Part I. Rulings — Internal Revenue Bulletin 2009-38

Section 101.—Certain Death Benefits

This revenue ruling addresses when interest that is disallowed as a deduction under section 264(a)(4) of the Code is taken into account in determining earnings and profits. See Rev. Rul. 2009-25, page 365.

Section 264.—Certain Amounts Paid in Connection With Insurance Contracts

Section 312.—Effect on Earnings and Profits

26 CFR 1.312–6: Earnings and profits. (Also §§ 101, 264.)

E&P determinations for section 264(a)(4) disallowed interest. This ruling addresses when interest that is disallowed as a deduction under section 264(a)(4) of the Code is taken into account in determining earnings and profits.

Rev. Rul. 2009–25

ISSUE

When is interest that is disallowed as a deduction under § 264(a)(4) of the Internal Revenue Code (“Disallowed Interest”) taken into account in determining earnings and profits?

FACTS

A, an individual, holds a paid-up life insurance contract on his own life. Upon the death of A, the death benefit under the contract ($500) is payable to the beneficiary named in the contract.

X is a calendar year subchapter C corporation unrelated to A . On the first day of Year 1, X purchases A ’s life insurance contract for $100 in a transaction that is not described in § 101(a)(2)(A) or (B), and names itself the beneficiary under the contract.

On the first day of Year 1, X borrows $100 at seven percent simple interest per

annum to purchase the life insurance contract. The interest on the loan is unconditionally payable at the end of Year 1 and Year 2 and the interest was in fact paid at the end of Year 1 and Year 2. But for its disallowance under § 264(a)(4), X could deduct seven dollars of interest on the loan in both Year 1 and Year 2 under § 163. Other than the initial purchase price, the interest on the loan is the only amount X incurs in connection with the contract.

A dies on the first day of Year 3, and X receives the $500 death benefit under the life insurance contract. Pursuant to § 101(a)(2), X includes $386 in gross income ($500 (death benefit) - ($100 (amount paid for the contract) + $14 (Disallowed Interest deductions in Year 1 and Year 2))).

LAW AND ANALYSIS

Section 101(a)(1) provides that except as otherwise provided in §§ 101(a)(2), 101(d), 101(f), and 101(j), gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.

Section 101(a)(2) generally provides that in the case of a transfer for valuable consideration, by assignment or otherwise, of a life insurance contract or any interest therein, the amount excluded from gross income by § 101(a)(1) shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and “other amounts” subsequently paid by the transferee. The term “other amounts” includes interest paid or accrued by the transferee on indebtedness with respect to the contract or any interest therein if such interest paid or accrued is not allowable as a deduction by reason of § 264(a)(4).

Section 163(a) generally provides that a deduction is allowed for all interest paid or accrued within the taxable year on indebtedness.

Section 264(a)(4) generally provides that no deduction shall be allowed for any interest paid or accrued on any indebtedness with respect to 1 or more life insurance policies owned by the taxpayer

covering the life of any individual, or any endowment or annuity contracts owned by the taxpayer covering any individual.

Earnings and profits are a measure of economic income, or a corporation’s capacity to pay dividends. See e.g., S. Rep. No. 169, Vol. 1, 98th Cong., 2d Sess., 198 (1984). “In general, the computation of earnings and profits of a corporation . . . is based upon reasonable accounting concepts that take into account the economic realities of corporate transactions as well as those resulting from the application of tax law. Thus, losses and expenses that are disallowed as a deduction for Federal income tax purposes, charitable contributions in excess of the limitation provided therefore [sic], and other items that have actually depleted the assets of the corporation, even though not reflected in the income computations, are allowed as deductions in computing earnings and profits.” Rev. Rul. 75–515, 1975–2 C.B. 117, obsoleted by Rev. Rul. 2003–99, 2003–2 C.B. 388 (holding codified in § 312(l)). See also Rev. Rul. 71–165, 1971–1 C.B. 111 (“An expense of an accrual basis corporation that under the Code is never an allowable deduction in computing taxable income usually is reflected in earnings and profits in the year to which it is attributable, except where the Code specifically provides that the corporation’s earnings and profits shall not be reduced by any amount which is not allowable as a deduction in computing its taxable income.”); Rev. Rul. 77–442,1977–2 C.B. 264 (quoting Rev. Rul. 71–165 and Rev. Rul. 75–515). Because Disallowed Interest depletes the assets of a corporation at the time the interest would be allowed as a deduction but for its disallowance under § 264(a)(4), earnings and profits are also reduced in that year. Accordingly, X in both Year 1 and Year 2 reduces its earnings and profits by the seven dollars of Disallowed Interest.

