SECTION 3. AFSI ADJUSTMENTS

FOR COVERED VARIABLE CONTRACTS

.01 Purpose . The Treasury Department and the IRS anticipate that the forthcom­ ing proposed regulations will be consistent with the guidance provided in this section 3. The Treasury Department and the IRS are providing this interim guidance to as­ sist taxpayers in determining AFSI with respect to Covered Variable Contracts pri­ or to the issuance of the forthcoming pro­ posed regulations.

.02 Covered Variable Contracts . (1) AFSI adjustments for Covered Vari- able Contracts . For purposes of determin­ ing AFSI of a Covered Insurance Compa­ ny issuing Covered Variable Contracts, to the extent (i) a change in the value of the Covered Investment Pool for such Covered Variable Contract(s) results in a change to the amount of the Covered Insurance Company’s obligations to the holders of such Covered Variable Contract(s) by rea­ son of law, regulation, or the terms of one or more such Covered Variable Contracts, and (ii) such change in the amount of the obligation is reflected in the Covered Obli­ gations, then such change in the amount of the Covered Obligations for a taxable year is disregarded to the extent of the § 56A(c) (2) exclusion amount for that taxable year. For purposes of the preceding sentence, the § 56A(c)(2) exclusion amount for Covered Obligations for a taxable year is equal to the amount of financial accounting gains and losses in the Covered Investment Pool for the Covered Variable Contract(s) to which the Covered Obligations relate that is (i) taken into account in Net Income of the Covered Insurance Company for the taxable year and (ii) disregarded under § 56A(c)(2)(C) or (D)(i) for purposes of determining AFSI of the Covered Insur­ ance Company for that taxable year.

(2) Example. The following example illustrates the rule set forth in section 3.02(1) of this notice.

(a) Facts . A is a life insurance company subject to tax under subchapter L of the Code and has a tax­ able year and accounting period that is based on the calendar year. A uses U.S. GAAP to prepare its AFS. On January 1 of Year 1, A issues a variable life insur­ ance contract (as described in § 817) to an individual, X. A owns assets that support A’s contractual obliga­ tion to X and holds those assets in a separate account that is segregated from the general asset accounts of A. A accounts for its contractual obligations to X in its Net Income. The separate account assets are stock in unrelated corporations. At the end of Year 1, no assets that support X’s variable contract have been sold, and the fair market value of such assets has increased by $10x. Pursuant to the terms of the variable life insurance contract, the increase in the value of the assets supporting X’s variable contract caused A’s contractual obligation to X to increase by $10x. On A’s AFS, the $10x increase in the value of the assets supporting the variable contract is includ­ ed in Net Income and offsets the $10x increase in A’s contractual obligation to X (which reduces A’s Net Income).

(b) Analysis . A is a Covered Insurance Compa­ ny as defined in section 2.05(1) of this notice, and the variable life insurance contract that A issued to X is a Covered Variable Contract described in sec­ tion 2.05(2) of this notice. The assets in the sepa­ rate account that A holds to support its contractual obligations to X constitute a Covered Investment Pool as described in section 2.05(3) of this notice, and A’s contractual obligation to X is reflected in A’s Covered Obligations as defined in section 2.05(4) of this notice. Pursuant to § 56A(c)(2)(C), although the $10x unrealized gain in the Covered Invest­ ment Pool is taken into account in Net Income on A’s AFS, it is not included in A’s AFSI because it is not a dividend from another corporation and is not includible in the gross income of A under chapter 1 of the Code. The $10x increase in the Covered Ob­ ligations is taken into account in Net Income on A’s AFS. Pursuant to section 3.02(1) of this notice, for purposes of determining A’s AFSI, the change in the amount of the Covered Obligations for the taxable year is disregarded to the extent of the § 56A(c)(2) exclusion amount for the taxable year. The relevant § 56A(c)(2) exclusion amount for the taxable year is equal to the $10x unrealized gain in the Covered Investment Pool because such $10x unrealized gain is taken into account in A’s Net Income for the tax­ able year and is disregarded under § 56A(c)(2)(C) for purposes of determining A’s AFSI for that taxable year. Accordingly, the $10x increase in the Covered Obligations is also disregarded in determining A’s AFSI for the taxable year. Thus, both the unrealized gain and offsetting change in the Covered Obliga­ tions are disregarded for purposes of determining A’s AFSI, which eliminates what would otherwise be a difference between A’s AFSI and A’s life insurance company taxable income.