# Petitioners Brief — Commissioner v. Standard Life & Accident Insurance

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Petitioners Brief
- **Published:** January 1, 1977
- **Citation:** 433 U.S. 148

## Text

No. 75-1771

athe Supreme Gout of te Waited Sites

OocropeR TERM, 1976

COMMISSIONER OF INTERNAL REVENUE, PETITIONER
v.
SranparD Lire & AccIDENT INSURANCE COMPANY

ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF
APPEALS FOR THE TENTH CIRCUIT

BRIEF FOR THE PETITIONER

BOBERT H. BORK,
Solkoitor General,
MYRON C. BAUM,
Acting Assistant Attorney General,
STUART A. SMITH,
Assistant to the Solkoitor General,
GARY 8. ALLEN,
STEPHEN M. GELBER,
Attorneys,
Department of Justice,
Washington, D.C, 20580.
JEANNE L. DOBRES,
Attorney,
Internal Revenue Service,
Washington, D.C., 20224

IESE EES Ss Se eT ee

(1) Taxable investment income_____.__._____
(2) Gain from operations__...._...-....____
B. The facts of this case and the proceedings below___

SUIRINNES CF CREEL. cccesccencecsqenseccaisteduamis
ATEN... ccctcccrecucwcrocnscwetscccunnsntccecccee

A life insurance company that includes the net val-
uation portion of its deferred and uncollected pre-
miums in its “reserves” for federal tax purposes on
the assumption that the gross annual premiums on its
policies have been paid in full on the policy anniver-
sary dates must consistently apply that assumption for
all of its tax computations and include the full amount
of its deferred and uncollected premiums in its “assets”
and “gross amount of premiums”_.........._..___-
A, TRIE sdtiticderctntubtnbidinndarsicuceccas
B. A life insurance reserve arises upon the company’s

assumption of the risk and the policyholder’s pay-
Stns 68 SUR nc nensvceeesessesestitondans
C. A life insurance company that increases its “re-
serves” by the net valuation portion of its de-
ferred and uncollected premiums must include the
gross amount of such premiums in its computa-
tion of “assets” under Section 805(b) (4) --------
D. A life insurance company that includes the net val-
uation portion of deferred and uncollected pre-
miums in “reserves” must include the gross
amount of such premiums in its computation of
“gross amount of premiums” under Section 809

(c)(1) -------------------------------------

a eee

Caan

noe

ss

51

Cases:

I
Argument—Continned —
E. Alternatively, if deferred and uncollected pre-
miums are not included in “assets” and “gross
amount of premiums,” the net valuation portion
of those premiums must likewise be excluded
I eo vccinivanliinenitiittniiiedionsii
CED cnccccdonmuwccinentstdtaisbatiibblanmandt 58
REGUS ccc cctccunannintvinitinnbitiinidditnaasaaiipia 1A
CITATIONS
Bankers Union Life Insurance Co. v. Commissioner, 62
aie GB. cccscnenncincstvindiibncrinitaiciiniilinarsslishisliciiyhiiaiaiaiiipiatiaisia 14, 42, 46
Commissioner v. South Texas Co., 333 U.S. 496__...-- 28
Continental Life Insurance Co. v. Commissioner, 5
A cle Ci eanienieniennnirntnatitrincagitnisenmpiiieibiiailimaii aii 28

Franklin Life Insurance Co. v. United States, 399 F, 2d

757, certiorari denied, 393 U.S. 1118___ 15, 41, 48, 50, 52, 57
Helvering v. Independent Life Ins. Co.,292 U.S. 371. 54
Helvering vy. Inter-Mountain Life Ins. Co., 294 U.S.

FED entre teins teintnhiniguahilitldeninllaindiaiittiniibllials <histaitnniaicnsts 30
Helvering v. LeGierse, 312 U.S. 531_------.----.--- 29
Helvering v. Wilshire Oil Co., 308 U.S. 90_.-------- 28

Jefferson Standard Life Insurance Co. v. United
States, 408 F. 2d 842, certiorari denied, 396 U.S.

GE cccvncencuctanunuiéadinideibiads 15, 18, 42, 43, 50-51, 53
Mass. Mutual Life Ins. Co. v. United States, 288 U.S.

SD pcenecconcenscenss cesntiantnehitltntminednn 28
McCoach v. Insurance Company of North America, 244

Wee | Bicereinnnendenngaseeiidbaiitaliiniinn 47
Midland National Life Insurance Co. v. Commissioner,

OS FES: CeO cc ncnnwentsictinniimapintiilicsinadmpens 42

Monumental Life Insurance Co. v. United States, No.
71-73, decided November 19, 1976 (Ct. Cl.) (76-2

De GUUS Petinnicacantémininbéhpiapremeniban 57
New Colonial Co. v. Helvering, 292 U.S. 485_-------- 54
New York Life Ins. Co. v. Bowers, 283 U.S, 242______- 30
New York Life Ins. Co. v. Edwards, 271 US.

DUD sicher rescteitta cctdestasiedtabisieasnciiatbetiecieiadetatia ia 30, 44, 56

Union Mutual Life Insurance Co. v. United States. No.
74-112 S.D., decided September 14, 1976 (D. Me.)
OF a en 42

Il
Cases—Continued
United Life and Accident Insurance Co. v. United
Biahen, GED Y.. Bapt.. Mba .cccvvsiucseccsscccee- 42
United States vy. Atlas Life Ins. Co., 381 U.S.
SRE ae tata ean) 9.6 4, 6, 21, 30, 39, 40
United States v. Catto, 384 U.S. 102_..------------- 28
W. L. Moody Cotton Co. v. Commissioner, 143 F. 2d
TID nnnashsemmnsscpimiabiniebibicseccsbaccasee 28

