory under § 42(j)(6) or the amount of United States Treasury securities to pledge in a Treasury Direct Account under Rev. Proc. 99–11 for dispositions of qualified low-income buildings or interests therein during the period July through September 2003.

26 CFR 1.44A–1: Expenses for household and depen- dent care services necessary for gainful employment.

A child attains an age on his or her birthday for purposes of sections 21 (child and dependent care credit), 23 (adoption credit), 24 (child tax credit), 32 (earned income credit), 129 (excludable dependent care benefits), 131 (excludable foster care benefits), 137 (excludable adoption assistance benefits), and 151 (dependency exemptions). See Rev. Rul. 2003-72, page 346.

Section 23.—Adoption Expenses

Section 24.—Child Tax Credit

Section 32.—Earned Income

26 CFR 1.32–2: Earned income credit for taxable years beginning after December 31, 1978. (Also §§ 21, 23, 24, 129, 131, 137, 151; 1.44A–1, 1.151–2.)

Determination of a child’s specific age. A child attains an age on his or her birthday for purposes of Code sections 21 (child and dependent care credit), 23 (adoption credit), 24 (child tax credit), 32 (earned income credit), 129 (excludable dependent care benefits), 131 (excludable foster care benefits), 137 (excludable

This revenue ruling applies a uniform method of determining when a child attains a specific age for purposes of the following sections of the Internal Revenue Code: 21 (dependent care credit), 23 (adoption credit), 24 (child tax credit), 32 (earned income credit), 129 (dependent care assistance programs), 131 (foster care payments), 137 (adoption assistance programs), and 151 (dependency exemptions).

Each of these provisions allows a credit, exclusion, or deduction to the taxpayer, provided, among other requirements, a child has not attained a specific age. For example, under § 24(c), one of the requirements for a qualifying child for the child tax credit is that the child “has not attained the age of 17 as of the close of the calendar year in which the taxable year of the taxpayer begins.”

HOLDING

For purposes of each of the provisions identified in this revenue ruling, a child attains a given age on the anniversary of the date that the child was born. For example, a child born on January 1, 1987, attains the age of 17 on January 1, 2004.

DRAFTING INFORMATION

The principal author of this revenue ruling is Karin Loverud of the Office of Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities). For further information regarding this revenue ruling, contact Ms. Loverud at (202) 622–6080 (not a toll-free call).

Section 42.—Low-Income Housing Credit

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

2003-33 I.R.B. 346 August 18, 2003

contract? Will income earned on those assets be included in the income of the holder in the year in which it is earned?

FACTS

Situation 1 : IC is a life insurance company subject to tax under § 801 of the Internal Revenue Code. In states where it is authorized to do so, IC offers variable life and variable annuity contracts that qualify as variable contracts under § 817(d) (“Contracts”).

The assets that fund the Contracts are segregated from the assets that fund IC 's traditional life insurance products. IC maintains a separate account (“Separate Account”) for the assets funding the Contracts, and the income and liabilities associated with the Separate Account are maintained separately from IC 's other accounts.

The Separate Account is divided into various sub-accounts (“Sub-accounts”). Each Sub-account's assets and liabilities

For a list of bond factor amounts applicable to dispositions occurring during other calendar years, see: Rev. Rul. 98–3, 1998–1 C.B. 248; Rev. Rul. 2001–2, 2001–1 C.B. 255; Rev. Rul. 2001–53, 2001–2 C.B. 488; and Rev. Rul. 2002–72, 2002–44 I.R.B. 759. For dispositions occurring during the period January through March 2003, see Rev. Rul. 2003–22, 2003–8 I.R.B. 494. For dispositions occurring during the period April through June 2003, see Rev. Rul. 2003–44, 2003–18 I.R.B. 848.

DRAFTING INFORMATION

The principal author of this revenue ruling is Gregory N. Doran of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Mr. Doran at (202) 622–3040 (not a toll-free call).

Section 61.—Gross Income Defined

26 CFR 1.61–1: Gross income. (Also §§ 801, 817; 1.817–5.)

Investor control doctrine. This ruling presents guidance on the investor control doctrine by presenting a factual scenario in which a variable contract holder does not have control over segregated account assets sufficient to be deemed the owner of the assets. In this manner, this ruling presents a “safe harbor” from which taxpayers may operate.

Rev. Rul. 2003–91

ISSUE

Under the facts set forth below, will the holder of a variable contract be considered to be the owner, for federal income tax purposes, of the assets that fund the variable

August 18, 2003 347 2003-33 I.R.B.

specific retention of legal title, the creation of a new equitable but controlled interest, or the maintenance of effective benefit through the interposition of a subservient agency. Christoffersen v. U.S., 749 F.2d 513 (8 ^th Cir.), rev'g 578 F. Supp. 398 (N.D. Iowa 1984).

Rev. Rul. 77–85, 1977–1 C.B. 12, considers a situation in which the individual purchaser of a variable annuity contract retained the right to direct the custodian of the account supporting that variable annuity to sell, purchase, and exchange securities or other assets held in the custodial account. The purchaser also was able to exercise an owner's right to vote account securities either through the custodian or individually. The Service concluded that the purchaser possessed “significant incidents of ownership” over the assets held in the custodial account. The Service reasoned that if a purchaser of an “investment annuity” contract may select and control the investment assets in the separate account of the life insurance company issuing the contract, then the purchaser is treated as the owner of those assets for federal income tax purposes. Thus, any interest, dividends, or other income derived from the investment assets are included in the purchaser's gross income.

In Rev. Rul. 80–274, 1980–2 C.B. 27, the Service, applying Rev. Rul. 77–85, concludes that, if a purchaser of an annuity contract may select and control the certificates of deposit supporting the contract, then the purchaser is considered the owner of the certificates of deposit for federal income tax purposes. Similarly, Rev. Rul. 81–225, 1981–2 C.B. 12, concludes that investments in mutual fund shares to fund annuity contracts are considered to be owned by the purchaser of the annuity if the mutual fund shares are available for purchase by the general public. Rev. Rul. 81–225 also concludes that, if the mutual fund shares are available only through the purchase of an annuity contract, then the sole function of the fund is to provide an investment vehicle that allows the issuing insurance company to meet its obligations under its annuity contracts and the mutual fund shares are considered to be owned by the insurance company. Finally, in Rev.

are maintained separately from the assets and liabilities of other Sub-accounts. Interests in the Sub-accounts are not available for sale to the public. Rather, interests in the Sub-accounts are available solely through the purchase of a Contract. IC engages an independent investment advisor (“Advisor”) to manage the investment activities of each Sub-account. ¹ Each Sub-account will at all times meet the asset diversification test set forth in § 1.817–5(b)(1) of the Income Tax Regulations.

Twelve sub-accounts are currently available under the Contracts, but IC may increase or decrease this number at any time. However, there will never be more than 20 Sub-accounts available under the Contracts. Each Sub-account offers a different investment strategy. The currently available Sub-accounts include a bond fund, a large company stock fund, an international stock fund, a small company stock fund, a mortgage backed securities fund, a health care industry fund, an emerging markets fund, a money market fund, a telecommunication fund, a financial services industry fund, a South American stock fund, an energy fund and an Asian markets fund.

An individual (“Holder”) purchases a life insurance Contract (“LIC”). At the time of purchase, Holder specifies the allocation of premium paid among the then available Sub-accounts. Holder may change the allocation of premiums at any time, and Holder may transfer funds from one Sub-account to another. Holder is permitted one transfer between Sub-accounts without charge per thirty-day period. Any additional transfers during this period are subject to a fee assessed against the cash value of LIC.

