Rev. Rul. 81-225

Rev. Rul. 81-225 ¹

ISSUE

Will the life insurance company or the policyholder be considered the owner, for federal income tax purposes, of the mutual fund shares under the circumstances described below?

FACTS

The terms "deferred variable annuity" and "policyholder," as used in this revenue ruling, are for descriptive convenience only and are not intended to have any substantive legal significance.

Situation 1. IC is a life insurance company taxable under section 802 of the Internal Revenue Code. In states where it is authorized to do so, IC issues contracts purporting to be deferred variable annuity contracts.

A, an individual, purchased for cash a deferred variable annuity contract (the "contract"). The contract contains a number of provisions common to deferred annuity contracts, including the right of the policyholder to surrender the contract in part or entirely for cash (subject to a surrender charge and/or contingent deferred sales load that decreases the longer the contract is outstanding) and the right, at future dates of the purchaser's choice, to convert the accumulated values under the contract into a stream of periodic payments under one of several settlement options.

The net premium received under the contract is allocated solely to IC's Variable Account 1. Pursuant to state law, Variable Account 1 is organized as a unit investment trust and is registered under the Investment Company Act of 1940, as amended.

IC has represented to policyholders that the assets of Variable Account 1 will be invested in XY Fund. XY Fund, whose shares are sold directly to the general public through registered broker-dealers, is an open-end investment company (a "mutual fund") registered as an open-end management company under the Investment Company Act of 1940, as amended. Although XY Fund has a stated investment goal, XY's investment discretion has not otherwise been limited. Existing shareholders of XY Fund may exchange their shares for a contract without payment of any fee, sales charge or transfer charge. Under the contract, IC has the right, with approval of the Securities and Exchange Commission, to substitute another mutual fund for XY Fund if investment in XY Fund is no longer possible, or if in the judgement of IC such investment becomes inappropriate. In accordance with the terms of the contract a purchaser may, in such event, surrender his or her contract.

Z, an investment management firm independent of IC, manages the investments of XY Fund under an investment advisory and administrative services contract with the fund.

A has the option to pay additional amounts to IC, which become part of the consideration for the contract. All distributions received by IC from the XY Fund are reinvested by IC through the purchase of additional shares of XY Fund for Variable Account 1, which are allocated to the purchasers of contracts on a prorata basis.

IC deducts annually a contract administration fee of $20 from the contract value of each contract on each contract anniversary prior to the annuity starting date. In addition, IC deducts an amount, computed on a daily basis, which is equal on an annual basis to 1.2 percent of the daily net asset value of Variable Account 1. IC characterizes this fee as reimbursement for mortality risks and for additional expenses.

In accordance with the Investment Company Act of 1940, as amended, IC will vote the XY Fund shares held in Variable Account 1 in accordance with instructions received from policyholders. XY Funds shares held in Variable Account 1 as to which no timely votng instructions are received will be voted by IC in proportion to the voting instructions that are timely received.

Situation 2. The facts are the same as in Situation 1 except that XY Fund is a mutual fund managed by IC, or an affiliate of IC, pursuant to an investment advisory and administrative services contract. The shares of XY Fund are sold to Variable Account 1 and, as in Situation 1, to the general public.

Situation 3. The facts are the same as in Situation 1 except that Variable Account 1 consists of 5 sub-accounts, each of which will be invested solely in the shares of a single, different mutual fund identified to the contract purchaser. Shares of each of these mutual funds are offered for sale to the general public. A has the right initially to designate and periodically to reallocate the cash value under the contract among the 5 sub-accounts.

Situation 4. The facts are the same as those in Situation 2 except that the shares are not sold directly to the public but are available only through the purchase of an annuity contract or by participation in an investment plan account of the type described in Rev. Rul. 70-525, 1970-2 C.B. 144.

Situation 5. The facts are the same as those in Situation 2 except that the shares are not sold directly to the general public but are available only through the purchase of an annuity contract.

LAW AND ANALYSIS

Section 61(a) of the Code provides that gross income means all income from whatever source derived, including interest.