Western and Southern Life Insurance Co, v. Commis-
sioner, 460 F. 2d 8, certiorari denied, 409 U.S.
IT sinartntistcisimmsatipiondedsnddei cake diais 15, 42, 51, 53
Western National Life Insurance Co. of Texas v. Com-
missioner, 50 T.C. 285, modified, 51 T.C. 824,

reversed, 432 F, 2d 298___-_______- 15, 42, 45, 46, 49, 51,53
Williams v. Union Central Life Insurance Co., 291 U.S.
OD cchtiiitintinennpetimnnmmnanindiplsighiinitiiiniitinas 30
Statutes and regulations:
Income Tax Act of 1913, c. 16, Section II(G) (b), 38
bas... BAA, FR Bi Rcinciiecnttinpinadosiiiiguniidwocs 29
Internal Revenue Code of 1939, Section 203(a) (26
CR: CORI OE hited eitidesiiqntndcsabwwndencus 23
Internal Revenue Code of 1954, as amended (26 U.S.C.
(1958 ed., Supp. IT)):
OEE Te nnccneccivccccceneccceswecsenceece 2,1A
OT: FER 6 nicdmctbovesitsestianicimenewst ‘ 8
SE BECP (3) cncrcmnncccmewecswesuds 4,12, 56,1A
EE GG iin sinc mitct a cbninnneinnca 31
Sections 801-820.....---------- mnetnbine mien 3, 21, 50
GONG, Bi iiiciincitinaictindvectoinavindewsiuces 2,2A
I I nctmineicsetinmengierpentcaienlgit 3,24
Battie BER (1) cine cenvnticcccwecewnns 3,2A-3A
Ee eRe 3, 3A
IGA BE icieviectwticdtecinvicsoosccedeecsus 2,3, 3A
ON | eee eae 39, 40, 3A
Deeb TRIES) siriicimcciisinednetivvaneinhowwss 5, 39,54
ell 2,12, 14, 8A
Bodies BIBGS) incccknncsonmeeceanedodcess 39, 40, 8A
Section 805(a) (4)---.------ snnpnnnnadiinadiiidin 27
ees BI iit eh nttite pe cicicivcneenionn 6, 39, 40, 8A
Besta, GIGI) (2) ncnnetrencnncccceensthssoncsion 5, 8A
PR BEEN ccanscncccnagummacccenesccce 5, 8A

IV

Statutes and regulations—Continued

Page
Section 805(b)(8)................... 5, 8A-9A
t-te og, ae passim, 9A
UI Cid a eciet hiinsncicnmaidcakianiiin dais 6,10A
att ta aie, ELLIE LEE NES: 39,10A
ste sts Ce RE a 6
eb SPENT 2, 3, 12, 13, 14,51, 11A
Section 809(b)(1)(A)-............ 51,12A
RY I cahiitiiadessidciciinsidnaehe Yuden ceca 52, 13A
Section 600(¢)(1).................. passim, 13A
apie spect TTL: 7, 52,14A
pug tigth sg! en 7,52,144
SS Calica chcinisleitniein bikin tiaidnaechentas 2,17A
staat tage nL TE TE 4
UII i sississnaniihinchcsititiid-eclasciasan cha sisi se. 2,18A
NTN cinsonnsibenittinebidiiinininic. cites oc 42d 48
CUE DO iscsi nimniencicteesinaadbialiiecs polio 3
seeing ag, 14
Life Insurance Company Income Tax Act of 1959,
Section 4, 78 Gtet. 168i so 3
Life Insurance Company Tax Act of 1955, c. 83, Sec-
tion 806, 70 Ghat. 96,41 no 23
Revenue Act of 1916, c. 463, Section 12(a) Second, 39
RO. TO: Te iiinncnniteiicintiainamindiiaens tie a 22
Revenue Act of 1918, c. 18, Section 234(a) (10), 40
GUD. BIOL, WD ckccctniniiielandliee aoe 22
Revenue Act of 1921, c. 136, Sections 242-947, 42 Stat.
Sy We Sc vcitisentenseineiniidns heh Sie. 22
Revenue Act of 1924, c. 234, Section 245(a), 43 Stat.
TR 0 cece ssictctinpersienininertianiinaiain ee hme ca 23
Revenue Act of 1926, c. 27, Section 245 (a), 44 Stat. 9,
DF cccectantimemanymwnntiingntniitinkaite lil 23
Revenue Act of 1928, c, 852, Section 203(a), 45 Stat.
TE, BD cctsimcimarninnincgins iia Been 23
Revenue Act of 1932, c. 209, Section 203(a), 47 Stat.
FED, TB rccscesennnmtiavenntvatiiminiaiaiitbiae ha. 23
Revenue Act of 1934, c. 277, Section 203 (a), 48 Stat.
060, TED... .wecoccesansomevesidnutsiniosilldspeinds 23
Revenue Act of 1936, c. 690, Section 203(a), 49 Stat.
SOO, SIDI ese x ssesessorsensesicsioentslesbeabpaiananiapiaitninics 23

ae

v
Statutes and regulations—Continued Page
Revenue Act of 1938, c. 289, Section 203(a), 52 Stat.
IDG, Gi ictbitimeteaios dit fi ei 23
Revenue Act of 1950, c. 994; Section 401 (a), 64 Stat.
aes TR RS NE PE RO aE RT AIS 23
Revenue Act of 1951, c. 521, Section 336, 65 Stat. 452,
sept SE EE Te 23
36 Okla. Stat. Ann, (1958) :-
ppd onan ge, og REE SESE Ce eT 33
ep tere. TR ETD a ee 33
Pe i itiditbdiincndbhtiiit cs a 25
Treasury Regulations No. 33 (Rev.), Art. 239, pars.
PI A ctesicmalebiiicwaiiebindee th i catta te a 22
Treasury Regulations No. 45, Arts. 548, 549, 569
FE SAINTS Save Om: SR eeN OT OOee eee oe 22
Treasury Regulations on Income Tax (26 C.F.R.) :
. &.. .. Serre 31
cea gE ee TT ee ee 2,19A
Section 1.801-4(f)___...___ 19, 27, 38, 56, 57, 58, 19A
ck TTL DIETS RESIS 2,20A
Section 1.805-5(a)(4)..............______ 13, 38, 204
Section 1.805(a) (4) (ii)_---______ 19, 27, 45, 55, 57, 20A
I 2
ee DOOR 13, 27, 52, 55
Section 1.809-4(a)(1)_-....... 19, 38, 57
Miscellaneous:
Beardsley, Life Company Annual Statement Hand-
eget tot ang IS ETI MENT Da 37
105 Cong. Rec. 8428-8429 (1959)_....... 24
Denney, Rua & Schoen, Federal Income Taxation of
Insurance Companies (2d ed. 1966)_______._______ 23
Ernst & Ernst, @AAP—Stock Life Companies (1974)_ 37,44
Greider and Beadles, Principles of Life Insurance
UN, iced en 32
Hearings on H.R. 4245 (Tax Formula for Life In-
surance Companies) before the Senate Committee
on Finance, 86th Cong., 1st Sess, (1959) _..________ 50
Hearings on the Taxation of Income of Life Insurance
Companies before the Subcommittee on Internal
Revenue Taxation of the House Committee on Ways
Ned and Means, 85th Cong., 2d Sess. (1958) .......____- 50
Saat
inc
Ns:
ihe, =