There is no arrangement, plan, contract, or agreement between Holder and IC or between Holder and Advisor regarding the availability of a particular Sub-account, the investment strategy of any Sub-account, or the assets to be held by a particular sub-account. Other than Holder's right to allocate premiums and transfer funds among the available Sub-accounts as described above, all investment decisions concerning the Sub-accounts are made by IC or Advisor in their sole and

absolute discretion. Specifically, Holder cannot select or recommend particular investments or investment strategies. Moreover, Holder cannot communicate directly or indirectly with any investment officer of IC or its affiliates or with Advisor regarding the selection, quality, or rate of return of any specific investment or group of investments held in a Sub-account. Holder has no legal, equitable, direct, or indirect interest in any of the assets held by a Sub-account. Rather, Holder has only a contractual claim against IC to collect cash from IC in the form of death benefits, or cash surrender values under the Contract.

All decisions concerning the choice of Advisor or the choice of any of IC 's investment officers that are involved in the investment activities of Separate Account or any of the Sub-accounts, and any subsequent changes thereof, are made by IC in its sole and absolute discretion. Holder may not communicate directly or indirectly with IC concerning the selection or substitution of Advisor or the choice of any IC 's investment officers that are involved in the investment activities of Separate Account or any of the Sub-accounts.

Situation 2 : The facts are the same as Situation 1 except that Holder purchases an annuity Contract (“Annuity”).

LAW

Section 61(a) provides that the term “gross income” means all income from whatever source derived, including gains derived from dealings in property, interest and dividends.

A long standing doctrine of taxation provides that “taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed—the actual benefit for which the tax is paid.” Corliss v. Bowers, 281 U.S. 376 (1930). The incidence of taxation attributable to ownership of property is not shifted if the transferor continues to retain significant control over the property transferred, Frank Lyon Company v. United States, 435 U.S. 561 (1978); Commissioner v. Sunnen, 333 U.S. 591 (1948); Helvering v. Clifford, 309 U.S. 331 (1940), without regard to whether such control is exercised through

1 For these purposes, the term investment officer refers to anyone whose responsibilities include giving investment advice or making investment decisions relating to assets held in a Sub-account and to any person who directly or indirectly supervises the work performed by such individual.

2003-33 I.R.B. 348 August 18, 2003

The temporary regulations . . . do not provide guidance concerning the circumstances in which investor control of the investments of a segregated asset account may cause the investor, rather than the insurance company, to be treated as the owner of the assets in the account. For example, the temporary regulations provide that in appropriate cases a segregated asset account may include multiple sub-accounts, but do not specify the extent to which policyholders may direct their investments to particular sub-accounts without being treated as owners of the underlying assets. Guidance on this and other issues will be provided in regulations or revenue rulings under section 817(d), relating to the definition of variable contracts. T.D. 8101, 1986–2 C.B. 97 [51 FR 32633] (Sept. 15, 1986). The text of the temporary regulations served as the text of proposed regulations in the notice of proposed rulemaking. See LR–295–84, 1986–2 C.B. 801 [51 FR 32664] (Sept. 15, 1986). The final regulations adopted, with certain revisions not relevant here, the text of the proposed regulations.

ANALYSIS

The determination of whether Holder possesses sufficient incidents of ownership over Sub-account assets to be deemed the owner of the assets supporting LIC and Annuity depends on all of the relevant facts and circumstances.

Holder may not select or direct a particular investment to be made by either the Separate Account or the Sub-accounts. Holder may not sell, purchase, or exchange assets held in the Separate Account or the Sub-accounts. All investment decisions concerning the Separate Account and the Sub-accounts are made by IC or Advisor in their sole and absolute discretion.

The investment strategies of the Sub-accounts currently available are sufficiently broad to prevent Holder from making particular investment decisions through investment in a Sub-account. Only IC may add or substitute Sub-accounts or investment strategies in the future. No arrangement, plan, contract, or agreement exists between Holder and IC or between Holder and Advisor regarding the specific investments or investment objective of the

Rul. 82–54, 1982–1 C.B. 11, the purchaser of certain annuity contracts could allocate premium payments among three funds and had an unlimited right to reallocate contract value among the funds prior to the maturity date of the annuity contract. Interests in the funds were not available for purchase by the general public, but were instead only available through purchase of an annuity contract. The Service concludes that the purchaser's ability to choose among general investment strategies (for example, between stock, bonds, or money market instruments) either at the time of the initial purchase or subsequent thereto, does not constitute control sufficient to cause the contract holders to be treated as the owners of the mutual fund shares.

In Christoffersen v. U.S., the Eighth Circuit considered the federal income tax consequences of the ownership of the assets supporting a segregated asset account. The taxpayers in Christoffersen purchased a variable annuity contract that reflected the investment return and market value of assets held in an account that was segregated from the general asset account of the issuing insurance company. The taxpayers had the right to direct that their premium payments be invested in any one of six publicly traded mutual funds. The taxpayers could reallocate their investment among the funds at any time. The taxpayers also had the right upon seven days notice to withdraw funds, surrender the contract, or apply the accumulated value under the contract to provide annuity payments.

The Eighth Circuit held that, for federal income tax purposes, the taxpayers, not the issuing insurance company, owned the mutual fund shares that funded the variable annuity. The court concluded that the taxpayers “surrendered few of the rights of ownership or control over the assets of the sub-account,” that supported the annuity contract. Christoffersen, 749 F.2d at 515. According to the court, “the payment of annuity premiums, management fees and the limitation of withdrawals to cash [did] not reflect a lack of ownership or control as the same requirements could be placed on traditional brokerage or management accounts.” Id . at 515–16. Thus, the taxpayers were required to include in gross income any gains, dividends, or other income derived from the mutual fund shares.

Section 817, which was enacted by Congress as part of the Deficit Reduction Act of 1984 (Pub. L. No. 98–369) (the “1984 Act”), provides rules regarding the tax treatment of variable life insurance and annuity contracts. Section 817(d) defines a “variable contract” as a contract that provides for the allocation of all or part of the amounts received under the contract to an account that, pursuant to State law or regulation, is segregated from the general asset accounts of the company and that provides for the payment of annuities, or is a life insurance contract. In the legislative history of the 1984 Act, Congress expressed its intent to deny life insurance treatment to any variable contract if the assets supporting the contract include funds publicly available to investors:

The conference agreement allows any diversified fund to be used as the basis of variable contracts so long as all shares of the funds are owned by one or more segregated asset accounts of insurance companies, but only if access to the fund is available exclusively through the purchase of a variable contract from an insurance company. . . . In authorizing Treasury to prescribe diversification standards, the conferees intend that the standards be designed to deny annuity or life insurance treatment for investments that are publicly available to investors . . . H. R. Conf. Rep. No. 98–861, at 1055 (1984).

Section 817(h)(1) provides that a variable contract based on a segregated asset account shall not be treated as an annuity, endowment, or life insurance contract unless the segregated asset account is adequately diversified in accordance with regulations prescribed by the Secretary. If a segregated asset account is not adequately diversified, income earned by that segregated asset account is treated as ordinary income received or accrued by the policyholders.

Approximately two years after enactment of § 817(h), the Treasury Department issued proposed and temporary regulations prescribing the minimum level of diversification that must be met for an annuity or life insurance contract to be treated as a variable contract within the meaning of § 817(d). The preamble to the regulations stated as follows:

August 18, 2003 349 2003-33 I.R.B.

or entirely for cash (subject to a surrender charge) and the right to convert (at future dates chosen by Contract Holder) the accumulated values under Annuity into a stream of periodic payments under one of several settlement options.

The assets supporting Annuity are held in a segregated asset account that is maintained separately from IC 's other accounts. The segregated asset account is divided into 10 sub-accounts (“Sub-accounts”). Each Sub-account's assets and liabilities are maintained separately from the assets and liabilities of other Sub-accounts. At the time of purchase, Contract Holder specifies the premium allocation among the available Sub-accounts. Contract Holder may change the allocation of subsequent premiums at any time.