In Year 3, X receives the $500 death benefit under the life insurance contract purchased from A and, under § 101(a)(2), excludes from gross income an amount representing the $14 of Disallowed Interest.

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Items excluded from gross income generally increase earnings and profits. See § 1.312–6(b). Furthermore, even though the Disallowed Interest in Year 1 and Year 2 actually depletes the amount of earnings available for distribution, X previously reduced its earnings and profits by the Disallowed Interest in each of those years. Section 1.312–6(d) (“A loss sustained for a year before the taxable year does not affect the earnings and profits of the taxable year.”); Rev. Rul. 76–299, 1976–2 C.B. 211 (“A capital loss carryover does not affect the earnings and profits of the taxable year in which it is used because the loss giving rise to the carryover is reflected in the accumulated earnings and profits at the beginning of the taxable year of the carryover”). Reducing earnings and profits in Year 3 by the amount of Disallowed Interest taken into account under § 101(a)(2) would cause an unwarranted double reduction of earnings and profits and, therefore, is not permitted. See, e.g., Bangor & Aroostook Railroad Co. v. Commissioner, 16 T.C. 578, 586 (1951), aff’d 193 F.2d 827 (1 ^st Cir. 1951). Although X in Year 3 includes in its gross income only $386 of the $500 death benefit because of the applicable offsets under § 101(a)(2) (including the $14 of Disallowed Interest), X includes $400 ($500 (the death benefit) less $100 (the amount X pays for the contract)) in its earnings and profits in Year 3.

HOLDING

Disallowed Interest under § 264(a)(4) reduces earnings and profits for the taxable year in which the interest would have been allowable as a deduction but for its disallowance under § 264(a)(4). It does not further reduce earnings and profits when the death benefit is received under a life insurance contract.

DRAFTING INFORMATION

The principal author of this revenue ruling is Russell P. Subin of the Office of Associate Chief Counsel (Corporate). For further information regarding this revenue ruling, contact Russell P. Subin at (202) 622–7790 (not a toll-free call).

Section 831.—Tax on Insurance Companies Other than Life Insurance Companies

Single insured-reinsurance. This ruling presents two situations to illustrate the application of insurance principles to whether a reinsurance arrangement is sufficient for the assuming company to qualify as an insurance company under section 831(c) of the Code. The guidance holds that 1) where the only business of the assuming company is the assumption of a block of business that itself constitutes insurance, the assuming company qualifies as an insurance company and 2) where the assuming company enters into agreements with various insurance companies, an agreement with one ceding company that involves the risks of a single policyholder should be treated as reinsuring risks such that the assuming company qualifies as an insurance company.

Rev. Rul. 2009–26

ISSUE

In the situations described below, is Z ’s agreement with IC Y treated as “reinsuring risks” underwritten by insurance companies for purposes of determining whether Z is an insurance company within the meaning of § 831(c)?

FACTS

Situation 1 . IC Y and Z are stock corporations that are licensed and regulated as insurance companies in all jurisdictions in which they do business. IC Y is an insurance company for federal income tax purposes, subject to tax under § 831(a).

For valid, non-tax business purposes, IC Y entered into a contract, or treaty, with Z at the beginning of Year 1. Under the contract, IC Y agreed to pay to Z 90 percent of all the premiums received with regard to all the insurance contracts issued by IC Y in the commercial multiple peril line of business in a 10-state region. In exchange, Z agreed to indemnify IC Y for 90 percent of all the losses under those contracts. IC Y remained directly liable to its policyholders. A contract of this type is sometimes referred to as indemnity reinsurance.

During Year 1, insurance contracts that IC Y entered into with 10,000 unrelated

policyholders were subject to the contract between IC Y and Z . Z possessed adequate capital to fulfill its obligations under the contract, and in all respects operated at arms-length in its transaction with IC Y and in accordance with the applicable requirements of state law. The contract with IC Y was Z ’s only business during Year 1.

Situation 2 . The facts are the same as in Situation 1, except that the contract between IC Y and Z covered only the risks of X, a policyholder of IC Y unrelated to Z . In addition, Z assumed risks of policyholders unrelated to X but in the same line of business through contracts with other insurance companies. The contracts with IC Y and with other insurance companies were Z ’s only business during Year 1. Had Z assumed these risks by entering into contracts with each of the original policyholders (including X ) directly, those contracts would have qualified as insurance contracts for federal income tax purposes, and Z would have qualified as an insurance company for federal income tax purposes. See, e.g., Rev. Ruls. 2005–40, 2005–2 C.B. 4; 2002–91, 2002–2 C.B. 991; 2002–90, 2002–2 C.B. 985; and 2002–89, 2002–2 C.B. 984.