vI

Miscellaneous—Continued Page
H.R. Rep. No. 34, 86th Cong., Ist Sess. (1959) __ 24, 39, 40, 49
Huebner and Black, Life Jnsurance (9th ed. 1976) _ 30, 31, 33
MacLean, Life Insurance (9th ed. 1962) ---.------ 9, 33, 37
Magee, Life Insurance (3d ed. 1958) ~------------ 30, 31, 32
McGill, Life Insurance (Rev. ed. 1967) -~------- 9, 30, 32, 39
Official Report of the Pruccedings of the National In-

surance Convention of the United States (1871) ---- 34
A Preliminary Statement of the Facts and Issues with
Respect to the Federal Taxation of Life Insurance
Companies, Subcommittee on the Taxation of Life
Insurance Companies, House Committee on Ways
and Means (November 1954) -.---..----------- 22, 23, 24
Report on the Taxation of Life Insurance Companies,
Subcommittee on Internal Revenue Taxation, House
Committee on Ways and Means (December 31,

MBGBD. .ndcncicncecowteencstenetbiihnitiieadbieliioins 23
S. Rep. No. 291, 86th Cong., Ist Sess. (1959) _.-.-- 24, 39, 49
Wightman, Life Insurance Statements and Accounts

CHEE OG) ncccnnnnnnasusncnesvtnntsiitaiindiage 8, 34, 37, 47

ge

Gn the Supreme Court of the United States

OctToBeR TERM, 1976

No. 75-1771

COMMISSIONER OF INTERNAL REVENUE, PETITIONER
v.
StTanDarD Lire & AccipentT INsuRANCE COMPANY

ON WRIT OF CERTIORARI TO THE UNITED STATES COURT OF
APPEALS FOR THE TENTH CIRCUIT

BRIEF FOR THE PETITIONER

CPINIONS BELOW

The memorandum opinion of the Tax Court (Pet.
App. A la-8a) is not officially reported. The opinion
of the court of appeals (Pet. App. B 9a-23a) is
reported at 525 F. 2d 786.

JURISDICTION

The judgment of the court of appeals (Pet. App. C
24a-25a) was entered on November 6, 1975. The court
of appeals denied a petition for rehearing with sug-
gestion for rehearing en bane on January 9, 1976
(Pet. App. D 26a-27a). By orders dated March 30
and April 26, 1976, Mr. Justice White extended the

(1)

2

time for filing a petition for a writ of certiorari to
and including June 6, 1976. The petition was filed on
June 4, 1976, and was granted on October 4, 1976
(A. 142). The jurisdiction of this Court rests on
28 U.S.C. 1254(1).

QUESTION PRESENTED

Whether a life insurance company that reduces its
federal tax liability by including in its “reserves’’ the
amount of the net valuation portion of its deferred
and uncollected premiums on the assumption that the
full annual premiums on all of its outstanding policies
have been paid on their anniversary dates, must apply
the same assumption and likewise include the full
amount of its deferred and uncollected premiums in
its “assets’’ and “gross amount of premiums’’ under
Sections 805(b)(4) and 809(c)(1) of the Internal
Revenue Code of 1954, or else must exclude such pre-
miums altogether in computing its “reserves,” ‘‘as-
sets” and “gross amount of premiums”; or whether,
as the court of appeals held, it may exclude its de-
ferred and uncollected premiums from “assets” and
“‘gross amount of premiums” but nevertheless include
the net valuation portion of such premiums in its
reserves.

STATUTES AND REGULATIONS INVOLVED

The pertinent provisions of Sections 801, 802, 804,
805, 809, 810 and 818 of the Internal Revenue Code
of 1954 as amended (26 U.S.C. (1958 ed., Supp. IT)),
and of Treasury Regulations on Income Tax, Sections
1.801+4, 1.805-5 and 1.8094 (26 C.F.R.), set forth
in the Appendix, infra, pp. 14-23a.

3
STATEMENT

A. THE STATUTE

The Life Insurance Company Income Tax Act of
1959, as set forth in Sections 801-820 of the Internal
Revenue Code of 1954, provides a three-phase pro-
cedure for the taxation of life insurance companies.’
The primary categories of inconie subject te tax are
‘‘taxable investment income’’ (as defined in Sec-
tion 804) and “gain from operations” (as defined in
Section 809). “Taxable investment income” is, as the
term implies, income from interest, dividends, and
the like. “Gain from operations” is a broader cate-
gory encompassing total net income from all sources,
i.e., investment income plus other income, principally
underwriting income from premiums.

Pursuant to Section 802(b), the total tax base of a life
insurance company to which the ordinary corporate
rates are applied is the sum of the tax bases derived
from computations under each of the three phases. The
Phase I tax base (Section 802(b)(1)) is the smaller
of “taxable investment income” or “gain from opera-
tions.’”’ The Phase II tax base is equal to 50 percent
of the excess, if any, of the gain from operations over
taxable investment income (Section 802(b)(2)). Fi-
nally, the portion of a company’s “gain from opera-

1 Section 4 of the Life Insurance Company Income Tax Act of
1959, 73 Stat. 141, makes the Act applicable to all taxable years
beginning after December 31, 1957. Pursuant to Section 843 of the
Code, life insurance companies are required to report their income
on a calendar year basis.

4

tions” or underwriting income that is not taxed under
Phase IT becomes the Phase III tax base when such
income is made available to shareholders (Section
815). See United States v. Atlas Life Ins. Co., 381
U.S. 233, 235 n. 2.

For purposes of the Phase I and II tax bases, the
determination of the total tax base involves a series
of computations directed toward arriving at the
fundamental categories of “taxable investment in-
come” and ‘‘gain from operations.” * The statute ree-
ognizes that life insurance companies are required to
compute their projected future liabilities to their
policyholders by establishing policyholder reserves to
meet future claims and that the annual additions to
those reserves should be free of tax. Section 801(b)
(1) of the Code defines life insurance reserves and the
statutory scheme provides a method for establishing
the amount which, for tax purposes, is deemed to be
added each year to these reserves.

