IRS RULES ON TAX CONSEQUENCES OF EXCHANGE OF INSURANCE CONTRACTS FOR SUBSIDIARY'S STOCK.

Rev. Rul. 94-45

ISSUE

If a life insurance company transfers investment assets together with the right to future income and obligations under its insurance and annuity contracts to a wholly owned subsidiary in exchange for stock in the subsidiary, what are the tax consequences of the transfer under sections 197, 351, 357, 358, 362, 803, 805, and 848 of the Internal Revenue Code?

FACTS

X, a life insurance company within the meaning of section 816(a) of the Code, owns all of the stock of Y corporation, which is also a life insurance company. For a valid business purpose, X transferred investment assets together with its right to future income and obligations under its insurance and annuity contracts in force to Y for additional shares of Y stock. After the transfer, X remained in existence as a general business corporation.

The transfer of X's insurance business was effectuated by an agreement under which Y became solely liable to X's policyholders under the insurance and annuity contracts written by X. Pursuant to the agreement, X transferred to Y investment assets with a fair market value of $1,250x and an adjusted basis of $1,000x, and Y assumed insurance reserve liabilities on the reinsured contracts of $850x. The fair market value of the additional shares of Y stock that X received was $600x. This amount was $200x greater than the net value of the investment assets and insurance reserve liabilities transferred by X to Y ($1,250x - $850x = $400x). This $200x excess represents the value of the insurance in force transferred by X to Y. No cash or other property was received by X as a result of the transaction. Y assumed no liabilities other than those under the insurance and annuity contracts.

Immediately prior to the transfer, X had an unamortized balance of specified acquisition expenses under section 848 of $35x with respect to the transferred contracts, which was subject to amortization under section 848(a).

APPLICABLE LAW AND ANALYSIS

Section 351(a) provides that no gain or loss will be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in the corporation and immediately after the exchange the person or persons are in control (as defined in section 368(c)) of the corporation.

Section 357(a) provides that, except as provided in sections 357(b) and (c), if the transferee of property in an exchange otherwise within the provisions of section 351 assumes a liability of the transferor of the property or acquires from the transferor property subject to a liability, for purposes of applying section 351, the assumption or acquisition will not be treated as money or other property and will not prevent the exchange from being within the provisions of section 351.

Section 357(c) provides that if the amount of the liabilities assumed exceeds the total adjusted basis of the property transferred in a section 351 exchange, the excess is considered gain from the sale or exchange of a capital asset or of property that is not a capital asset, as the case may be.

Section 358(a) provides that, in the case of an exchange to which section 351 applies, the basis of the stock received in the exchange by the transferor of property will be the same as the basis of the property exchanged, decreased by, among other items, the amount of any money received by the transferor. For this purpose, under section 358(d), where the transferee of the property assumes a liability of the transferor or acquires the property subject to a liability, the assumption or acquisition will be treated as money (in the amount of the liability) received in the exchange.

Section 362(a) provides that if property is acquired by a corporation in connection with a transaction to which section 351 applies, the basis of the property is the same as it was in the hands of the transferor, increased by the amount of any gain recognized by the transferor on the transfer.

Section 1032 provides that no gain or loss will be recognized to a corporation on the receipt of money or other property in exchange for the corporation's stock.

Section 801(b) of the Code provides that the term "life insurance company taxable income" means life insurance gross income reduced by life insurance deductions.

Section 803(a)(1)(A) provides that life insurance gross income includes the gross amount of premiums and other consideration on insurance and annuity contracts.

Section 803(b)(1) specifies certain items that are included in the gross amount of premiums and other consideration on insurance and annuity contracts, including the consideration in respect of assuming liabilities on insurance and annuity contracts not issued by the taxpayer.

Section 803(a)(2) provides that life insurance gross income includes each net decrease in reserves that is required by section 807(a) to be taken into account.

Section 803(a)(3) provides that life insurance gross income includes all other amounts generally includible in gross income under subtitle A.

Section 804 provides that life insurance deductions consist of the general deductions provided in section 805 and the small life insurance company deduction (if any) determined under section 806(a).

