Office of Chief Counsel

Office of Chief Counsel

Internal Revenue Service

memorandum

CC:NER:NED:BOS:TL-N-2728-99

MASullivan

date:

to:

w

e P l%?l

District

Director,

New England District

Attn:

Louis F. Bourke, Team Coordinator

from:

District

Counsel,

New England

Jbject:

--------------------------------- -------U.I.L.

#807.05-00

-- -----------------

District,

Boston

DISCLOSURE STATEMENT

THIS DOCUMENTMAY CONTAIN CONFIDENTIAL INFORMATION SUBJECT TO THE

ATTORNEY-CLIENT AND DELIBERATIVE PROCESSPRIVILEGES, AND MAY ALSO

HAVE BEEN PREPARED IN ANTICIPATION OF LITIGATION.

THIS DOCUMENT

SHOULD NOT BE DISCLOSED TO ANYONEOUTSIDE THE INTERNAL REVENUE

SERVICE, INCLUDING THE TAXPAYERINVOLVED, AND ITS USE WITHIN THE

INTERNAL REVENUE SERVICE SHOULDBE LIMITED TO THOSE WITH A NEED

TO REVIEW THE DOCUMENTIN RELATION TO THE SUBJECT MATTER OF THE

CASE DISCUSSED HEREIN. THIS DOCUKZNTIS ALSO TAX INFORMATION OF

THE INSTANT TAXPAYER THAT IS SUX'ECT TO I.R.C.

§ 6103.

This responds to your reo_est for advice

spread rule of section

807(f)

~5 the Internal

on the lo-year

Revenue Code.

Does the rule of section

807(f) of the Internal

Revenue Code

requiring

a lo-year

spread of the adjustment

for a change in the

basis of life

insurance

reserves apply to the taxpayer's

strengthening

of its tax reserves on noncancellable

individual

disability

insurance

policies

in ----?

Conclusion

A lo-year

spread

of the adjustment

is

required

under

section

807(f).

10673

page 2

CC:NER:NED:BOS:TL-N-2728-99

Facts

---------------------------- ----------------including

-------- -------------------- ----------------------- ----- ------ ------------------------------ ------------------------- --- Form- -------- --------------------- ----- ----- --------- are

insurance

companies subject

to tax- -------- --------83--During

----------------------- and ----- --------- strengthened

the

approved clai--- --s--------- ---- ----canc------------ividual

disability

income contracts

for statutory

purposes because claim experience

had deteriorated.

The federally

prescribed

reserve

(FPR)

determined

under section

807(d) (2) for the contracts

exceeded the

statutory

reserves both before

and after

the strengthening,

and

under section

807(d) (1) the amount of the reserves before

and

after

strengthening

was limited

to the amount of the statutory

reserves.

The item "Tax Reserves"

on the return

for "Approved

dpen pay claim reserves"

was increased.

The statutory

reserves

for approved claims of ------------------- was increased by $ -- --------You have not indicated

----- ----------- -- the increase

in t---- -----------of ----- ---------. The taxpayer

--------- argues that because the

fed-----------cribed

reserve ---- -ot change, section

807(f)

does

not require

the adjustment

for the change in computing the

reserves

to be spread.

Law & Analvsis

Section 832(b) (1) provides

that the gross income of an

insurance

company subject

to the tax imposed by section

831

includes

underwriting

income. Section

832(b)(3)

provides

that

underwriting

income means the premiums earned on insurance

contracts

during the taxable

year less losses incurred

and

expenses incurred.

See also 5 1.832-4(a)

(1).

Section 832(b) (4) provides

that premiums earned

contracts

means an amount computed (in relevant

part)

on insurance

as follows:

(A) From the amount of gross premiums written

on

insurance

contracts

during the taxable

year, deduct return

premiums and premiums paid for reinsurance.

(B) To the result

so obtained,

add 80 percent

of the

unearned premiums on outstanding

business at the end of the

preceding taxable year and deduct 80 percent of the unearned

premiums on outstanding

business

at the end of the taxable

year.

CC:NER:NED:BOS:TL-N-2728-99

page 3

Section 832(b) further

provides

that unearned premiums

include life

insurance

reserves,

as defined

in section

816(b),

but determined

as provided

in section

807. Section 832(b) (7) (A)in

effect

provides

that the reduction

of unearned premiums otherwise

required by section

832(b) (4) (B) does not apply with respect

to

life

insurance

reserves

treated

as unearned premiums.

Section

816(b) provides

that life

insurance

reserves

include

amounts set

either

by payment or reinsurance,

aside to mature or liquidate,

future

unaccrued claims arising

from noncancellable

accident

and

health insurance contracts

involving,

at the time with respect

to

which the reserve is computed, life,

accident,

or health

contingenckes.

Section 807(d) concerns the method of computing reserves

for

purposes of determining

the income of a life

insurance

company.

Section 807(d)(l)

provides

that the amount of the life

insurance

reserve for any contract

is the greater

of -- (A) the net

surrender

value of such contract,

or (B) the reserve

determined

under section

807(d) (2). However, under section

807(d)(l),

the

reserve cannot exceed the amount that would be taken into account

with respect to such contract

in determining

statutory

reserves

(as defined in section

809(b) (4) (B)).

Section 807(d) (2) (C) provides

that the amount of the reserve

under section

807(d) (2) is determined

by using the prevailing

commissioners'

standard tables

for mortality

and morbidity

adjusted as appropriate

to reflect

the risks

incurred

under the

contract

which are not otherwise

taken into account.