Each Sub-account available under Annuity invests in interests in a partnership (“Partnership”). None of the Partnerships are publicly traded partnerships under § 7704. All of the Partnerships are exempt from registration under federal security laws. Interests in each Partnership are sold in private placement offerings and are sold only to qualified purchasers that are accredited investors or to no more than one hundred accredited investors.

Each Partnership has an investment manager that selects the Partnership's specific investments. Contract Holder may not act as an investment manager or independently own any interest in any Partnership offered under Annuity. In addition, Contract Holder will have no voting rights with respect to any Partnership interest held by any Sub-account.

Each Sub-account will at all times meet the asset diversification test set forth in § 1.817–5(b)(1) of the Income Tax Regulations.

Situation 2 . The facts are the same as those in Situation 1, except IC offers, and Contract Holder purchases, a variable life insurance contract (“LIC”) that qualifies as a life insurance contract under § 7702.

Situation 3 . The facts are the same as those in Situation 1, except that (i) Contract Holder purchases both an Annuity and an LIC and (ii) interests in each Partnership are available for purchase only through the purchase of an Annuity,

Sub-accounts. In addition, Holder may not communicate directly or indirectly with Advisor or any of IC 's investment officers concerning the selection, quality, or rate of return of any specific investment or group of investments held by Separate Account or in a Sub-account.

Investment in the Sub-accounts is available solely through the purchase of a Contract, thus, Sub-accounts are not publicly available. The ability to allocate premiums and transfer funds among Sub-accounts alone does not indicate that Holder has control over either Separate Account or Sub-account assets sufficient to be treated as the owner of those assets for federal income tax purposes.

Based on all the facts and circumstances, Holder does not have direct or indirect control over the Separate Account or any Sub-account asset. Therefore, Holder does not possess sufficient incidents of ownership over the assets supporting either LIC or Annuity to be deemed the owner of the assets for federal income tax purposes. So long as LIC and Annuity continue to satisfy the diversification requirements of § 817(h) and IC 's and Holder's future conduct is consistent with the facts of this ruling, Holder will not be required to include the earnings on the assets held in Separate Account or any of the Sub-accounts in income under § 61(a).

HOLDING

Under the facts set forth above, the holder of a variable contract will not be considered to be the owner, for federal income tax purposes, of the assets that fund the variable contract. Therefore, any interest, dividends, or other income derived from the assets that fund the variable contract is not included in the holder's gross income in the year in which the interest, dividends, or other income is earned.

DRAFTING INFORMATION

The principal author of this revenue ruling is James Polfer of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact

Mr. Polfer at (202) 622–3970 (not a toll-free call).

26 CFR 1.61–1: Gross income. (Also §§ 801, 817, 7702; 1.817–5.)

Variable contract holder. This ruling holds that a variable contract holder is the owner of interests in a nonregistered partnership where interests in the nonregistered partnership are not available exclusively through the purchase of a life insurance or annuity contract. Rev. Rul. 81–225 clarified and amplified.

Rev. Rul. 2003–92

ISSUES

Under the facts set forth below, will the holder of a variable annuity or life insurance contract be considered to be the owner, for federal income tax purposes, of the partnership interests that fund the variable contract if interests in the partnerships are available for purchase by the general public? What are the income tax consequences to the holder of the contract if that holder is considered to be the owner of the partnership interests that fund the variable contract?

FACTS

Situation 1 . IC is a life insurance company subject to tax under § 801 of the Internal Revenue Code. In states where it is authorized to do so, IC offers deferred variable annuity contracts. IC has developed a variable annuity contract (“Annuity”) for sale only to “qualified purchasers” ¹ that are “accredited investors” ² or to no more than one hundred accredited investors. IC is not required to register Annuity under the federal security laws.

Contract Holder, an individual qualifying as both a qualified purchaser and an accredited investor, purchases Annuity from IC . Annuity contains a number of provisions common to deferred annuity contracts, including the right of Contract Holder to surrender Annuity in part

1 Under 15 U.S.C. § 80a–2(a)(51) a “qualified purchaser” is an individual, or other specified entity, that satisfies certain threshold financial requirements.

2 The term “accredited investor,” as defined by 15 U.S.C. § 77b(a)(15), and amplified by 17 CFR § 230.501(a), is also an investor that satisfies certain financial criteria. An accredited investor may be either an individual or certain enumerated entities. Because the criteria to be an accredited investor are similar to, but not identical to, the criteria that must be met to be a qualified purchaser it is possible for an accredited investor to also be a qualified purchaser. It is also possible for an investor to qualify only as either an accredited or qualified investor.

2003-33 I.R.B. 350 August 18, 2003

the purchaser will be treated as the owner of those assets for federal income tax purposes. Thus, any interest, dividends, or other income derived from the investment assets are includible in the gross income of the purchaser. Similarly, Rev. Rul. 80–274, 1980–2 C.B. 27, holds that if a purchaser of an annuity contract may select and control the certificates of deposit supporting the contract, then the purchaser is treated as the owner of the certificates of deposit for federal income tax purposes. In Rev. Rul. 80–274, the insurance company could not dispose of the deposit or convert it into a different asset. The insurance company did, however, have the power to withdraw the deposit from a failing savings and loan association.

Rev. Rul. 81–225, 1981–2 C.B. 12, describes four situations in which investments in mutual fund shares to fund annuity contracts are treated as owned by the policyholder rather than by the issuing insurance company, and one situation in which the issuing insurance company is treated as the owner of the mutual fund shares. In Situation 1, the investment assets in the segregated account supporting the annuity contracts consisted solely of shares in a single, publicly available mutual fund managed by an independent investment advisor. Situation 2 is similar to Situation 1, except that the publicly available mutual fund was managed by the issuing insurance company or one of its affiliates. Situation 3 also is similar to Situation 1, except that the segregated asset account supporting the annuity contracts consisted of five sub-accounts. Each sub-account was invested in the shares of a different mutual fund. Shares of the mutual funds were offered for sale to the general public. The policyholder retained the right to allocate or reallocate funds among the five sub-accounts during the life of the annuity contract. Situation 4 is similar to Situation 2, except that the mutual fund did not sell shares directly to the public. The shares of the mutual fund were available only through the purchase of an annuity contract or by participation in an investment plan account of the type described in Rev. Rul. 70–525, 1970–2 C.B. 144. Situation 5 also was similar to Situation 2, except that the shares in the mutual fund were available only through the purchase of an annuity contract.

an LIC, or other variable contracts from insurance companies.

LAW

Section 61(a) provides that the term “gross income” means all income from whatever source derived, including gains derived from dealings in property, interest, and dividends.

Section 817, which was enacted by Congress as part of the Deficit Reduction Act of 1984 (Pub. L. No. 98–369) (the “1984 Act”), provides rules regarding the tax treatment of variable life insurance and annuity contracts. Section 817(d) defines a “variable contract” as a contract that provides for the allocation of all or part of the amounts received under the contract to an account that, pursuant to State law or regulation, is segregated from the general asset accounts of the company and that provides for the payment of annuities, or is a life insurance contract. In the legislative history of the 1984 Act Congress expressed its intent to deny life insurance treatment to any variable contract if the assets supporting the contract include funds publicly available to investors:

The temporary regulations . . . do not provide guidance concerning the circumstances in which investor control of the investments of a segregated asset account may cause the investor, rather than the insurance company, to be treated as the owner of the assets in the account. For example, the temporary regulations provide that in appropriate cases a segregated asset account may include multiple sub-accounts, but do not specify the extent to which policyholders may direct their investments to particular sub-accounts without being treated as owners of the underlying assets. Guidance on this and other issues will be provided in regulations or revenue rulings under section 817(d), relating to the definition of variable contracts. 51 FR 32633 (Sept. 15, 1986). The text of the temporary regulations served as the text of proposed regulations in the notice of proposed rulemaking. See 51 FR 32664 (Sept. 15, 1986). The final regulations adopted, with certain revisions not relevant here, the text of the proposed regulations.