Accordingly, the computations of both “taxable in-
vestment income” and “gain from operations” pro-
vide a mechanism for excluding from the total tax
base those portions of investment and premium in-
come that must be held to meet policyholder obliga-
tions. The payment of premiums necessarily results in

* There is a variation between the Phase I and II methods of
computing the company’s share of “investment income.” Simply
stated, the Phase I computation is based upon the company’s actual
earnings experience, while the Phase II computation permits the
use of the company’s assumed rate of interest.

5

the creation of a reserve liability reflecting amounts
that the company must invest at an assumed rate
of interest to meet future death claims. All other
elements of the tax computation remaining constant,
as the reserves and the ameunt of income necessary
to cover the reserves increase, the federal tax base
will correspondingly decrease.

(1) Taxable Investment Income.—With respect to
determining ‘‘taxable investment income,” the statu-
tory computations are generally directed toward divid-
ing the investment income for the taxable year on an
item-by-item basis between a nontaxable ‘‘policyhold-
ers’ share” deemed necessary for policyholder reserve
obligations and a taxable “life insurance company’s
share.’’ This is accomplished by dividing the com-
pany’s “investment yield’’* by the “assets’’ of the
company * to derive the company’s actual earnings
rate. This rate, after adjustment,’ is then multiplied

® Section 804(c) defines “investment yield” as “gross investment
income,” less specified deductions, including investment expenses,
real estate expenses, and depreciation and trade and business ex-
penses, subject to certain exceptions and limitations.

* Section 805(b) (4) defines “assets” as “all assets of the com-
pany * * * other than real and personal property (excluding
money) used by it in carrying on un insurance trade or business.”
Thus, a building owned by the company to house its offices and its
furniture and fixtures are excluded from the computation of its
“assets,”

° The adjusted earnings rate (which the statute calls the “ad-
justed reserves rate”) equals the current earnings rate, or the aver-
age of the current earnings rate and the rates from the four years
prior to the current year, whichever is lower. See Section 805(b)
(1), (2) and (3).

n

by the company’s adjucte ~ ue insurance reserves for
policyholders.’ The resulting produ*t is the exclusion
from the company’s tax base for tae amounts of in-
vestment income that are considered xecessary for tax
purposes to cover its life insurance reserves.

The foregoing computation may be expressed by the
following formuiae:

Investment Yield ;
(1) a = Earning Rate

(2) Earning Ratex Reserves=Tax Exclusion

(3) Investment Yield
Assets

X Reserves = Tax Exclusion

or

Reserves
Assets
These formulae demonstrate .aat the proportion of the
company’s reserves to its total assets controls the frac-
tional amount of the investment income that will be
excluded from tax. Thus, as “reserves” increase in pro-

Investment Yieldx< = Tax Exclusion

* Adjusted life insurance reserves are the company’s life insur-
ance reserves for policyholder obligations, adjusted for the differ-
ence bet ween the assumed interest rate used by the company in com-
puting the reserves and the actual earnings rate. The reserve is re-
duced by 10 percent for every 1 percent by which the applicable
earnings rate exceeds the company’s assumed rate. The resulting
figure—the adjusted life insurance reserves—is then multiplied
by the company’s adjusted earnings rate. To the amount so calcu-
lated are added pension plan reserve requirements and interest
paid during the taxable year, all of which are excluded from the
copmany’s tax base. See Sction 805; United States v. Atlas Life
Ins. Co., supra, 381 U.S. at 236 n. 4.

7

portion to the company’s assets, the tax exclusion will
likewise increase.

(%) Gain from Operations.—The company’s ‘‘gain
frum operations” includes its income from ail sources,
less certain specified deductions. Since ‘‘gain from op-
erations” includes the element of investment income,
the computation of “gain from operations”’ is further
directed toward taking inte account income from
other sources, principally underwriting income. Un-
derwriting gains result when the premium charged
for a policy exceeds the company’s costs in provid-
ing the coverage. Thus, in addition to its share of
investment income, the principal item in computing
“gain from operations” is the “gross amount of pre-
miums and other consideration * * * on insurance
and annuity contracts * * *.” (See. 809(c)(1)).

The specified deductions (Section 809(d)) include
noninvestment expenses, such as underwriting expenses,
salaries, general overhead, and claims paid. In accord
with the congressional decision to exclude net addi-
tions to policyholder reserves from the tax base,
Section 809(d)(2) generally permits a deduction for
increases in reserves during the taxable year attrib-
utable to the premiums included in income under
Section 809(c)(1). When the various deductions are
subtracted from the company’s gross income from all
sources, the resulting figure is the “gain from
operations.”

Since “gross amount of premiums” is an income
item in the above computation, increases in that ele-
ment will result in a higher figure for “gain from op-

8

erations”’ and a larger tax base. Conversely, since the
“net increase in reserves” is a deduction item, incre-
ments to that statutory element will decrease the tax
base.

B. THE FACTS OF THIS CASE AND ee —_— BELOW

1. Respondent is an Oxiahoma stock corporation
engaged in the business of issuing insurance. During
1958-1961, it qualified for preferential federal tax
treatment as a “‘life insurance company,” as that term
is defined by Section 801(a) of the Internal Revenue
Code of 1954. As a life insurance company, respondent
was subject to supervision and audit by the Oklahoma
Insurance Commissioner and by officials of the other
states in which it did business (Pet. App. A 2a-—3a;
Pet. App. B 10a).’

During the years in question respondent received
income consisting of life insurance premiums and the
return on the investment of those premiums and pre-
viously received premiums (Exs. A, B, and D, A.
23-24, 25, 33-34, 36, 45-46, 48). The “gross premium”
is the amount actually charged the insured, and con-

* In order to facilitate the work of making these examinations,
the National Association of Insurance Commissioners (NAIC)
has divided the United States intc various zones. Under this zone
system, an examination is made every three years of each company
whose operations extend beyond any one zone. The examinations
are performed by a team of auditors from the insurance depart-
ment of the company’s domiciliary state and from each of the
other zones in which the company does business. Where a company
operates in more than one state but not in more than one zone, the
outside auditors are chosen from one or more states in the zone.
See Wightman, Life Jnsurance Statements and Accounts 31-32
(1952 ed.).

sists of the “net valuation premium’”’ and “‘loading.”
The “net valuation premium’ is the amount com-
puted under applicable actuarial tables (based upon
mortality and interest rate assumptions) that the
company must accumulate in order to pay all death
claims." The net valuation premium reflects the
amount, together with assumed interest, that respond-
ent wes required under local iaw to add each year
to its policy reserves. “Loading” is the amount added
to the “net valuation premium” for agents’ commis-
sions and other acquisition costs, management and op-
erating expenses, profits and dividends. (Pet. App.
B 10a).

