Rev. Rul. 76-281

Advice has been requested whether the variable annuity contracts issued by the taxpayer qualify as "contracts with reserves based on a segregated asset account" pursuant to section 801(g) of the Internal Revenue Code of 1954 under the circumstances described below. Advice has also been requested whether, under these circumstances, interest credited to the transfer account of each accountholder is "interest paid" by the taxpayer within the meaning of section 805(e)(1).

The taxpayer is a life insurance company subject to the tax imposed by section 802 of the Code. It is incorporated under the laws of state X and is subject to the state requirements applicable to life insurance companies. The taxpayer established a program that was designed to provide participants and their families with various means of providing for their financial security including, among other contracts, single purchase payment variable annuity contracts. A purchase of any contract issued by the taxpayer that forms part of this financial security program may be made only through the transfer of funds from a transfer account that has been set up under the program. As part of this program, the taxpayer has issued single purchase payment variable annuity contracts that provide for allocation of amounts received to an annuity plan account.

Although the taxpayer markets other insurance contracts through the transfer account, the issue presented here concerns only the Federal income tax treatment by the taxpayer of amounts credited to the transfer account and amounts allocated to the annuity plan account under the variable annuity contracts provided for by the program.

An individual opening a transfer account with the taxpayer is known as an "accountholder" who may at any time, upon written request to the taxpayer, withdraw funds from his or her transfer account, or arrange for payments from the transfer account to purchase a variable annuity contract issued by the taxpayer.

The taxpayer credits interest as of the end of each calendar quarter to the accountholder's transfer account. Deposits in the transfer account earn interest from the date of deposit to the date of transfer or withdrawal. The rate of interest is guaranteed and is established by the taxpayer prior to each calendar year. The taxpayer reserves the right to limit the amount maintained as a balance in the transfer account and the period of time during which it may be maintained, as well as the right to limit the amount of any single deposit.

The variable annuity contract can be in the form of a variable life annuity, a variable life annuity with 120 payments guaranteed, or a variable last survivor life annuity. The variable annuity is computed on the basis of a recognized mortality table, which is a part of the contract, and on the basis of the investment experience of the annuity plan account.

An accountholder may purchase the variable annuity contract provided by the program by making a single payment of the minimum amount required, and directing that such amount, after authorized deductions, be immediately transferred from the transfer account to the taxpayer's annuity plan account to purchase the variable annuity contract.

Pursuant to the state insurance laws, the assets of the annuity plan account are segregated from the general asset accounts of the taxpayer.

Under state law, the assets held in a segregated account may be invested in shares of any investment company specified in the contract or contracts participating in the segregated asset account and registered under the Investment Company Act of 1940, as amended, 15 U.S.C. sections 80a-1 to 80a-52 (1971) (Act).

The annuity plan account may hold, as assets, only amounts derived from purchase payments made for variable annuities sold by the taxpayer, amounts necessary to comply with the Act, amounts the taxpayer may place in the account for purposes of maintaining a surplus to support the guarantee under the contracts, and amounts derived from the dividends, interest, and gains produced by the investment of the assets in the account. Assets in the annuity plan account, equal in market value to the reserve liability required by law, are held for the sole benefit of all variable annuity contracts that participate in the account.

In the instant case, the assets of the annuity plan account are invested in shares of the taxpayer's own regulated investment company. The annuity plan account is registered under the Act as a unit investment trust and the taxpayer's regulated investment company is registered under the same Act as an open-end diversified management investment company.

The amount paid by the accountholder to purchase the variable annuity contract is converted into units (called "annuity shares"). The value of the units reflect the investment return and market value of the assets in the annuity plan account and, thus, under the variable annuity contract the amount paid as annuities reflects the investment return and market value of the annuity plan account. The variable annuity contract, however, does contain guarantees that neither the number nor the dollar amount of annuity payments will be affected by mortality or sales and administrative expenses. These guarantees are irrevocable with respect to annuities in effect and insurance reserves must be held by the taxpayer to satisfy the mortality guarantees provided by it. In the event that the charges made for expenses and guarantees are inadequate, the general assets of the taxpayer are available to meet and fulfill the obligation for the variable annuities purchased under the program.

Specifically, the questions presented are: (1) whether interest credited to the transfer account by the taxpayer will be deductible when accrued and credited to the transfer account as interest paid under section 805(e)(1) of the Code; and (2) whether the variable annuity contracts issued by the taxpayer qualify as "contracts with reserves based on a segregated asset account" under section 801(g).

Section 805(e)(1) of the Code provides that the interest paid for any taxable year includes all interest for the taxable year on indebtedness, except for indebtedness incurred to purchase obligations the interest on which is wholly tax exempt.

The taxpayer is obligated at all times to pay the amounts in the transfer account to the accountholder or to apply such amounts as the accountholder may direct. The taxpayer's liability with respect to the balance in the transfer account is fixed and unconditional. The interest is credited quarterly by the taxpayer on the balance of the transfer account at a guaranteed rate and, like the principal balance, such interest may also be withdrawn at any time by the accountholder. Accordingly, it is held that such interest is "interest paid" within the meaning of section 805(e)(1) of the Code.

Section 801(g)(1)(B) of the Code defines the term "contract with reserves based on a segregated asset account" as a contract (1) that provides for the allocation of all or part of the amounts received under the contract to an account which, pursuant to state law or regulation, is segregated from the general asset accounts of the company; (2) that provides for the payment of annuities; and (3) under which the amounts paid in, or the amount paid as annuities, reflect the investment return and the market value of the segregated asset account. Section 801(g)(1)(B) of the Code also provides that if a contract ceases to reflect current investment return and current market value, such contract shall not be considered as meeting the requirements of (3) above after such cessation.

The variable annuity contract under the program provides for the allocation of all or a part of the amounts received under the contract to the annuity plan account which, pursuant to state law, is segregated from the general asset accounts of the taxpayer, and provides for the payment of annuities. In addition, it is a contract under which the amounts paid in, or the amounts paid as annuities reflect the investment return and the market value of the segregated asset account. Accordingly, it is further held that the variable annuity contract qualifies as a contract with reserves based on a segregated asset account under section 801(g)(1)(B) of the Code.