Prior to enactment of § 817, the Service issued a number of revenue rulings regarding when the owner of an annuity contract will be treated as the owner of the assets that fund the annuity. In the revenue rulings, the Service relied on long standing tax principles. See generally, Commis- sioner v. Sunnen, 333 U.S. 591 (1948); Helvering v. Clifford, 309 U.S. 331 (1940); Corliss v. Bowers, 281 U.S. 376 (1930). The revenue rulings consider whether the contract owners described in each ruling have retained sufficient incidents of ownership, as described in cases cited above, over the assets or retain sufficient control over the assets to be treated as the owners of those assets.

Rev. Rul. 77–85, 1977–1 C.B. 12, concludes that if a purchaser of an “investment annuity” contract selects and controls the investment assets in the separate account of the issuing life insurance company, then

August 18, 2003 351 2003-33 I.R.B.

tax purposes, IC owns the interests in Partnerships that fund the Sub-accounts. As a result, pursuant to § 61(a), any interest, dividends, or other income derived from the Partnerships is not included in Contract Holder's gross income in the year in which the interest, dividends, or other income is earned.

HOLDINGS

Under the facts set forth above, the holder of a variable annuity or life insurance contract will be considered to be the owner, for federal income tax purposes, of the partnership interests that fund the variable contract if interests in the partnerships are available for purchase by the general public. If the holder of a variable annuity or life insurance contract is considered to be the owner of the partnership interests that fund the variable contract, pursuant to § 61(a), the contract holder must include any interest, dividends, or other income derived from the partnership interests in gross income in the year in which the interest, dividends, or other income is earned.

EFFECT ON OTHER REVENUE RULING

Rev. Rul. 81–225, 1981–2 C.B. 12 is hereby clarified and amplified.

DRAFTING INFORMATION

Section 72.—Annuities; Certain Proceeds of Endowment and Life Insurance Contracts

A revenue ruling describes the tax treatment of a cash distribution made in connection with a reduction

Rev. Rul. 81–225 concludes that the policyholders in Situations 1 through 4 had sufficient control and other incidents of ownership to be treated as the owners of the mutual fund shares for federal income tax purposes. The ruling reaches the opposite conclusion in Situation 5, because the sole function of the mutual fund in Situation 5 was to provide an investment vehicle that allows the issuing insurance company to meet its obligations under its annuity contracts and the insurance company possessed sufficient incidents of ownership to be treated as the owner of the underlying portfolio of assets of the mutual fund for federal income tax purposes.

In Rev. Rul. 82–54, 1982–1 C.B. 11, the purchasers of certain annuity contracts could direct the issuing insurance company to invest in the shares of any one or any combination of three mutual funds that were not available to the public. One mutual fund invested primarily in common stocks, another in bonds, and the third in money market investments. Policyholders could allocate their premium payments among the three funds and had an unlimited right to reallocate contract values among the funds prior to the maturity date of the annuity contract. The ruling concludes that the policyholders' ability to choose among general investment strategies (for example, between stock, bonds, or money market funds) either at the time of the initial purchase or subsequent thereto, did not constitute control sufficient to cause the policyholders to be treated as the owners of the mutual fund shares.

In Christoffersen v. United States, 749 F.2d 513 (8 ^th Cir.), rev'g 578 F. Supp. 398 (N.D. Iowa 1984), the Eighth Circuit considered the federal income tax ownership of the assets supporting a segregated asset account. The taxpayers in Christoffersen purchased a variable annuity contract that reflected the investment return and market value of assets held in an account that was segregated from the general asset account of the issuing insurance company. The taxpayers had the right to direct that their premium payments be invested in any one or a combination of six publicly traded mutual funds. The taxpayers could reallocate their investment among the funds at any time. The taxpayers also had the right upon seven days notice to withdraw funds,

surrender the contract, or apply the accumulated value under the contract to provide annuity payments.

The Eighth Circuit held that, for federal income tax purposes, the taxpayers, not the issuing insurance company, owned the mutual fund shares that funded the variable annuity. The court concluded that the taxpayers “surrender few of the rights of ownership or control over the assets of the sub-account” that supported the annuity contract. Christoffersen, 749 F.2d at 515. According to the court, “the payment of annuity premiums, management fees and the limitation of withdrawals to cash [did] not reflect the lack of ownership or control as the same requirements could be placed on traditional brokerage or management accounts.” Id . at 515–16. Thus, the taxpayers were required to include in gross income any gains, dividends, or other income derived from the mutual fund shares.

ANALYSIS

In Situation 1, Sub-accounts hold interests in Partnerships available for purchase other than by purchasers of Annuity or other variable contracts from insurance companies. Therefore, for federal income tax purposes, Contract Holder is the owner of the interests in Partnerships held by Sub-accounts. As a result, pursuant to § 61(a), Contract Holder must include in its gross income any interest, dividends, or other income derived from the interests in the Partnerships in the year in which the interest, dividends, or other income is earned.

In Situation 2, Sub-accounts hold interests in Partnerships available for purchase other than by purchasers of LIC or other variable contracts from insurance companies. Therefore, for federal income tax purposes, Contract Holder is the owner of the interests in Partnerships held by Subaccounts. As a result, pursuant to § 61(a), Contract Holder must include any interest, dividends, or other income derived from the Partnerships in gross income in the year in which the interest, dividends, or other income is earned.

In Situation 3, Sub-accounts hold interests in Partnerships available for purchase only by a purchaser of an Annuity, a LIC, or other variable contracts from insurance companies. Therefore, for federal income

2003-33 I.R.B. 352 August 18, 2003

in the benefits of a life insurance contract. See Rev. Rul. 2003-95, page 358.

Notice addresses the taxation of certain tax-free exchanges of annuity contracts under section 72(e) and section 1035 of the Internal Revenue Code. This notice announces that Treasury and the Service are considering whether to exercise the authority granted under section 72(e)(11) to promulgate regulations that would prescribe the tax treatment of these transactions. See Notice 2003-51, page 361.

Section 129.—Dependent Care Assistance Programs

Section 131.—Certain Foster Care Payments

Section 137.—Adoption Assistance Programs

Section 151.—Allowance of Deductions for Personal Exemptions

26 CFR 1.151–2: Additional exemptions for depen- dents.

A child attains an age on his or her birthday for purposes of sections 21 (child and dependent care credit), 23 (adoption credit), 24 (child tax credit), 32 (earned

income credit), 129 (excludable dependent care benefits), 131 (excludable foster care benefits), 137 (excludable adoption assistance benefits), and 151 (dependency exemptions). See Rev. Rul. 2003-72, page 346.

Section 280G.—Golden Parachute Payments

Federal short-term, mid-term, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 382.—Limitation on Net Operating Loss Carryforwards and Certain Built-In Losses Following Ownership Change

The adjusted applicable federal long-term rate is set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 412.—Minimum Funding Standards

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 461.—General Rule for Taxable Year of Deduction

26 CFR 1.461–1: General rule for taxable year of deduction.

Accrual of liability for California franchise tax. This ruling holds that, for federal income tax purposes, a taxpayer that uses an accrual method of accounting incurs a liability for California franchise tax in the taxable year following the taxable year in which the tax is incurred under the California Revenue and Tax Code. Rev. Rul. 79–410 amplified.

Rev. Rul. 2003–90

ISSUE

For taxable years beginning on or after January 1, 2000, when does a taxpayer using an accrual method of accounting incur a liability for California franchise tax for federal income tax purposes?