Respondent’s policyholders pay their premiums an-
nually on the anniversary dates of their policies, or
in semi-annual, quarterly, or monthly installments.
When the policyholders elect to pay their premiums
other than annually, respondent imposes a supple-
mental charge in addition to the annual premium

* On a level premium plan, the aggregate amount of the net valu-
ation premiums on a block of policies will more than cover the
assumed death claims during the initial years the policies are in
effect. In practical terms, the total amount of the net valuation
premiums on these policies will be greater during these early years
than the amount of death claims made against the company. Con-
versely, during the later years when the age of the policyholders
has increased, death claims will exceed the aggregate amount of
the net valuation portion of the level premiums currently paid by
the policyholders. The excess amounts received by the company
in the early years, together with interest at an assumed rate, will
enable the company to meet death claims during the later years,
See McGill, Life Insurance 32-36, 218-219 (Rev. ed. 1967);
MacLean, Life Insurance 13-17, 111-116 (9th ed. 1962).

10

(Stip. par 6, A. 16).° “Deferred premiums” are those
portions of the gross annual premiums that become
due after the end of each calendar year but before
the next anniversary date of the policy. Respondent’s
life insurance policies provide for a grace period of
31 days or longer for the payment of premiums dur-
ing which the policy is fully effective. “Due and
unpaid premiums” or ‘“‘uncollected premiums”’ are
premiums that are due and payable before the end of
the calendar year but which have not been paid (Pet.
App. B 11a; Stip. pars. 6-8, A. 16-17).

The insured has no obtigation to pay the deferred
or due and unpaid premiums on his policy. However,
the insurer has no obligation to continue the insurance
coverage beyond the period for which premiums have
been paid. Thus, non-payment causes the policy to
lapse (Pet. App. B lla).

2. Respondent computed its reserves on its policies
on the assumption that the annul premiums had been
paid in full as of the anniversary date of each policy,
whether or not this was in fact the case. Accordingly,
on its annual financial statements required to be filed
under state law, respondent increased its reserves by
the amount of the net valuation portion of both its
fully paid and its deferred and uncollected premiums
(Stip. par. 11, A. 17; Pet. App. A 3a; Pet. App. B
lla). Respondent reflected the resulting figure on its

* The increased annual premium charged to the policyholders
electing installment payment of their premium serves to compen-
sate the company for the interest it would have otherwise earned
had the premium been paid in full on the anniversary date.

11

annual statements as its “Aggregate reserve for life
policies and contracts” (Exs. E, F, H, A. 61, 76, 91).’°
On its annual statements, respondent offset the inclu-
sion of the net valuation portion of its deferred and
uncollected premiums in reserves by also including
such amounts on the assets side of the balance sheet
(Pet. App. A 4a; Exs. E, F, H, A. 60, 75, 90)."
Respondent likewise computed its reserves for fed-
eral income tax purposes on the basis of the same
assumption that the annual premiums on all of its
outstanding policies had been paid in full as of the

© The annual statement forms filed by respondent with the state
authorities are designed by the Nationa] Association of Insurance
Commissioners (NAIC) to promote uniform reporting require-
ments in the various states, As a result, they are ofte1. referred to
as the “NAIC annual statement” (see Pet. App. A 4a and n. 3).

These annual reports contain summary statements of the com-
pany’s total assets and the total of its various reserves and other
liability accounts established as of the end of each year. Examina-
tion of the company’s annual report enables the various insurance
commissioners in the states in which the company conducts busi-
ness to measure the company’s solvency and to determine whether
it has sufficient assets on hand to cover its potential obligations to
its policyholders (see Exs. E, F, H, A. 60-61, 75-76, 90-91).

* Respondent made a similar adjustment on the “Summary of
Operations” schedule of its annual financial statement designed to
offset the inclusion in its reserves of its deferred and uncollected
premiums. In order to compensate for the deduction of the in-
crease in reserves attributable to the deferred and uncollected pre-
miums, it included the gross amount of such premiums in income
and further deducted the increase in loading on such premiums as
an expense, The net effect of these offsetting entries was to elimi-
nate the impact of deferred and uncollected premiums on respond-
ent’s summary of operations (Pet. App. A 5a; Exs. E, F, H, A. 62,
77, 92). See pp. 35-37, n. 26, infra. |

226-549—77——2

12

anniversary dates of the policies. It therefore in-
eluded the net valuation portion of its “deferred
and uncollected premiums’’™” in its “life insurance
reserves” under Section 801(b)(1) of the Internal
Revenue Code of 1954. Respondent accordingly added
these amounts of its reserves in making the federal
tax computations under Sections 805 and 809 of the
Code (Pet. App. A 3a; Pet. App. B lla).
Although respondent assumed that the annual pre-
miums had been paid in full on the anniversary
dates of all of the policies for purposes of computing
its reserves on its 1958, 1959, and 1961 tax returns,
it did not consistently apply that assumption in mak-
ing the other required computations on its returns
for those years. In computing its “assets’’ under
Section 805(b)(4) on its 1958 return, respondent
excluded the entire amount of deferred and uncol-
lected premiums on the converse assumption that it
did not receive the deferred and uncollected pre-
miums during the taxable year. On its 1959 and 1961
returns, respondent computed its “assets” under Sec-
tion 805(b) (4) in accordance with a different assump-
tion. For those years, it included in its assets only
the net valuation portion of its deferred and uncol-
lected premiums (t.e., exclusive of loading). Similarly,
in its Section 809(c)(1) computation of *‘eross
amount of premiums’ on its 1958, 1959, and 1961
returns, respondent included only the net valuation

_™ For purposes of convenience, we employ the conventional term
“deferred and uncollected premiums” to include deferred premi-
ums, and due and unpaid or ucollected premiums.