Section 805(a)(2) provides that life insurance deductions include a deduction for the net increase in reserves required by section 807(b) to be taken into account.

Section 805(a)(6) provides that life insurance deductions include a deduction for the consideration (other than consideration arising out of indemnity reinsurance) in respect of the assumption by another person of liabilities under insurance and annuity contracts.

Section 1.809-5(a)(7) of the Income Tax Regulations provides that for purposes of former section 809(d)(7) (current section 805(a)(6)), the term "assumption reinsurance" means an arrangement whereby another person (the reinsurer) becomes solely liable to the policyholders on contracts transferred by a taxpayer (the ceding company).

Section 1.817-4(d)(1) of the regulations provides that the reinsurance of insurance contracts by a life insurance company, whereby the reinsurer assumes all of the liabilities under the contracts, is not treated as the sale or exchange of a capital asset but is subject to the provisions of former sections 806(a) and 809 of the Code (current sections 803 and 805, in general), and the regulations thereunder. However, if either the ceding company or the reinsurer transfers an asset that is a capital asset within the meaning of section 1221 (as modified by former section 817(a)(2)) (current section 818(b)) as part of the reinsurance agreement, that transfer is treated as the sale or exchange of a capital asset by the transferor.

Section 1.817-4(d)(2)(i) of the regulations provides that the ceding company treats the consideration paid to the reinsurer in an assumption reinsurance transaction as an item of deduction under former section 809(d)(7) (current section 805(a)(6)). However, if any amount is received from the reinsurer for the purchase of the insurance contracts, the ceding company must apply that amount against and reduce (but not below zero) the deduction for consideration paid under former section 809(d)(7) (current section 805(a)(6)). If the amount received from the reinsurer is in excess of the consideration paid, the ceding company includes that excess as an item of gross income under former section 809(c)(3) (current section 803(a)(3)).

Section 1.817-4(d)(2)(ii) of the regulations provides that the reinsurer treats the consideration received from the ceding company in an assumption reinsurance transaction as an item of gross income under former section 809(c)(1) (current section 803(a)(1)). See also section 803(b)(1)(E). The regulation also requires the reinsurer to treat any amount paid for the purchase of the insurance contracts, to the extent that this amount meets the requirements of section 162, as a deferred expense to be amortized over the reasonably estimated life of the contracts, and to treat the portion of the expense so amortized during the taxable year as an item of deduction under former section 809(d)(12) (current section 805(a)(8)), irrespective of the taxable year in which the amount was paid.

Section 848 provides that insurance companies must capitalize an amount of otherwise deductible expenses equal to specified percentages of net premiums with respect to certain types of insurance contracts. Under section 848(a), the capitalized amounts, or "specified policy acquisition expenses," generally are to be amortized over a 120-month period. The amount of an insurance company's net premiums is determined by taking into account the consideration in respect of any reinsurance agreement. See section 1.848-2 of the regulations. Section 848(g) provides that, except as otherwise provided by sections 848 and 197, a ceding commission incurred for the reinsurance of a specified insurance contract is not required to be capitalized.

Section 197 provides an amortization deduction with respect to certain intangible property (a "section 197 intangible") that is acquired by a taxpayer after August 10, 1993, and held in connection with the conduct of a trade or business or an activity described in section 212 of the Code.

Section 197(d)(2) of the Code provides that a customer-based intangible is treated as a section 197 intangible. Under section 197(d)(2)(A)(iii), a customer-based intangible includes any value resulting from the future provision of goods or services pursuant to relationships (contractual or otherwise) in the ordinary course of business with customers. Insurance in force is treated as a customer- based intangible for purposes of section 197. See H. R. Conf. Rep. No. 213, 103d Cong. 1st Sess. 675, 687-88 (1993).

Section 197(f)(5) provides that any amortizable section 197 intangible resulting from an assumption reinsurance transaction must be taken into account under section 197(a) to the extent that the amount paid or incurred by the acquirer exceeds the amount required to be capitalized under section 848 in connection with the transaction. The amount paid or incurred for insurance in force in respect of contracts transferred in a taxable assumption reinsurance transaction is determined under the principles of section 1.817-4(d) of the regulations. See H.R. Conf. Rep. No. 213 at 688 f.26. See also section 1.817-4(d)(2)(iii) and section 1.817-4(d)(3) of the regulations.