Rev. Rul. 77-85, 1977-1 C.B. 12, holds that the purchaser of an "investment" annuity contract, by means of which the purchaser individually selected and controlled one or more investments in a portfolio comprising a separate account of the life insurance company issuing the contract, is considered the owner of the underlying investments for federal income tax purposes. Similarly, Rev. Rul. 80-274, 1980-2 C.B. 27, holds that the purchaser of an annuity contract, by means of which the purchaser selected and controlled specified certificates of deposit issued by a savings and loan association, is considered the owner of the certificates for federal income tax purposes. Under the facts of both rulings, the purchasers possessed sufficient incidents of ownership with respect to the underlying investments or certificates so that the interest, dividends, or other income therefrom was held to be includible in gross income of the purchasers under section 61(a) of the Code; the insurance companies did not possess incidents of ownership adequate to make them the owners of the underlying investments or certificates for federal income tax purposes.

In Situations 1, 2, 3, and 4 the policyholder has investment control over the mutual fund shares and possesses sufficient other incidents of ownership to be considered the owner of the mutual fund shares for federal income tax purposes. In each of these situations, the mutual fund shares are available for purchase not only by the prospective purchaser of the deferred variable annuity, but also by other members of the general public either directly (as in Situations 1, 2, and 3) or indirectly (as in Situation 4). The policyholder's position in each of these situations is substantially identical to what his or her position would have been had the mutual fund shares been purchased directly (or indirectly, as in Situation 4). Although a mutual fund's diversified portfolio of securities is controlled by the manager of the mutual fund and not by the policyholder, this does not distinguish these situations from Rev. Ruls. 77-85 and 80-274 because the mutual fund themselves are securities the incidents of ownership of which may be attributed to the policyholder in these situations. Prior to the annuity starting date IC is, in such circumstances, little more than a conduit between the policyholders and their mutual fund shares.

Furthermore, contracts described in Situations 1, 2, 3, and 4 are not annuity contracts described in section 403(a) or (b) or section 408(b) of the Code.

In Situation 5, the shares of XY Fund are not separate investment assets: XY Fund is nothing more than the alter ego of IC. The sole function of XY Fund is to provide an investment vehicle to allow IC to meet its obligations under its annuity contracts. This situation is equivalent for federal income tax purposes to the direct purchase by IC of the underlying portfolio of assets of XY Fund. IC possesses sufficient incidents of ownership to be considered the owner of these underlying assets for federal income tax purposes.

HOLDING

In Situations 1, 2, 3, and 4, prior to the annuity starting date, A, and not IC, is the owner of the mutual fund shares for federal income tax purposes and the earnings and/or gains from the shares are thus includible in the policyholder's gross income under section 61(a) of the Code.

In Situation 5, IC, and not A, is the owner of the shares of XY Fund for federal income tax purposes.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 76-281, 1976-2 C.B. 206, is hereby amplified.

PROSPECTIVE APPLICATION

In light of the holding in Rev. Rul. 80-274 and pursuant to the authority contained in section 7805(b) of the Code, payments made into separate accounts, such as Variable Account 1 (other than in Situation 5) on or before December 31, 1980, will be treated as though they are paid into a segregated asset account within the meaning of section 801(g)(1). After December 31, 1980, except as set forth below with regard to section 403(a) or (b) or section 408(b) payments made into separate accounts such as Variable Account 1 (other than in Situation 5) will be treated as payments to the mutual fund and the policyholder will be treated as the owner of the mutual fund shares for federal tax purposes.

For gross dividends and other distributions on stock received on account of shares purchased with payments made by A after December 31, 1980, IC is a nominee of A in Situations 1, 2, 3, and 4 for purposes of section 6042 of the Code unless and until IC distributes to A the evidences of ownership of interests in the mutual fund purchased with payments received after December 31, 1980. IC must file Forms 1096 and 1087 with the Internal Revenue Service to report the dividends received from XY as a nominee of A and furnish A a statement showing those amounts.

Because Rev. Rul. 80-274 did not address section 403(a) or (b) or section 408(b) of the Code, any contract described in Situations 1, 2, 3, and 4 entered into on or before September 25, 1981, will be treated as an annuity contract described in those sections if:

(1) the contract was entered into under an arrangement that, without taking into account the holding or rationale of this revenue ruling, would have been determined to meet the requirements of section 403(a) or (b) or section 408(b) of the Code, and

(2) no contributions are made on behalf of any individual who was not included under the contract on or before September 25, 1981.

1 Also released as News Release IR-81-114, dated September 25, 1981.