13

portion of its deferred and uncollected premiums.”
(Pet. App. A 5a-6a; Pet. App. B 1la-12a).

Respondent’s exclusions of its deferred and uncol-
lected premiums from the computations of its ‘‘assets”
and “gross amount of premiums,” coupled with its in-
clusion of such premiums in its ‘‘reserves,” had the
effect of reducing its ‘‘taxable investment income” and
its ‘‘gain from operations,” and thus its tax.

3. On audit, the Commissioner of Internal Revenue
accepted respondent’s computation of its reserves
based upon the assumption that the annual premiums
had been paid in full on alt policies in force. However,
pursuant to Treasury Regulations, Sections 1.805-5
(a) (4) and 1.809-4(a), the Commissioner applied this
assumption as well to the other tax computations;
he accordingly concluded that respondent was re-
quired to include the gross amount of its deferred and
uncollected premiums in “assets” and in “gross
amount of premiums’’ under Sections 805(b)(4) and
809(¢) (1), respectively (Pet. App. B 12a). The Com-
missioner thereby determined deficiencies ugainst re-
spondent for 1958, 1959, and 1961, of $25,974.93, $90,-
647.02 and $34,986.04, respectively (Pet. App. A la).™

‘* The courts below characterized respondent as having claimed
“deductions for the increases in loading” in computing its gains
from operations under Section 809 (Pet. App. A 6a; Pet. App. B
12a). In fact, respondent actually included the gross amount of
deferred and uncollected premiums in its “gross amount of pre-
miums” but claimed a deduction for the loading portion of these
premiums. The net effect was the same as if respondent included
only the net valuation portion of its deferred and uncollected pre-
miums in its “gross amount of premiums.”

‘* The Commissioner’s adjustments did not result in a deficiency
for 1960 (A. 103).

The Commissioner also imposed a five percent penalty under

14

On the authority of its unanimous reviewed decision
in Bankers Union Life Insurance Co. vy. Commissioner,
62 T.C. 661, the Tax Court upheld the Commissioner’s
determination that the assumption that the annual
premiums had been paid in full on all policies had to
be consistently applied to all of the tax computations.
It therefore held that respondent was required to in-
clude its deferred and uncollected premiums in
“assets’’ under Section 805(b)(4) and in “gross
amount of premiums’’ under Section 809(¢) (1), with-
out offset or deduction with respect to the loading
portion of these premiums (Pet. App. A 7a-8a).

A divided court of appeals reversed (Pet. App. B
9a-23a). The court held that respondent was not re-
quired to include any portion of its deferred and un-
collected premiums in ‘‘assets” and “yross amount of
premiums,” even though it included the net valuation
portion of these premiums in its reserves for purposes
of the Sections 805 and 809 computations. In so hold-
ing, the court accorded respondent the benefit of more
favorable tax treatment than it claimed on its 1959
and 1961 returns, when it included the net valuation
portions of the deferred and uncollected premiums in
‘“‘assets” and in “gross amount of premiums” as well
as in its ‘‘reserves” (Pet. App. B lla-12a).

While the court acknowledged that four other courts
of appeals had upheld the Commissioner’s position

Section 6653(a) of the Code because of respondent's negligence
or intentional disregard of the Regulations (Pet, App. A la; A.
103). The parties have stipulated that the five percent penalty
would apply to any deficiency upheld in the ultimate disposition
of the case (Stip. par. 22, A. 19).

15

(Pet. App. B 13a-14a), it stated that those decisions
“are predicated on a fiction” (Pet. App. B 16a). It
reasoned that respondent “has no legal, enforceable
right to collect any unpaid premiums * * *” (Pet.
App. B 18a), and that “it is * * * obvious that unpaid
premiums are not ‘assets used ly a company in
carrying on a trade or business’ and that they cannot
have any ‘viable’ asset basis until collected’’ (ibid.).
@he court likewise concluded that the “gross amount
of premiums” under Section 809(c)(1) “cannot ex-
tend to unpaid premiums ia which a taxpayer has no
legally enforceable right” (Pet. App. B 21a). In so
holding, the court invalidated the Treasury Regula-
tions that mandated the Commissioner’s consistent
treatment of deferred and uncollected premiums in
the computation of “reserves,’’ “assets,” and “gross
amount of premiums’’ (Pet. App. B 16a-19a).

After observing that the issue ‘“‘has been considered
‘y four other Circuits, and in ee 4 instance * * *
{those courts had] reached a conclusion contrary to
the result reached by the majority * * *,” the dis-
senting judge stated that he was ‘‘persuaded that
the result reached by the Fourth, Fifth, Sixth, and
Seventh Circuits is the proper one’ (Pet. App. B
22a).

* Franklin Life Insurance Co. v. United States, 399 F. 2d 757
(C.A, 7), certiorari denied, 393 U.S. 1118; Jefferson Standard
Life Insurance Co, v. United States, 408 F. 2d 842 (C.A. 4) cer-
tiorari denied, 396 U.S. 828; Western National Life Insurance Co.
of Texas v. Commissioner, 432 F. 2d 208 (C.A. 5); Western and

Southern Life Insurance Co. v. Commissioner, 460 F, 2d 8 (C.A.
6), certiorari denied, 409 U.S. 1068.

16
SUMMARY OF ARGUMENT
I

The Life Insurance Company Income Tax Act of
1959 provides a three-phase procedure for the taxa-
tion of life insurance companies. The primary catego-
ries of income subject to tax are ‘‘taxable investment
income’ and “gain from operations.” Pursuant to the
statute, the computations of both “taxable investment
income” and “gain from operations” provide a mecha-
nism for excluding from the total tax base those por-
tions of a company’s investment and premium income
that must be held to meet its policyholder obligations.

The three principal elements that enter into the fed-
eral income tax computations of a life insurance com-
pany are: (1) “reserves,” (2) ‘‘assets,” and (3) ‘‘gross
amount of premiums.” The computation of the tax-
free portion of investment income generally involves
multiplying the company’s total investment income by
the fraction Reserves, The computation of ‘gain from

Assets

operations” is a more traditional net income caleu-
lation, with “gross amount of premiums” included as
an income item and “reserves” subtracted as a deduc-
tible expense. Thus, all other elements of the tax
computation remaining constant, as a life insurance
company’s “reserves” increase, its tax liability will
_ correspondingly decrease, Conversely, as the com-
pany’s “assets” and “gross amount of premiums”
increase, its tax liability will also increase.