LAW

Section 831(a) of the Internal Revenue Code provides that taxes, computed as provided in § 11, are imposed for each taxable year on the taxable income of each insurance company other than a life insurance company. Section 831(c) provides that, for purposes of § 831, the term “insurance company” has the meaning given to such term by § 816(a). Under § 816(a), the term “insurance company” means “any company more than half the business of which during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.”

Neither the Code nor the regulations define the terms “insurance” or “insurance contract.” The Supreme Court of the United States has explained that in order for an arrangement to constitute insurance for federal income tax purposes, both risk shifting and risk distribution must be present. Helvering v. Le Gierse, 312 U.S. 531 (1941). The risk transferred must be risk of economic loss. Allied Fidelity Corp. v. Commissioner, 572 F.2d

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1190, 1193 (7 ^th Cir. 1978). The risk must contemplate the fortuitous occurrence of a stated contingency, Commissioner v. Treganowan, 183 F.2d 288, 290–91 (2d Cir. 1950), and must not be merely an investment or business risk. Rev. Rul. 2007–47, 2007–2 C.B. 127. In addition, the arrangement must constitute insurance in the commonly accepted sense. See, e.g., Ocean Drilling & Exploration Co. v. U.S., 988 F.2d 1135, 1153 (Fed. Cir. 1993); AMERCO, Inc. v. Commissioner, 979 F.2d 162 (9 ^th Cir. 1992). Risk shifting occurs if a person facing the possibility of an economic loss transfers some or all of the financial consequences of the potential loss to the insurer, such that a loss by the insured does not affect the insured because the loss is offset by a payment from the insurer. Risk distribution incorporates the statistical phenomenon known as the law of large numbers. Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed the amount taken in as premiums and set aside for the payment of such a claim. By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smooths out losses to match more closely its receipt of premiums. Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987).

Courts have recognized that risk distribution necessarily entails a pooling of premiums, so that a potential insured is not in significant part paying for its own risks. Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989). See also Ocean Drilling & Exploration Co., 988 F.2d at 1153 (“Risk distribution involves spreading the risk of loss among policyholders.”); Beech Aircraft Corp. v. U.S., 797 F.2d 920, 922 (10th Cir. 1986) (“[R]isk distributing means that the party assuming the risk distributes his potential liability, in part, among others.”) Thus, purported insurance arrangements that involve an issuer who contracts with only one policyholder do not qualify as insurance contracts for federal income tax purposes. Rev. Rul. 2005–40.

The Code and administrative guidance treat reinsurance in a manner similar to insurance for many purposes. For example, gross premiums of both life and non-life insurance companies include not only premiums on direct business, but also gross

premiums in respect of assumed liabilities under contracts issued by another company. Section 803(b)(1)(E); Rev. Rul. 77–453, 1977–2 C.B. 236. Consistently, both life insurance reserves under § 807 and discounted unpaid losses under § 846 include not only reserves and losses on direct business, but also reserves and losses on liabilities assumed under contracts issued by another company. Furthermore, a contract that reinsures another contract is treated in the same manner as the reinsured contract under § 848(e)(5) for purposes of computing the amount of specified policy acquisition expenses that must be capitalized and amortized as deferred acquisition costs (DAC) under § 848. Most importantly, both direct insurance and reinsurance business may qualify a taxpayer as an insurance company under § 816(a) or § 831(c), as applicable. But see § 845 (granting the Secretary explicit authority to reallocate, recharacterize, or make other adjustments with respect to certain reinsurance arrangements, but not referring to direct insurance).

Courts have generally analogized reinsurance to insurance, as well. For example, in Ocean Drilling & Exploration Co., 988 F.2d at 1153 n25, the court noted that “[d]irect insurance and reinsurance are both considered insurance,” and in Cologne Life Reinsurance Co. v. Com- missioner, 80 T.C. 859, 862 (1983), acq, 1985–2 C.B. viii, the court noted that “[u]nder [part I of subchapter L], the issuance of indemnity life reinsurance is treated generally as the issuance of life insurance”, except where specified otherwise.