FACTS

X is a corporation that uses an accrual method of accounting and files its federal

income tax return on a calendar year basis. X has conducted business in California continuously for several years and is required to pay a franchise tax imposed under § 23151 of the California Revenue & Taxation Code (Cal. Rev. & Tax. Code) (West 1998 & Supp. 2002). In 2002, X has net income attributable to California of $10,000. X remits payments of estimated California franchise tax of $884 during 2002. Under California law, X's franchise tax liability for 2002 is $884, determined on the basis of X's 2002 net income attributable to California of $10,000.

LAW AND ANALYSIS

Section 164(a) of the Internal Revenue Code allows a deduction for certain taxes paid or accrued during the taxable year including state franchise taxes imposed on corporations.

Section 461(a) provides that the amount of any deduction or credit is taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income.

Section 1.461–1(a)(2)(i) of the Income Tax Regulations provides that under an accrual method of accounting, a liability is incurred in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. Section 1.461–4(g)(6)(i) generally provides that if the liability of a taxpayer is to pay a tax, economic performance occurs as the tax is paid to the governmental authority that imposed the tax.

However, § 461(d) provides that, in the case of a taxpayer whose taxable income is computed under an accrual method of accounting, to the extent the time for accruing a tax is earlier than it would have been but for any action of any taxing jurisdiction taken after December 31, 1960, the tax is to be treated as accruing at the time it would have accrued but for the action by the taxing jurisdiction. Section 1.461–1(d)(1) provides that any action by a taxing jurisdiction that results in the acceleration of the accrual of any tax is to be disregarded in determining the time for accruing the tax for purposes of the deduction allowed for the tax, with respect to both taxpayers upon which the tax is imposed at

August 18, 2003 353 2003-33 I.R.B.

(West Supp. 2002). As a result, the California franchise tax is measured by the net income of the year in which the tax is imposed and payable. Cal. Rev. & Tax. Code § 23151.1(c)(2) (West Supp. 2002). The transition year (2000) was the California taxable year under the former law with respect to income earned in 1999, and also the redefined California taxable year under the amendment for income earned in the first taxable year beginning on or after January 1, 2000. The accompanying legislative history states, however, that there was no intent to change the amount of tax or the timing of payment. See 2000 Cal. Stat. 862 (Sept. 29, 2000).

Under § 1.461–1(a)(2)(i), the liability for California franchise tax is established and the amount can be determined with reasonable accuracy in the taxable year that the net income is earned. However, when compared to pre-1961 California law, the 2000 amendment to the California law, like the 1971 and 1972 amendments, accelerates the accrual of the franchise tax for a continuing corporation from the taxable year following the taxable year in which the net income is earned to the taxable year in which the net income is earned. Thus, pursuant to § 461(d), the 2000 amendment must be disregarded and the liability for California franchise tax continues to be incurred for federal income tax purposes in the California taxable year, the taxable year in which the liability became fixed under pre-1961 California law.

Therefore, for taxable years beginning on or after January 1, 2000, X incurs a liability for California franchise tax for federal income tax purposes in the taxable year that follows the taxable year in which X earns the income on which the tax is measured. The California franchise tax of $884 that X pays in 2002, based on the $10,000 of net income that X earns in 2002, is deductible on X's federal income tax return for taxable year 2003.

HOLDING

For taxable years beginning on or after January 1, 2000, a taxpayer that uses an accrual method of accounting incurs a liability for California franchise tax for federal income tax purposes in the taxable year following the taxable year in which the

the time of the action, and taxpayers upon which the tax is imposed at any time subsequent to the action.

Section 1.461–1(d)(1) further provides that, whenever an acceleration of the time for accruing a tax is to be disregarded, the taxpayer shall accrue the tax at the time the tax would have accrued but for the accelerating action (original accrual date). Section 1.461–1(d)(1) also provides that in the absence of any action of the taxing jurisdiction placing the time for accruing the tax at a time subsequent to the original accrual date, the taxpayer shall continue to accrue the tax as of the original accrual date for all future taxable years.

Section 1.461–1(d)(2)(iii) provides that the term “any action” includes the enactment or re-enactment of legislation, the adoption of an ordinance, the exercise of any taxing or administrative authority, or the taking of any other step, the result of which is an acceleration of the accrual event of any tax.

Cal. Rev. & Tax. Code § 23151 (West 1998 & Supp. 2002) imposes a franchise tax for the privilege of doing business as a corporation within California. For years beginning before January 1, 2000, the tax generally was measured by the net income of the year preceding the year for which the tax was imposed, subject to a minimum tax, with special rules for corporations commencing or ceasing business in California. Cal. Rev. & Tax. Code, § 23151.1 (West 1998 & Supp. 2002). The year in which the tax was imposed and payable was a corporation's “taxable year” (“California taxable year”). Cal. Rev. & Tax. Code § 23041(a) (West 1998 & Supp. 2002). The income year (“California income year”) was defined as the “year upon the basis of which the net income is computed.” Cal. Rev. & Tax. Code § 23042(a) (West 1998 & Supp. 2002). Thus, in the case of an ongoing corporation, the tax due for a California taxable year for the privilege of exercising the corporate franchise during the California taxable year was calculated based on the net income earned during the preceding year (the California income year).

Under pre-1961 California law, a corporation's liability for the franchise tax became fixed upon the corporation's exercise of the franchise in the California taxable year. Central Investment Corpora- tion v. Commissioner, 9 T.C. 128 (1947),

aff'd 167 F.2d 1000 (9th Cir. 1948). A corporation that ceased to do business in California had no liability to pay franchise tax measured by income earned in the final year of operation if the corporation did not exercise its franchise in the following California taxable year. Thus, under pre-1961 California law, a continuing corporation did not have a fixed liability to pay California franchise tax with respect to income earned in Year 1 (the California income year) until the corporation exercised its corporate franchise in Year 2 (the California taxable year). As a result, for purposes of § 1.461–1(a)(2), the corporation did not have a fixed liability in Year 1 for the California franchise tax with respect to income earned in Year 1, but rather the liability for California franchise tax with respect to income earned in Year 1 became fixed in Year 2, when the corporation exercised its corporate franchise. See Hall- mark Cards , Inc. v. Commissioner, 90 T.C. 26 (1988).

Rev. Rul. 79–410, 1979–2 C.B. 213, addresses the timing of the deduction for California franchise tax liabilities and the application of § 461(d) to California law for years after 1972. Amendments to California law in 1971 and 1972 required a corporation ceasing to do business after December 31, 1972, to pay a franchise tax in its final year of operation based upon both the preceding year's net income and the net income earned in the corporation's final year. The ruling concludes that the 1971 and 1972 amendments caused the liability for California franchise tax to become fixed for purposes of § 1.461–1(a)(2) in the California income year. However, because the fixing of the liability in the California income year was earlier than when the liability became fixed under pre-1961 California law, the ruling concludes that, pursuant to § 461(d), the amendments are disregarded and the liability continues to be incurred for federal income tax purposes in the California taxable year, the taxable year in which the liability became fixed under pre-1961 California law. See also Epoch Food Service, Inc. v. Commis- sioner, 72 T.C. 1051, 1054 (1979).

For taxable years beginning on or after January 1, 2000, the Cal. Rev. & Tax. Code was amended to replace references to the term “income year” with the term “taxable year” (“redefined California taxable year”). Cal. Rev. & Tax. Code § 23042(b)

2003-33 I.R.B. 354 August 18, 2003

Section 1035.—Certain Exchanges of Insurance Policies

26 CFR 1.1035–1: Certain exchanges of insurance policies. (Also Part I, §§ 72, 1031.)

Exchange of a portion of annuity con- tract. An exchange of a portion of an annuity contract into a new annuity contract is treated as a tax-free exchange under section 1035 of the Code. Investment in the contract and basis are allocated according to cash value immediately prior to the exchange using the rules of sections 72 and 1031.