The question presented in this case involves the
extent to which “deferred and uncollected premiums”

17

are taken into account in determining a life insurance
company’s “reserves,’’ “‘assets,” and “gross amount of
premiums.” Deferred and uncollected premiums are
the sum of: (1) those portions of the gross annual
premiums that become due after the end of the
calendar year but before the next anniversary dates
of the policies because of the policyholders’ election
to pay their annual premium in installments; and (2)
the premiums that have become due and payable be-
fore the end of the year but that have not been paid.
In both instances, it is undisputed that the company
does not, have deferred and uncollected premiums on
hand as of the end of the calendar year and has no
legal right to compel their payment. In the event of
nonpayment, the policy lapses.

Following the longstanding accounting convention
of the life insurance industry, respondent computed
its year-end reserves for both financial reporting and
federal tax purposes on the assumption that the full
annual premium had been paid as of the anniversary
dates of all of its policies in force. Insurance reserves
arise upon the acceptance of a risk and the payment
of premiums. Thus, respondent’s premium receipt
assumption resulted in an overstatement of its re-
serves by the net valuation portion of the deferred
and uncollected premiums because it had not in fact
received the full annual premiums and did not in fact
have any liability to the policyholders with respect to’
these unpaid premiums. Respondent’s increase in re-
serves based upon its assumption of full premium
payment had the effect of decreasing its tax liability.

18

However, in computing its ‘‘assets’’ and ‘‘gross
amount of premiums”—statutory elements that
increase a life insurance company’s tax liability—
respondent abandoned the full premium payment
assumption upon which it calculated its reserves. For
those purposes, it included none of the deferred and
uncollected premiums in “assets” for 1958, and only
the lesser ‘‘net valuation’’ portion of those premiums
in “assets” for 1959 and 1961 and “‘gross amount of
premiums”’ for all those years. j

Four courts of appeals have correctly held that a
life insurance company cannot first treat its deferred
and uncollected premiums as having been paid dur-
ing the taxable year for purposes of increasing its
“reserves” and thereby reducing its tax base; and then
turn around and claim that it has not received the
identical premiums for purposes of the “assets’’ and
“gross amount of premiums” computations. The deci-
sion below improperly treats the deferred and uncol-
lected premiums as both having been paid and
having not been paid during the taxable year.

The integrity of the federal tax formulae, which
rest upon the proportionate relationship between ‘‘re-
serves’’ and ‘‘assets,”’ demands that all of its statutory
elements be computed in accordance with a consistent
set of assumptions. As the Fourth Circuit succinctly
stated in Jefferson Standard Life Insurance Co. v.
United States, 408 F. 2d 842, 856, certiorari denied,
396 U.S. 828: “Symmetry would require * * * that
both sides of the equation by which taxable income
is determined be treated alike. Thus, if taxpayer treats
its reserve liabilities for tax purposes with a full

19

year’s net valuation * * * it should be required to
include gross annual premiums * * *” in its assets
and premium income.

II

The pertinent Treasury Regulations (Sections
1.805-5(a)(4)(ii) and 1.809-4(a)(1)), which the
court of appeals erroneously invalidated, likewise rec-
ognize the insurance industry’s convention of over-
stating reserves by assuming full annual premium
payment, They accordingly provide that a company
must include the gross amount of deferred and un-
collected premiums in “assets” and “gross amount of
premiums” as long as it computes its reserves on the
assumption that these premiums have been paid. If a
life insurance company asumes that the deferred and
uncollected premiums on all of its policies have been
paid as of their anniversary dates and increases its
reserves by the net valuation of such premiums, that
assumption necessarily stands on the hypothesis that
the company has received the full amount of those
premiums.

Hence, our primary position is that gross deferred
and uncollected premiums must be included in ‘‘as-
sets” and “gross amount of premiums” if the net
valuation portion of such premiums is to be included
in ‘‘reserves.” However, if the Court disagrees with
our submission that the full amount of deferred and
uncollected premiums be included in “assets’’ and
“gross amount of premiums,” the proper disposition
of this case is to exclude such premiums altogether
from the caleulation of both (1) “reserves’’ and (2)
“assets” and “gross amount of premiums,”’ in accord-
ance with Treasury Regulations, Section 1.801-4(f).

20
ARGUMENT

A LIFE INSURANCE COMPANY THAT INCLUDES THE NET
VALUATION PORTION OF ITS DEVERRED AND UNCOLLECTED
PREMIUMS IN ITS “RESERVES” FOR FEDEKAL TAX PUR-
POSES ON THE ASSUMPTION THAT THE GROSS ANNUAL
PREMIUMS ON ITS POLICIES HAVE BEEN PAID IN FULL ON
THE POLICY ANNIVERSARY DATES MUST CONSISTENTLY
APPLY THAT ASSUMPTION FOR ALL OF ITS TAX COMPU-
TATIONS AND INCLUDE THE FULL AMOUNT OF ITS DE-
FERRED AND UNCOLLECTED PREMIUMS IN ITs ‘‘ ASSETS”
AND ‘‘GROSS AMOUNT OF PREMIUMS”

A. INTRODUCTION

1. This case presents a question of major fiseal im-
portance affecting the federal income taxation of every
life insurance company. Life insurance companies gen-
erally permit their policyholders to pay their annual
premium either in full on the anniversary date of the
policy or in installments on a monthly, quarterly, or
semi-annual basis. In the event the policyholder elects
to pay the annual premium in installments, those por-
tions of the gross annual premiums that become due
after the end of the calendar year but before the next
anniversary date of the policy are known as “deferred
premiums.” ‘Due and unpaid premiums” or “uneol-
lected premiums” are premiuti that are due and pay-
able before the end of the ca! Jar year but which
have not been paid. These two types of premiums—

described in the aggregate by the insurance literature .

as “deferred and uncollected premiums”—are a sub-
stantial element in the business of all life insurance
companies. The issue here involves the proper federal

21

tax treatment of these deferred and uncollected
premiums.

