SECTION 2. BACKGROUND — Internal Revenue Bulletin 2008-29

.01 Definition and tax treatment of a variable contract.

(1) Section 817(d) defines the term “variable contract” to mean a contract that (a) provides for the allocation of all or part of the amounts received under the contract to an account that, pursuant to state law or regulations, is segregated from the general asset accounts of the company, and (b) 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) of the Code provides that a variable contract (other than a pension plan contract) based on a segregated

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(b) the investments of the account satisfy the diversification requirements within a reasonable item after discovery of the failure; and

(c) the issuer or holder agrees to make such adjustments or pay such amounts as the Commissioner may require. For this purpose (and for purposes of this revenue procedure), income on the contract is computed under § 7702(g)(1)(B), without regard to § 7702(g)(1)(C), and is computed using the period or periods of nondiversification instead of the “taxable year” referred to in § 7702(g)(1)(B). Thus, for example, income attributable to each segregated asset account on which a contract is based (including accounts that at all times were adequately diversified) is included in the computation of income on the contract.

(2) Rev. Proc. 92–25, 1992–1 C.B. 741, set forth the procedure by which an issuer of a variable contract could request the relief described in § 1.817–5(a)(2) with regard to an inadvertent failure to satisfy the diversification requirements of § 817(h). Among the requirements set forth in Rev. Proc. 92–25 was a requirement that the issuer pay an amount under the closing agreement based on all the income on the annuity contracts that invested in the nondiversified accounts, including income with regard to accounts that were adequately diversified.

(3) Notice 2000–9, 2000–1 C.B. 449, reminded issuers of variable annuity contracts that the special rules of § 817(h)(3) and § 1.817–5(b)(3), concerning diversification of accounts with respect to variable life insurance contracts, do not apply with respect to variable annuity contracts. Notice 2000–9 provided a one-time procedure to cure diversification failures that resulted from a misapplication of that rule. That procedure applied to requests for closing agreement relief that were received on or before August 1, 2000.

.06 Changes to correction procedure . In Notice 2007–15, 2007–7 I.R.B. 503, the Service requested comments as to how various correction procedures — including those for inadvertent failures to satisfy the diversification requirements of § 817(h) — may be improved. This revenue procedure incorporates a number of changes that taxpayers suggested in response to Notice 2007–15. Most significantly, this revenue procedure (1) updates the model closing

asset account shall not be treated as an annuity, endowment, or life insurance contract if the investments made by the account are not adequately diversified in accordance with regulations prescribed by the Secretary.

(3) Section 1.817–5(a)(1) provides that a variable contract is treated as based on a segregated asset account for a calendar quarter period if amounts received under the contract (or earnings thereon) are allocated to the account at any time during the period. Section 1.817–5(e) of the Income Tax Regulations provides that a “segregated asset account” consists of all assets the investment return and market value of each of which must be allocated in an identical manner to any variable contract invested in any of such assets. Section 1.817–5(g) illustrates the application of this provision.

(4) Section 1.817–5(a) provides that, if a variable contract that is a life insurance contract under applicable law is not treated as a life insurance or endowment contract under § 7702(a), the income on the contract for any taxable year of the policyholder is treated as ordinary income received or accrued by the policyholder during such year in accordance with § 7702(g) and (h). Likewise, if a variable contract is not treated as an annuity contract under § 72, the regulation provides that 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 in the same manner as a life insurance or endowment contract under § 7702(g) and (h).

.02 Diversification requirements. (1) Section 1.817–5(b)(1) provides that the investments of a segregated asset account are adequately diversified for purposes of § 817(h) only if—

(a) No more than 55% of the value of the total assets of the account is represented by any one investment;

(b) No more than 70% of the value of the total assets of the account is represented by any two investments;

(d) No more than 90% of the value of the total assets of the account is represented by any four investments. For purposes of § 1.817–5, all securities of the same issuer, all interests in the same

real property project, and all interests in the same commodity are each treated as a single investment. In the case of government securities, each government agency or instrumentality is treated as a separate issuer.

(2) Section 817(h)(2) provides a safe harbor under which the investments of a segregated asset account are adequately diversified for purposes of § 817(h) if (a) the account meets the requirements of § 851(b)(3), and (b) no more than 55% of the value of the total assets of the account are assets described in § 851(b)(3)(A)(i) ( i.e., cash, cash items (including receivables), Government securities, and securities of other regulated investment companies).

(3) Under § 1.817–5(c)(1), a segregated asset account that satisfies the requirements of § 1.817–5(b) as of the last day of any calendar quarter period (or within 30 days after that last day) is considered adequately diversified for that period.

.03 Recordkeeping, reporting, with- holding, and deposit requirements for nondiversified contracts.

An issuer of a variable contract that fails to satisfy the requirements of § 817(h) may have recordkeeping, reporting, withholding, and deposit obligations. An issuer that fails to meet these obligations also may be subject to penalties. See Rev. Rul. 91–17.

.04 Authority to enter into closing agreements. Under § 7121, the Secretary is authorized to enter into an agreement in writing with any person relating to the liability of such person (or of the person or estate for whom he acts) in respect of any internal revenue tax for any period. Such agreement is generally final and conclusive, except upon a showing of fraud or malfeasance, or misrepresentation of a material fact.

.05 Correction procedure for failure to satisfy the diversification requirements of § 817(h).

(1) Section 1.817–5(a)(2) provides that, in the event of an inadvertent failure to diversify, the investments of a segregated asset account are nevertheless treated as satisfying the diversification requirements of § 1.817–5(b) for one or more periods if (a) the issuer or holder of the variable contract shows that the failure to satisfy the diversification requirements was inadvertent;

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determined based on the amount by which the segregated asset account was nondiversified is an amount equal to 100% of the amount by which the account’s interest in a single investment exceeded the applicable limitation of § 1.817–5(b). Thus, for example, if a segregated asset account’s investment in a single security exceeded both the 55% limitation of § 1.817–5(b)(1)(i)(A) and the 70% limitation of § 1.817–5(b)(1)(i)(B), the amount determined under this section 4.03(3) is the total amount by which the investment would need to be reduced in order to satisfy both requirements and comply with the rules of § 817(h) and § 1.817–5(b). This amount is determined as of the 30th day after the last day of each calendar quarter for which the segregated asset account was not diversified. If nondiversification spans multiple calendar quarters, the amount payable under this section is based on the calendar quarter that produces the highest amount.

(4) Limitation on amount required to be paid. Notwithstanding section 4.03(2) or section 4.03(3) of this revenue procedure, as applicable, the amount required to be paid shall not exceed the lesser of $5,000,000 or 5% of the total asset value of the segregated asset account on the 30th day after the last day of each calendar quarter for which the segregated asset account was not diversified. If nondiversification spans multiple calendar quarters, the amount payable under this section is based on the calendar quarter that produces the highest amount. The limitation applies on a per segregated asset account basis, and is not increased by any interest computed under § 6621(a)(2).

.04 Payment of amount . The issuer is required to pay the amount determined under section 4.03 of this revenue procedure within 60 days of the date of execution of the closing agreement by the Service. Payment shall be made by check payable to the “United States Treasury” delivered, together with a fully executed copy of the closing agreement, to Internal Revenue Service, Receipt & Control Stop 31, 201 W. Rivercenter Blvd., Covington, KY 41011.

.05 Correction of contracts . The issuer is required to have satisfied the requirements of § 817(h) and § 1.817–5(b) of the regulations within a reasonable time after

agreement set forth in Rev. Proc. 92–25, and (2) provides both an alternative computation of the amount due under the closing agreement and an overall limit on the amount that must be paid.