Rev. Rul. 2003–76

ISSUES

Under the facts stated below, is a direct transfer of a portion of the cash surrender value of an existing annuity contract for a new annuity contract issued by a second insurance company a tax-free exchange under § 1035 of the Internal Revenue Code? What is the basis under § 1035 and the investment in the existing contract under § 72 after the transfer? What is the basis under § 1035 and the investment in the new annuity contract under § 72?

FACTS

A owns Contract B, an annuity contract issued by Company B. A is the obligee under Contract B. A contracts with Insurance Company C to issue Contract C, a new annuity contract. A assigns 60 percent of the cash surrender value of Contract B to Company C to be used to purchase Contract C. At no time during the transaction does A have access to the cash surrender value of Contract B that is transferred by Company B to Company C and used to purchase Contract C. No consideration other than the cash surrender value of Contract B that is transferred from Company B to Company C will be paid in this transaction. The terms of Contract B are unchanged by this transaction, and Contract B is not treated as newly issued.

LAW AND ANALYSIS

Section 1035(a)(3) provides that no gain or loss shall be recognized on the

California franchise tax is incurred under the Cal. Rev. & Tax. Code, as amended.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 79–410 is amplified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Sean M. Dwyer of the Office of Associate Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Mr. Dwyer at (202) 622–5020 (not a toll-free number).

Section 467.—Certain Payments for the Use of Property or Services

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 468.—Special Rules for Mining and Solid Waste Reclamation and Closing Costs

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 482.—Allocation of Income and Deductions Among Taxpayers

Federal short-term, mid-term, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 483.—Interest on Certain Deferred Payments

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 642.—Special Rules for Credits and Deductions

Federal short-term, mid-term, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 807.—Rules for Certain Reserves

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 817.—Treatment of Variable Contracts

A revenue ruling describes the tax treatment of the assets in a variable contract’s segregated asset account. See Rev. Rul. 2003-91, page 347.

A revenue ruling describes the tax treatment of the assets in a variable contract’s segregated asset account. See Rev. Rul. 2003-92, page 350.

Section 846.—Discounted Unpaid Losses Defined

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 856.—Definition of Real Estate Investment Trust

If a REIT leases space to a joint venture that includes a taxable REIT subsidiary of the REIT, do payments to the REIT from the joint venture qualify as rents from real property under section 856(d) of the Internal Revenue Code. See Rev. Proc. 2003-66, page 364.

Section 1031.—Exchange of Property Held for Productive Use or Investment

August 18, 2003 355 2003-33 I.R.B.

to Company C for Contract C is a tax-free exchange under § 1035.

(2) After the transaction, pursuant to § 1035, A’s basis in Contract C equals 60 percent of A’s basis in Contract B immediately before the exchange. After the transaction, A’s basis in Contract B equals 40 percent of A’s basis in Contract B immediately before the exchange.

(3) After the transaction, pursuant to § 72, A’s investment in Contract C equals 60 percent of A’s investment in Contract B immediately before the exchange. After the transaction, A’s investment in Contract B equals 40 percent of A’s investment in Contract B immediately before the exchange.

TREATMENT OF CERTAIN PARTIAL EXCHANGES

Treasury and the Internal Revenue Service (the Service) are concerned that some taxpayers may enter into a partial exchange of a portion of one annuity contract for a new annuity contract as a means of reducing or avoiding tax that would otherwise be imposed under § 72(e). On August 18, 2003, Treasury and the Service published Notice 2003–51, 2003–33 I.R.B. 361, which announced that Treasury and the Service are considering whether to exercise the authority granted under § 72(e)(11) to promulgate regulations that would prescribe the tax treatment of these transactions. Notice 2003–51 provides interim guidance regarding the tax treatment of these transactions. Finally, Notice 2003–51 requests comments regarding the appropriate application of § 72(e)(11) to these transactions. Taxpayers should review Notice 2003–51 prior to entering into a partial exchange to determine whether their transaction is subject to the interim guidance provided by the notice.

DRAFTING INFORMATION

The principal author of this revenue ruling is Ann H. Logan of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact her at (202) 622–3970 (not a toll-free call).

exchange of an annuity contract for an annuity contract. Section 1.1035–1 of the Income Tax Regulations provides that the exchange, without recognition of gain or loss, of an annuity contract for another annuity contract under § 1035(a)(3) is limited to cases in which the same person or persons are the obligee or obligees under the contract received in the exchange as under the original contract.

The legislative history of § 1035 states that exchange treatment is appropriate for “individuals who have merely exchanged one insurance policy for another better suited to their needs and who have not actually realized gain.” H.R. Rep. No. 1337, 83d Cong., 2d Sess. 81 (1954). In Conway v. Commissioner, 111 T.C. 350 (1998), acq ., 1999–2 C.B. xvi, the Tax Court held that the direct exchange by an insurance company of a portion of an existing annuity contract to an unrelated insurance company for a new annuity contract was a tax-free exchange under § 1035. In that case, the transfer was made directly from the first insurance company to the unrelated insurance company, and none of the assets transferred in the transaction were received by the taxpayer.

Section 1035(d)(2) references § 1031 for the rules to determine the basis of property acquired in a § 1035 exchange. Section 1031(d) provides that property acquired in a § 1035 exchange has the same basis as that of the property exchanged, decreased by the amount of any money received by the taxpayer and increased by any gain (or decreased by any loss) recognized by the taxpayer on the exchange.

Section 1.1031(d)–1 provides, in part, that in a § 1035 exchange the basis of the property acquired is the same as the basis of the property transferred by the taxpayer with proper adjustments to the date of the exchange. Section 1.1031(j)–1(c) provides that, in the case of a multiple exchange of properties, the basis of properties received is the “aggregate adjusted basis of the properties transferred,” which is then “allocated proportionately to each property received in the transaction.” Cf. Section 1.1031(j)–1(d) ex. 5 (the basis of a single property transferred in a non-recognition transaction is allocated on a pro rata basis to the two properties received in the transaction). Section 1.61–6(a) echoes the allocation rule of § 1.1031(d)–1, providing

that when a part of a larger property is sold, the basis of the entire property is equitably apportioned among the parts, and the gain realized or loss sustained on the part sold is the difference between the selling price and the basis allocated to such part.

Section § 72 governs the federal tax treatment of distributions from an annuity contract. When amounts received are not annuity payments, § 72(e)(6) defines the investment in the contract. (For purposes of § 72(b), which applies to annuity payments, § 72(c)(1) defines the investment in the contract in a similar, but not identical, manner). Section 72(e) sets forth rules regarding the tax treatment of distributions from annuity contracts. Under § 72(e)(2), distributions that are not amounts received as an annuity, including withdrawals and partial surrenders, result in income to the contract holder to the extent of the earnings in the contract and then in a recovery of the contract holder’s investment in the contract.

After completion of the transaction, A still owns original Contract B, reduced in value to reflect the cash surrender value transferred to Company C for Contract C. A also owns new Contract C. Because the funds were transferred by Company B directly to Company C, A had no access to the funds during the transaction other than in the form of annuity contracts. Therefore, the transfer of a portion of Contract B to Company C for new Contract C is a tax-free exchange under § 1035. The continued existence of Contract B with its reduced cash value does not affect the tax-free character of the exchange.

Under § 1035(d), A’s basis in Contract B immediately before the exchange is allocated ratably between Contract B and Contract C based on the percentage of the cash value retained in Contract B and the percentage of the cash value transferred to purchase Contract C. A’s investment in Contract B immediately before the exchange is allocated ratably between Contract B and Contract C based on the percentage of the cash value retained in Contract B and the percentage of the cash value transferred to purchase Contract C.