Section 197(f)(2) provides, however, that if a section 197 intangible is transferred in a transaction described in sections 332, 351, 361, 721, 731, 1031, or 1033 of the Code, the transferee is treated as the transferor with respect to the amount of the adjusted basis of the transferee that does not exceed the adjusted basis of the transferor for purposes of applying section 197. See also H. R. Conf. Rep. No. 213, at 686.

In Rev. Rul. 75-382, 1975-2 C.B. 121, the Service considered the treatment of a mutual life insurance company's incorporation of a wholly owned stock life insurance subsidiary, and shortly thereafter the transfer of a portion of the mutual parent's life insurance business to that subsidiary by an assumption reinsurance agreement. As consideration for the subsidiary's assumption of the parent's obligations under the life insurance contracts, the parent transferred to the subsidiary assets (other than the reinsured contracts) with a fair market value equal to the amount of the decrease in the parent's reserves, which amount was also equal to the increase in the subsidiary's reserves.

Rev. Rul. 75-382 concluded that the incorporation transaction and the assumption reinsurance agreement constituted a single integrated transaction to which section 351 applied. The ruling also concluded that the assumption reinsurance agreement was governed by section 1.817-4(d) of the regulations insofar as that provision did not conflict with section 351. Thus, the parent corporation had to recognize the released reserves for the reinsured contracts in income under former section 809(c)(2) (current section 803(a)(2)), but was allowed a deduction under former section 809(d)(7) (current section 805(a)(6)) for the fair market value of the assets (other than the reinsured contracts) transferred to the subsidiary for assuming the liabilities under the reinsured contracts. The ruling also concluded that the subsidiary was required to recognize premium income under former section 809(c)(1) (current 803(b)(1)), to the extent of the fair market value of the assets that it received for assuming the parent's obligations under the transferred contracts, but was allowed a deduction under former section 809(d)(2) (current section 805(a)(2)) for the increase in its reserves as a result of assuming the obligations on the reinsured contracts. The ruling also provided that the parent would not recognize gain or loss on the assets (other than the reinsured contracts) that it transferred unless the liabilities assumed by the subsidiary exceeded the adjusted basis of those assets.

Under various nonrecognition provisions of subchapter C of the Code, including section 351, a transferor of property does not recognize gain or loss on the transfer of property in exchange for stock of a corporation controlled by the transferor. Rather, the transferee obtains the property as transferred basis property having the same basis it had in the hands of the transferor. To facilitate the incorporation of assets in controlled corporations, gain or loss is generally not recognized with respect to property transferred in such exchanges, even where other Code provisions would ordinarily treat the transfer as a taxable event. See, e.g., Hempt Bros., Inc. v. United States, 490 F.2d 1172 (3rd Cir. 1974), cert. denied, 419 U.S. 826 (1974); Focht v. Commissioner, 68 T.C. 223 (1977); Rev. Rul. 80-198, 1980-2 C.B. 113.

Under the facts of this ruling, X obtained stock in Y with a fair market value ($600x) that was $200x greater than the net value of the investment assets and insurance reserve liabilities transferred by X to Y ($1,250x - 850x = $400x). This $200x excess represents the value of the insurance in force transferred by X to Y. Under the provisions of section 1.817-4(d), the value of insurance in force would ordinarily be taken into account as a reduction of the ceding company's deduction under section 805(a)(6) for the consideration paid for assumption of the liabilities under the reinsured contracts, and as a deferred expense to be amortized by the reinsurer under section 805(a)(8). The application of these provisions would implicitly result in X's inclusion in income of the value of the insurance in force transferred to Y, and in Y's obtaining a cost basis in that intangible asset. However, in this case, the value of insurance in force is realized in the form of the stock of a controlled corporation, Y, as part of a transaction qualifying for nonrecognition under section 351. The application of the provisions of section 1.817-4(d) of the regulations would thus reach a result contrary to that called for by sections 351 and 362. Accordingly, in this case, the transfer of the insurance in force should not be subject to the provisions of sections 803 and 805 of the Code and section 1.817-4(d) of the regulations, relating to assumption reinsurance transactions.

