SECTION 3. EXISTING CORRECTION

PROCEDURES

To remedy the significant unforeseen tax consequences for holders of contracts that fail these provisions, the Service provides procedures for issuers of these failed contracts to enter into closing agreements with the Service.

(1) In Rev. Rul. 91–17, 1991–1 C.B. 190, amplified by Rev. Proc. 92–25, 1992–1 C.B. 741, an insurance company issued contracts that qualified as life insurance, endowment, and annuity contracts under the applicable law, but otherwise failed to meet the definition of life insurance contracts under § 7702(a) or the diversification requirements of § 817(h). The ruling concludes that the income on the contracts is a non-periodic distribution for which the insurance company is subject to certain recordkeeping, reporting, withholding and deposit obligations. In addition, if the company’s failure to meet those obligations was not due to reasonable cause, the company could be subject to various penalties under the Code. Rev. Rul. 91–17 provides that the Service will waive civil penalties for failure to satisfy the reporting, withholding, and deposit requirements for income deemed received under § 7702(g) if (a) the insurance company requests and receives a waiver of the failure to meet the definition of a life insurance contract pursuant to § 7702(f)(8); (b) the insurance company satisfies the conditions of § 1.817–5(a)(2)(i)-(iii) of the regulations; or (c) the insurance company requests and, in a timely manner, executes a closing agreement under which the company agrees to pay an amount based on the amount of tax that would have been owed by the policyholders if they were treated as receiving the income on the contracts, and any interest with regard to such tax. Notice 99–48, 1999–2 C.B. 429, provides the tax rates to be used to compute the amount of tax that would have been owed by the policyholders if they were treated as receiving the income on the contracts.

(2) Charges for benefits that are qualified additional benefits (QABs) within the meaning of § 7702(f)(5) are subject to the expense charge rule of § 7702(C)(3)(B)(ii) for purposes of determining whether a contract satisfies the cash value accumulation test or the guideline premium requirements, as applicable. Section 7702(b)(2)(B); Rev. Rul. 2005–6, 2005–1 C.B. 471.

(3) Section 7702(f)(8) provides that if a taxpayer establishes to the satisfaction of the Secretary that the requirements of § 7702(a) were not met due to reasonable error, and reasonable steps are being taken to remedy that error, the Secretary may waive such failure.

(4) Section 7702(g)(1)(A) provides that if at any time a contract that is a life insurance contract under the applicable law does not meet the definition of a life insurance contract under § 7702(a), the income on the contract for any taxable year of the policyholder shall be treated as ordinary income received or accrued by the policyholder during such year. Further, § 7702(g)(1)(C) provides that if, during any taxable year of the policyholder, a contract that is a life insurance contract under the applicable law ceases to meet the definition of life insurance contract under § 7702(a), the income on the contract for all prior taxable years is treated as received or accrued during the taxable year in which such cessation occurs.

.02 Diversification requirement for variable contracts . (1) Section 817(d) defines the term “variable contract” to mean a contract that (1) 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 (2) provides for the payment of annuities, or is a life insurance contract, or provides for funding of insurance on retired lives. In the case of an annuity contract or a contract that provides funding of insurance on retired lives, the amounts paid in or the amounts paid out are required to reflect the investment return and the market value of the segregated asset account. In the case of a life insurance contract, the amount of the death benefit (or the period of coverage) must be adjusted on the basis of the investment return and the market value of the segregated asset account.

(2) Section 817(h) provides that for purposes of §§ 72 and 7702(a), a variable contract (other than a pension plan contract) that is otherwise described in § 817, and that is based on a segregated asset account, is not treated as an annuity, endowment, or life insurance contract for any period (and any subsequent period) for which the investments made by such account are not adequately diversified.

(3) Section 1.817–5(a)(2) of the Income Tax Regulations provides that the investments of a segregated asset account are treated as satisfying the diversification requirements of § 1.817–5(b) for one or more periods if (1) the issuer or holder of a variable contract based on the account shows that the failure to satisfy the diversification requirements was inadvertent; (2) the investments of the account satisfy the diversification requirements within a reasonable time after discovery of the failure; and (3) the issuer or holder agrees to make such adjustments or pay such amounts as the Commissioner may require.

.03 Treatment of Modified Endowment Contracts . (1) Section 7702A defines a modified endowment contract (MEC) as a contract that meets the requirement of § 7702 but fails to meet the 7-pay test of § 7702A(b), or that is received in exchange for a contract that is a MEC. Under § 7702A(b), a contract fails to meet the 7-pay test if the accumulated amount paid under the contract at any time during the first seven contract years exceeds the sum of the net level premiums that would have been paid on or before that time if the contract provided for paid-up future benefits after the payment of seven level annual premiums.

(2) Section 7702A(c)(1) provides that determinations under the 7-pay test are made by applying the rules of §§ 7702(b)(2) and 7702(e), with modifications. Under this provision, charges for QABs are accounted for under the expense charge rule of § 7702(c)(3)(B)(ii).

(3) Section 72(e)(10) provides that a MEC is subject to the rules of § 72(e)(2)(B) (which taxes non-annuity distributions on an income-out-first basis) and § 72(e)(4)(A) (which generally treats loans, assignments, or pledges of any portion of the value of a MEC as non-annuity distributions). Further, under § 72(v), an amount received under a MEC may be subject to a 10% additional tax.

2007–7 I.R.B. 504 February 12, 2007

(e) Could the amounts that are required to be paid under the model closing agreements be determined more simply, without altering the incentives already in place for complying with §§ 72, 817(h), 7702 and 7702A and for coming forward voluntarily once errors are discovered? For example, do the existing procedures require issuers to produce information not otherwise generated in the normal course of administering the contracts? Are there circumstances in which the amount paid under the model closing agreements would more appropriately be determined based on factors other than total income on the contract?

(f) Do the amounts required to be paid under the model closing agreements strike an appropriate balance between making the government whole for the tax that otherwise would be due, and encouraging voluntary compliance with the underlying provisions once an error is discovered? If lesser amounts might be appropriate in some circumstances, what are those circumstances and how should those amounts be limited?

(g) Should each model closing agreement contain language to the effect the agreement is null and void if the taxpayer does not remit the required payment and undertake the required corrective actions within the time frames set forth in the agreement? Do the time frames in the draft model closing agreements allow taxpayers enough time to satisfy their obligations under those agreements?

.04 Address for submitting com- ments . Written comments on the issues addressed in this notice may be submitted to the Office of the Associate Chief Counsel (Financial Institutions and Products), Attention: Melissa S. Luxner (Notice 2007–15), room 3552, CC:FIP:4, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC 20224. Alternatively, taxpayers may submit comments electronically to Notice.Comments@irscounsel.treas.gov . The Service requests any comments by June 12, 2007.