In Alinco Life Insurance Co. v. United States, 373 F.2d 336 (Ct.Cl. 1967), a large finance company formed a wholly-owed subsidiary corporation (Alinco), which qualified as a life insurance company under the laws of Indiana. Customers of the finance company (borrowers) purchased credit life insurance from an unrelated insurance company, which in turn reinsured a fixed proportion of those contracts with Alinco. Even though Alinco reinsured risks underwritten by only one insurance company, those risks aggregated nearly one billion dollars of business, with a large number of customers, for which Alinco was required by the state insurance department to maintain reserves. Interpreting regulatory language that was identical to

what now appears in § 816(a), the court concluded that Alinco was in the business of “reinsuring risks” underwritten by insurance companies.

In the context of captive insurance, courts have likewise looked through a fronting arrangement to analyze whether the requirements of risk shifting and risk distribution were met. See, e.g., Carnation Co. v. Commissioner, 71 T.C. 400 (1978), aff’d 640 F.2d 1010 (9th Cir. 1981) (concluding that premiums paid by taxpayer to an unrelated insurer were not deductible to the extent risks under the contract were in turn reinsured with taxpayer’s wholly-owned subsidiary); Kidde Industries, Inc. v. United States, 40 Fed. Cl. 42 (1997).

ANALYSIS

Situation 1

In Situation 1, the contracts issued by IC Y to 10,000 unrelated policyholders involved commercial multiple peril risks, which are insurance risks. The contracts shifted those insurance risks from those policyholders to IC Y, and distributed those risks such that a loss by one policyholder was not borne, in substantial part, by the premiums paid by that policyholder. The contracts were insurance in the commonly accepted sense. The contracts thus were insurance contracts for federal income tax purposes.

The contract, or treaty, between IC Y and Z in turn shifted 90 percent of the risks under those insurance contracts from IC Y, an insurance company, to Z . As in Alinco Life, the transaction shifted insurance risks which were funded by reserves and constituted reinsurance in the commonly accepted sense. As to Z, the risks of each original policyholder were still distributed such that a loss by one such policyholder was not borne, in substantial part, by the premiums paid by that policyholder. Hence, by entering into its arrangement with IC Y, Z was “reinsuring risks” within the meaning of §§ 816(a) and 831(c).

Because, under the arrangement with IC Y, Z was treated as “reinsuring risks” underwritten by an insurance company, and the arrangement represented more than half the business of Z for Year 1, Z qualified as an insurance company within the meaning of § 831(c), even though the

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In Situation 2, Z ’s agreement with IC Y is treated as “reinsuring risks” underwritten by insurance companies because, even though the agreement covered only the risks of a single policyholder, Z assumed sufficient risks under agreements with other insurance companies in Year 1 such that requirement of risk distribution was met from the standpoint of Z as to each original policyholder. Accordingly, Z was an insurance company within the meaning of § 831(c).

DRAFTING INFORMATION

The principal author of this revenue ruling is John E. Glover of the Office of Associate Chief Counsel (Financial Institutions & Products). For further information regarding this revenue ruling, contact Mr. Glover at (202) 622–3970 (not a toll-free call).

contract with IC Y was Z ’s only business for the year.

Situation 2

In Situation 2, the facts are the same as in Situation 1, except that the arrangement between IC Y and Z shifted to Z only the risks of X, a policyholder of IC Y unrelated to Z. Z assumed additional risks of the same line under contracts with other insurance companies in the same line of business.

The risks assumed by Z under the arrangements with IC Y and with other insurance companies were insurance risks. Those risks were shifted from the original policyholders (including X ) to the primary insurers (including IC Y ), and in turn to Z . As to Z, the risks of each original policyholder (including X ) were distributed such that a loss by one policyholder was not borne, in substantial part, by the premiums paid by that policyholder. Hence, by entering into its arrangements with the primary

insurers (including IC Y ), Z was “reinsuring risks” underwritten by insurance companies within the meaning of §§ 816(a) and 831(c). Because under the arrangements with the primary insurers (including IC Y ) Z is treated as “reinsuring risks” underwritten by insurance companies, and those arrangements represented more than half the business of Z for Year 1, Z qualified as an insurance company within the meaning of § 831(c).

HOLDINGS

In Situation 1, Z ’s agreement with IC Y is treated as “reinsuring risks” underwritten by an insurance company because, even though the agreement was Z ’s only business during Year 1, the requirement of risk distribution was still met from the standpoint of Z as to each original policyholder. Accordingly, Z was an insurance company within the meaning of § 831(c).

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