This conclusion is consistent with the anti-churning rule of section 197(f)(2) which treats the transferee in the same manner as the transferor with respect to the amount of the adjusted basis of any section 197 intangible (including insurance in force) acquired in certain nonrecognition transactions, including section 351, as does not exceed the transferor's adjusted basis. If the transfer of insurance in force in a section 351 transaction were subject to the assumption reinsurance provisions of section 1.817-4(d) of the regulations, the application of section 197(f)(2) to the transferee would be inappropriate since the transferee would have acquired the insurance in force at its fair market value in a fully taxable transaction.

HOLDINGS

(1) Because the assumption reinsurance transaction between X and Y is used to effectuate a transfer of insurance or annuity contracts as part of a section 351 exchange, the reinsurance transaction is not subject to the provisions of sections 803 and 805 of the Code and sections 1.817-4(d) and 1.848-2 of the regulations.

(2) For purposes of the provisions of Part I of subchapter L, the transferor and the transferee account for the transfer of investment assets and the right to future income and obligations on insurance and annuity contracts in a section 351 exchange as follows:

(i) For the taxable year in which X (the transferor) transfers the insurance and annuity contracts to Y (the transferee), X includes in its reserves as of the close of that year, for purposes of sections 807(a) and (b) of the Code, the ending balances of the reserves described in section 807(c) that X held for the contracts immediately before the transfer ($850x), and X is not entitled to a deduction under section 805(a)(6) for transferring assets to Y in consideration of the assumption by Y of the liabilities under the insurance and annuity contracts.

(ii) For the first taxable year beginning after the transfer of the insurance and annuity contracts to the transferee, X does not include in its reserves as of the beginning of that year, for purposes of sections 807(a) and (b) of the Code, the ending balances of the reserves described in section 807(c) that X held for the contracts immediately before the transfer.

(iii) For the taxable year in which X transfers the insurance and annuity contracts to Y, Y includes in its reserves at the beginning of such year, for purposes of sections 807(a) and (b) of the Code, the ending balances of the reserves described in section 807(c) that X held for the contracts immediately before the transfer ($850x), and Y does not take into premium income under section 803(a)(1) any amount with respect to the assets transferred to Y in consideration of the assumption of liabilities under the insurance and annuity contracts.

(iv) For purposes of section 848 of the Code, X and Y do not recognize net premiums as a result of the assumption reinsurance transaction. The unamortized specified policy acquisition expenses of X attributable to the transferred insurance and annuity contracts ($35x) are treated as transferred to Y and continued to be amortized by Y over the remaining period as the amounts would have been deductible by X.

(3) Additional tax consequences to X and Y are as follows:

(i) For purposes of sections 357 and 358 of the Code, the insurance reserve liabilities on the transferred insurance and annuity contracts ($850x) are considered liabilities of X that are assumed by Y pursuant to the section 351 exchange. As these reserves do not exceed the total adjusted basis of the property transferred by X to Y in the exchange ($1,035x), X does not recognize gain or loss on the transfer of the assets.

(ii) X's basis in the stock of Y received in the section 351 exchange is $185x, which equals the sum of the excess of the total adjusted basis of the investment assets transferred by X to Y over the insurance reserve liabilities assumed by Y in the section 351 exchange ($1,000x - 850x = $150x), plus X's unamortized balance of specified policy acquisition expenses under section 848 attributable to the transferred insurance and annuity contracts ($35x).

(iii) Except as provided in paragraph (2)(iv) above, Y has no basis in the insurance in force with respect to the transferred insurance and annuity contracts.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 75-382 is revoked.

DRAFTING INFORMATION

The principal author of this revenue ruling is Gary Geisler of the Office of the Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Mr. Geisler on (202) 622-3970 (not a toll-free call).