If

the basis for determining

the life

insurance

reserves

of

a life

insurance company as the close of a taxable

year differs

from the basis for such determination

as of the close of the

807(f)

requires

a spread of the

preceding

taxable year, section

difference

between the amount of the item at the close of the

taxable year, computed on the new basis,

and the amount of the

item at the close of the taxable

year, computed on the old basis,

that is attributable

to contracts

issued before

the taxable

year.

A positive

difference,

such at the one that resulted

in this

over the ten succeeding years

case, is taken into account ratably

as a deduction

under section

805(a) (2). A n,egative difference

is

included in gross income ratably

over the ten succeeding years

under section

803(a) (2).

Rev. Rul. 65-240, 1965-2 C.B. 236, considers

the proper

treatment

of an increase

in the life

insurance

reserves

of an

insurance

company subject

to tax under section

831. Rev. Rul. 65240 holds that any increase

or decrease in the basis of life

insurance

reserves of an insurance

company subject

to tax under

section 831 is taken into account in accordance with the

-

CC:NER:NED:BOS:TL-N-2728-99

page 4

predecessor

of section

807(f),

former section

810(d).

Because the

applicable

laws have not materially

changed, see Rev. Rul. 94-74,

807(f) of current

1994-2 C.B. 157, 159, we conclude that section

law likewise

applies

to the life

insurance

reserves of an

insurance

company taxable

under section

831.

The taxpayer

responded to your question

about why it did not

spread the adjustments

in this case variously

that because it

changed nothing

in calculating

reserves

for tax purposes,

and

because the federally

prescribed

reserve

for the disability

policies

of ------------------- and ----- -------M did not change,

section

807(f-- ------- ----- -equire- -- --------- of the change in

To support

its position,

the taxpayer

apparently

relies

reserves.

on language (quoted below) from the General Explanation

of the

Tax Reform Act of 1984 prepared by the Staff

of the Joint

Committee on Taxation

(Blue Book).

Under section

1.806-4(a),

a change in basis of computing

life

insurance

reserves

is not a change in method of accounting

requiring

the consent of the Secretary

under section

446(e).

It

was in the 1984 Act that Congress retained

the rule of former

section

810(d),

which had required

an adjustment

for a change in

method of computing life

insurance

reserves

to be spread ratably

over a lo-year

period,

by enacting

new section

807(f).

In

explaining

the enactment of section

807(f),

the Blue Book

comments that "[glenerally,

the rule for a change in basis in

computing reserves

will

be applied

to life

insurance tax reserves

only if there is a change in basis in computing the Federally

prescribed

reserve

(as distinguished

from the net surrender

value)."

Blue Book at 603-04.

Rev. Rul. 94-74, 1994-2 C.B. 157, explains

that under

a

spread

is

required

when

there

is a change in

section

807(f),

specified

or unspecified

assumptions

used in computing the life

insurance

reserve

for tax purposes.

Rev. Rul. 94-74 at 159.

of reserves

for a mathematical

or posting

However, the correction

error is not change in basis to which the lo-year

spread rule of

section

807(f)

applies.

Rev. Rul. 94-74 at 159-60. In this case,

the taxpayer

changed the assumptions

used in computing its life

insurance

reserves.

It did not correct

a mathematical

or posting

error.

As a result,

the adjustment

required

by section

807(f) (1)

must be spread under the rule of section

807(f)(Z).

The taxpayer

has not argued that the change to its life

insurance

reserve

was the result

of a mathematical

or posting

It instead

apparently

interprets

the quoted statement

from

error.

the Blue Book to mean that section

807(f)

cannot apply when the

statutory

life

insurance

reserves

exceed the life

insurance

reserve amount determined

under section

807(d) (2) and become the

-

CC:NER:NED:BOS:TL-N-2728-98

page 5

measure of the tax life

insurance

reserve,

because in that case

there is no change in basis in computing the Federally

prescribed

We disagree with this argument.

reserve.

Section 807(f)

applies

if a taxpayer

changes its basis for

computing its tax life

insurance

reserve.

The statute

by its

terms applies

without

regard to whether the tax life

insurance

reserve equals the amount determined

under section

807(d)(2),

or

is instead

limited

by the statutory

cap imposed by section

between the statute

and the

807(d) (1). If there were a conflict

the

statute

would

control.

However,

they

do

not

Blue Book,

conflict.

It can accurately

be said that the federally

prescribed

reserve did change in this case. The amount computed under

section

807(d) (2) with respect

to the taxpayer's

life

insurance

reserves

would change with the addition

of the load.

the sentence from the Blue Book quoted

More importantly,

above is introduced

by the word "generally,"

indicating

that the

Joint Committee contemplated

the typical

case in which the

statutory

life

insurance

reserve

exceeds the Federally

prescribed

Furthermore,

the aim of the sentence is to indicate

that

reserve.

if the net surrender

value is the measure of the tax life

insurance

reserve under section

807(d) (1) (because it exceeds the

federally

prescribed

reserve)

and the net surrender

value of the

807(f)

does not require

a spread of

contracts

changes, section

the change because the net surrender

value is really

a current

liability

rather

than a reserve.

See Blue Book at 604. What is at

issue in this case is a change in a reserve,

not an increase

in a

current

liability

because of a change in net surrender

value.

GERALD J. O'TOOLE

District

Counsel

By:

DAVID N. BRODSKY

Assistant

District

a

Counsel