HOLDINGS

(1) The direct transfer by A of a portion of the cash surrender value of Contract B

2003-33 I.R.B. 356 August 18, 2003

Section 1274.—Determina- tion of Issue Price in the Case of Certain Debt Instruments Issued for Property

(Also Sections 42, 280G, 382, 412, 467, 468, 482, 483, 642, 807, 846, 1288, 7520, 7872.)

Federal rates; adjusted federal rates; adjusted federal long-term rate and the long-term exempt rate. For purposes of sections 382, 1274, 1288, and other sections of the Code, tables set forth the rates for August 2003.

Rev. Rul. 2003–94

This revenue ruling provides various prescribed rates for federal income tax purposes for August 2003 (the current month). Table 1 contains the short-term, mid-term, and long-term applicable federal rates (AFR) for the current month for purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the short-term, mid-term, and long-term adjusted applicable federal rates (adjusted AFR) for the current month for purposes of section 1288(b). Table 3 sets forth the adjusted federal long-term rate and the long-term tax-exempt rate described in section 382(f). Table 4 contains the appropriate percentages for determining the low-income housing credit described in section 42(b)(2) for buildings placed in service during the current month. Finally, Table 5 contains the federal rate for determining the present value of annuity, an interest for life or for a term of years, or a remainder or a reversionary interest for purposes of section 7520.

Applicable Federal Rates (AFR) for August 2003

Period for Compounding

Annual Semiannual Quarterly Monthly

Short-Term

AFR 1.21% 1.21% 1.21% 1.21%

110% AFR 1.33% 1.33% 1.33% 1.33%

120% AFR 1.46% 1.45% 1.45% 1.45%

130% AFR 1.58% 1.57% 1.57% 1.56%

Mid-Term

AFR 2.70% 2.68% 2.67% 2.67%

110% AFR 2.97% 2.95% 2.94% 2.93%

120% AFR 3.25% 3.22% 3.21% 3.20%

130% AFR 3.51% 3.48% 3.46% 3.46%

150% AFR 4.06% 4.02% 4.00% 3.99%

175% AFR 4.74% 4.69% 4.66% 4.64%

Long-Term

AFR 4.36% 4.31% 4.29% 4.27%

110% AFR 4.80% 4.74% 4.71% 4.69%

120% AFR 5.24% 5.17% 5.14% 5.12%

130% AFR 5.68% 5.60% 5.56% 5.54%

August 18, 2003 357 2003-33 I.R.B.

Short-term adjusted AFR

Mid-term adjusted AFR

Long-term adjusted AFR

REV. RUL. 2003–94 TABLE 2

Adjusted AFR for August 2003

Period for Compounding

Annual Semiannual Quarterly Monthly

1.08% 1.08% 1.08% 1.08%

2.37% 2.36% 2.35% 2.35%

4.12% 4.08% 4.06% 4.05%

REV. RUL. 2003–94 TABLE 3

Rates Under Section 382 for August 2003

Adjusted federal long-term rate for the current month 4.12%

Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted federal long-term rates for the month and the prior two months.)

REV. RUL. 2003–94 TABLE 4

Appropriate Percentages Under Section 42(b)(2) for August 2003

4.35%

Appropriate percentage for the 70% present value low-income housing credit 7.82%

Appropriate percentage for the 30% present value low-income housing credit 3.35%

REV. RUL. 2003–94 TABLE 5

Rate Under Section 7520 for August 2003

Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest

3.2%

Section 1288.—Treatment of Original Issue Discounts on Tax-Exempt Obligations

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 7520.—Valuation Tables

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

Section 7702.—Life Insurance Contract Defined

(Also Section 72.)

Life insurance contracts; distribu- tions made in connection with a change in benefits. This ruling describes the rules of section 7702(f)(7) of the Code regarding the tax treatment of a cash distribution made in connection with a reduction in the benefits of a life insurance contract.

Rev. Rul. 2003–95

ISSUE

How is a cash distribution upon a change in the benefits of a life insurance contract taxed under § 7702(f)(7) of the Internal Revenue Code?

FACTS

Situation 1 . In Year 1, A purchased a life insurance contract with a $350,000 death benefit. The contract is a life insurance contract under applicable state law and meets the cash value accumulation test prescribed in § 7702(a)(1) and § 7702(b). The contract is not a “modified endowment contract” as defined in § 7702A.

Through the end of Year 4, A paid total premiums of $45,000 with regard to the contract. At the end of the Year 4, when the cash surrender value of the contract was $60,000, A surrendered 60% of the contract and received a cash distribution of $36,000. The death benefit under the contract decreased to $140,000 as a result of the partial surrender. Based on A 's age at the time of the partial surrender,

2003-33 I.R.B. 358 August 18, 2003

the net single premium (determined under § 7702(b)) was $355 per $1000 of insurance coverage.

Situation 2 . Same facts as Situation 1, except that the contract qualifies as a life insurance contract using the guideline premium/cash value corridor test of §§ 7702(a)(2), 7702(c), and 7702(d) rather than the cash value accumulation test. When the contract was issued, the guideline premium limitation was $80,500. Immediately after the partial surrender, the guideline premium limitation (determined under § 7702(c)(3)) was $265 per $1000 of insurance coverage and the cash value corridor percentage (determined under § 7702(d)) was 185.

Situation 3 . Same facts as Situation 2, except that the partial surrender occurred 6 years after the issuance of the contract.

LAW AND ANALYSIS

Section 7702(f)(7)(B) provides that if the benefits under a life insurance contract are reduced during the 15-year period beginning on the issue date of the contract and a cash distribution is made to the policyholder as a result of the reduction in benefits, then § 72(e) (other than subsection (e)(5) thereof) applies to the portion of the cash distribution that does not exceed the applicable recapture ceiling. Under § 72(e)(2)(B), a distribution is included in gross income to the extent of the income on the contract. Income on the contract is the amount by which the contract's cash value (determined without regard to any surrender charge) immediately before the distribution exceeds the policyholder's investment in the contract (determined under § 72(e)(6)) at such time. See § 72(e)(3)(A). Accordingly, under § 7702(f)(7)(B), the gross income of a policyholder receiving a cash distribution upon a reduction in the benefits during the 15 year period following the issue date of the contract includes an amount equal to the lesser of— (i) the applicable recapture ceiling, (ii) the income on the contract, or (iii) the amount of the distribution. To the extent the distribution exceeds the amount included in gross income, the excess is treated as a tax-free recovery of investment in the contract. See § 72(e)(2)(B).

The applicable recapture ceiling under § 7702(f)(7) varies depending on when the reduction in benefits occurs and on which

of the § 7702 tests is used to qualify the contract as a life insurance contract for federal tax purposes.

If the reduction in benefits occurs during the 5-year period beginning on the issue date of the contract and the contract qualifies as a life insurance contract by satisfying the cash value accumulation test, then § 7702(f)(7)(C)(i) provides that the applicable recapture ceiling equals the excess of— (1) the cash surrender value of the contract immediately before the reduction in benefits, over (2) the net single premium (determined under § 7702(b)) for the contract immediately after the reduction in benefits. If the contract qualifies as a life insurance contract under the guideline premium/cash value corridor test, then § 7702(f)(7)(C)(ii) provides that the applicable recapture ceiling is the greater of—

(1) the excess of— (A) the aggregate premiums paid under the contract immediately before the reduction in the contract's benefits, over (B) the adjusted guideline premium limitation for the contract; or

(2) the excess of— (A) the cash surrender value of the contract immediately before the reduction in the contract's benefits, over (B) the maximum cash value permitted under the cash value corridor of § 7702(d) immediately after the reduction of the contract's benefits.

The first and third of the four amounts required for this calculation, the aggregate premiums paid under the contract immediately before the reduction in the contract's benefits and the cash surrender value, are known facts. The second amount, the adjusted guideline premium limitation for the contract, is calculated by subtracting from the original guideline premium limitation a guideline premium limitation (determined under § 7702(c)(2)) for the decrease in the contract's benefits. The guideline premium limitation is determined as of the date of the reduction in benefits using the attained age of the insured on that date. S. Rep. No. 313, 99 ^th Cong. 2d Sess. 989 (1986); 1986–3 (Vol. 3) C.B. 989. The fourth amount, the maximum cash value permitted under the cash value corridor of § 7702(d) immediately after the reduction of the contract's benefits, is calculated by dividing the death benefit of the contract immediately after the reduction by the applicable percentage set forth in § 7702(d).

If the reduction in benefits occurs more than 5 years but less than 16 years after

the contract's issue date, a single recapture ceiling applies to all contracts. The recapture ceiling equals the excess of— (1) the cash surrender value of the contract immediately before the reduction, over (2) the maximum cash value that would be permitted under the cash value corridor of § 7702(d) immediately after the reduction of the contract's benefits. See § 7702(f)(7)(D).

In Situation 1, A received a $36,000 cash distribution upon the surrender of 60% of the benefits under the life insurance contract. Immediately before the surrender, the income on the contract was $15,000 [$60,000 − $45,000 = $15,000].

The partial surrender reduced the death benefit under A 's contract from $350,000 to $140,000. As the reduction in the benefits occurred within the 5-year period beginning on the issue date of the contract and the contract qualifies as a life insurance contract under the cash value accumulation test, the applicable recapture ceiling is determined under § 7702(f)(7)(C)(i). The recapture ceiling is the excess of the contract's $60,000 cash surrender value immediately before the reduction in benefits over the net single premium for the contract immediately after the reduction in benefits. On the date of the reduction in benefits, the net single premium was $355 per $1000 of insurance coverage. The net single premium for the contract's reduced death benefit was $49,700 [$140,000 × $355 ÷ $1,000 = $49,700]. The recapture ceiling, therefore, was $10,300 [$60,000 - $49,700 = $10,300].

Pursuant to § 7702(f)(7)(B), A 's gross income includes the portion of the distribution equal to the lesser of— (i) the applicable recapture ceiling ($10,300), (ii) the income on the contract ($15,000), or (iii) the amount of the distribution ($36,000). Accordingly, $10,300 is included in A 's gross income. The remaining $25,700 of the distribution is treated, under § 72(e)(5), as a return of a portion of the A 's $45,000 investment in the contract. A 's investment in the contract immediately after the partial surrender is $19,300 [$45,000 - $25,700 = $19,300]. See § 72(e)(6).

In Situation 2, the reduction in the benefits under A 's life insurance contract also occurred within the 5-year period beginning on the issue date of the contract. However, because the contract qualifies

August 18, 2003 359 2003-33 I.R.B.

Pursuant to section 7702(f)(7)(B), A 's gross income includes the portion of the distribution equal to the lesser of— (i) the applicable recapture ceiling ($0), (ii) the income on the contract ($15,000), or (iii) the amount of the distribution ($36,000). Accordingly, none of the $36,000 distribution is included in A 's gross income. The entire distribution is treated, under § 72(e)(5), as a return of a portion of the A 's $45,000 investment in the contract. A 's investment in the contract immediately after the partial surrender is $9,000 [$45,000

$36,000 = $9,000].

HOLDING

In Situation 1, $10,300 of the cash distribution is included in A 's gross income. The remaining $25,700 of the distribution is treated as a return of a portion of the A 's $45,000 investment in the contract, which reduces A 's investment in the contract to $19,300.

In Situation 2, $15,000 of the cash distribution is included in A 's gross income. The remaining $21,000 of the distribution is treated as a return of a portion of the A 's $45,000 investment in the contract, which reduces A 's investment in the contract to $24,000.

In Situation 3, none of the cash distribution is included in A 's gross income. The entire $36,000 of the distribution is treated as a return of a portion of the A 's $45,000 investment in the contract, which reduces A 's investment in the contract to $9,000.

DRAFTING INFORMATION

The principal author of this revenue ruling is Stephen Hooe of the Office of Associate Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling, contact Kay Hossofsky at (202) 622–3970 (not a toll-free call).

Section 7872.—Treatment of Loans With Below-Market Interest Rates

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month of August 2003. See Rev. Rul. 2003-94, page 357.

as a life insurance contract using the guideline premium/cash value corridor test, the applicable recapture ceiling under § 7702(f)(7)(C)(ii) is the greater of—

A paid aggregate premiums of $45,000 under the contract prior to the reduction of the contract's benefits. The adjusted guideline premium limitation for the contract immediately after the reduction of benefits is calculated by subtracting from the $80,500 original guideline premium limitation a guideline premium limitation for the amount of the decrease in the contract's death benefit. The partial surrender resulted in a $210,000 decrease in the death benefit under A 's contract. Immediately after the reduction in benefits, the guideline premium limitation was $265 per $1000 of insurance coverage. The guideline premium for the decrease in death benefits was $55,650 [$210,000 × $265 ÷ $1,000 = $55,650]. The adjusted guideline premium limitation for the contract immediately after the reduction in benefits, therefore, was $24,850 [$80,500 - $55,650 = $24,850]. The excess of the aggregate premiums paid under the contract over the adjusted guideline premium limitation was $20,150 [$45,000 − $24,850 = $20,150].

The cash surrender value of A 's contract immediately before the reduction in benefits was $60,000. Immediately after the reduction of benefits, the cash value corridor of § 7702(d) requires the contract's death benefit to be at least 185% of the contract's cash surrender value. The partial surrender reduced the contract's death benefit to $140,000. The maximum cash value permitted under the cash value corridor requirement, therefore, was $75,675

[$140,000 ÷ 1.85 = $75,675]. The cash surrender value of A 's contract immediately before the reduction in the contract's

benefits was less than the maximum cash value permitted under the cash value corridor of § 7702(d) immediately after the reduction in benefits.

As the $20,150 excess of the aggregate premiums paid under the contract over the adjusted guideline premium limitation was greater than the $0 excess of the cash surrender value of the contract immediately before the reduction in the contract's benefits over the maximum cash value permitted under the cash value corridor immediately after the reduction of the contracts benefits, the recapture ceiling was $20,150.

Pursuant to § 7702(f)(7)(B), A 's gross income includes the portion of the distribution equal to the lesser of— (i) the applicable recapture ceiling ($20,150), (ii) the income on the contract ($15,000), or (iii) the amount of the distribution ($36,000). Accordingly, $15,000 is included in A 's gross income. The remaining $21,000 of the distribution is treated, under § 72(e)(5), as a return of a portion of the A 's $45,000 investment in the contract. A 's investment in the contract immediately after the partial surrender is $24,000 [$45,000 - $21,000 = $24,000].

In Situation 3, the reduction in the benefits under A 's life insurance contract occurred more than 5 years but less than 16 years after the contract's issue date. Under § 7702(f)(7)(D), the recapture ceiling equals the excess of— (1) the cash surrender value of the contract immediately before the reduction, over (2) the maximum cash value that would be permitted under the cash value corridor of § 7702(d) immediately after the reduction of the contracts benefits.

The cash surrender value of A 's contract immediately before the reduction in benefits was $60,000. The maximum permitted cash value under the cash value corridor requirement immediately after the reduction of benefits was $75,675 [$140,000 ÷ 1.85 = $75,675]. As the $60,000 cash surrender value of A 's contract immediately before the reduction in the contract's benefits was less than the $75,675 maximum cash value permitted under the cash value corridor requirement immediately after the reduction in benefits, the excess was $0. The applicable recapture ceiling, therefore, was $0.

2003-33 I.R.B. 360 August 18, 2003