A life insurance company receives its income from
the receipt of premiums and the imvestment of its
assets. As we have pointed out supra, pp. 3-8, the
Life Insurance Company Income Tax Act of 1959,
set forth in Sections 801-820 of the Internal Revenue
Code of 1954, provides a three-phase procedure for
the taxation of both types of life insurance company
income. The Act represented “a comprehensive over-
haul of the laws relating to the taxation of life in-
surance companies.” United States v. Atlas Life Ins.
Co., supra, 381 U.S. at 235.

The basic thrust of the statute is to permit a life
insurance company to exclude from its tax base that
portion of its premium and investment income that
is necessary to cover its reserve liabilities—the amount
computed to be sufficient under the statute to pay
future death claims. Thus, the cornerstone of the
statutory system is the reserve which, as we shall
explain infra, pp. 29-33, arises from the policyholders’
payment of premiums.

Under the 1959 Act, a life insurance company is
subject to tax on its “taxable investment income”
plus one-half of the amount by which its total “gain
from operations” exceeds its “taxable investment in-
come.” To the extent that it recognizes that amounts
computed by life insurance companies as necessary to
cover their reserves should be free of tax, the 1959
Act represents a continuation of the longstanding con-
gressional policy to treat increments to the reserves

99 °

as representing amounts belonging to the policyholders __

rather than to the company. See A Preliminary. State-
ment of the Facts and Issues with Respect to the Fed-
eral Taxation of Life Insurance Companies, Subcom-
mittee on the Taxation of Life Insurance Companies,
House Committee on Ways and-Means, p. 21 (No-
vember 1954).

While Congress has always recognized that amounts
that life insurance companies set aside to pay future
death claims should be excluded from their tax base,
it has employed various approaches in determining
the measure of this tax exclusion. Thus, from 1913 to
1920, life insurance companies were taxed like all
other corporations on their entire investment and pre-

mium income but were allowed a deduction for the _

“net addition required by law to be made within the
taxable year to reserve funds.” In 1921, however,
Congress abandoned this so-called “total income” ap-
proach and determined that life insurance companies
would be taxed only on their “free investment in-
come’’ not needed to cover policyholder obligations.
During this period, premium income was totally
excluded from the tax base. See Revenue Act of 1921,
c. 136, Sections 242-247, 42 Stat. 227, 261-264. The
concept that a tax should be levied on net investment
income after an allowance to meet obligations to

5 See, e.g., Income Tax Act of 1913, c. 16, 38 Stat. 114, 166,
172, See. 11(G)(b); Revenue Act of 1916, c. 463, 39 £ tat. 756,
768, See. 12(a) Second; Revenue Act of 1918, ¢, 18, 40 Stat. 1057,
1079, Section 234(a) (10). See also Treasury Regulations No. 33
(Rev.), Art. 239, pars. 673-674 (1918); Treasury Regulations
No. 45 (1920 ed.), Arts. 548, 549, 569.

23

policyholders was carried forward in subsequent acts |
and is also included in the broad revision of the 1959
Aet.” fr aa

The 1959 Act introduced two fundamental changes
in the taxation of life insurance companies. While
it retained the concept of excluding from tax that
portion of investment income necessary to cover
policyholder reserves, the Act abandoned the assumed

#* During the period 1921-1959, various formulae were used in
computing the amount of the reserve exclusion. See e.g., Revenue
Act of 1924, c. 234, 43 Stat. 253, 289, Sec. 245(a); Revenue Act
of 1926, c. 27, 44 Stat. 9, 47, Sec. 245(a); Revenue Act of 1928,
c. 852, 45 Stat. 791, 842, Sec. 203(a) ; Revenue Act of 1932, c. 209,
47 Stat. 169, 224, Sec. 203(a) ; Revenue Act of 1934, c, 277, 48 Stat.
680, 732, Sec. 202(a); Revenue Act of 1936, c. 690, 49 Stat. 1648,
1710, Sec. 203(a) ; Revenue Act of 1938, c. 289, 52 Stat. 447, 523,
Sec. 203(a); Internal Revenue Code of 1939, Sec. 203(a) (26
U.S.C. 203(a) (1952 ed.)).

Some of the formulae employed an industry-wide assufhed rate
of interest and resulted in the complete erosion of the tax base
of life insurance companies. Thus, in 1947 and 1948, no life insur-
ance company paid any federal taxes on profits from its life in-
surance business. See A Preliminary Statement of the Facts and
Issues with Respect to the Federal Taxation of Life Insurance
Companies, supra, at 16-17; Denney, Rua & Schoen, Federal Jn-
come Taxation of Insurance Companies, pp. 1.1-1.2 (2d ed. 1966).
Between 1949 and 1958, Congress accordingly enacted a series of
“stopgap” measures to provide a short-term remedy. Sce Report
on the Taxation of Life Insurance Companies, Subcommittee on
Internal Revenue Taxation, House Committee on Ways and
Means, pp. 2-3 (December 31, 1958). See, e.g., Revenue Act of
1950, «. 994, 64 Stat. 906, 961, Sec. 401(a); Revenue Act of 1951, —
c. 521, 65 Stat. 452, 507, Sec. 336; Life Insurance Company Tax
Act of 1955, c. 83, 70 Stat. 36,41, Sec. 804. Some of these “stopgap” -
measures were designed to impose a tax, at ordinary corporate
rates, on a smal] fixed percentage of investment income. Others
imposed a tax, at greatly reduced rates, on all investment income.

24

or industry-wide average rate of interest approach
that had been employed in the allocation formulae
under the prior law. Instead, the 1959 Act prescribed
a method of allocating investment income based upon
the company’s actual earnings experience. See 8S. Rep.

No. 291, 86th Cong., Ist Sess. 5 (1959); 105 Cong.

Ree. 8428-8429 (1959) (remarks of Senator Curtis).
The Act also expanded the companies’’ tax base to
include underwriting gains, i.c., the amount by which
premiums exceeded the actual expenses and policy
obligations. See H.R. Rep. No. 34, 86th Cong., Ist Sess.
2-3, 12-13 (1959); S. Rep. No. 291, supra, at 6-7.
Specifically, the .1959 Act taxes one-half of the com-
pany’s underwriting gains on a current basis and
generally postp mes taxation of the remaining half
until such gains are distributed to shareholders.
Thus, while the computations are more detailed, the
hasic approach of the 1959 Act was to return in part
to the pre-1921 ‘‘total income” approach under which
jusurance companies were immediately taxed on their
entire net investment and underwriting (premium)
income.”

2. Three principal elements that enter into the fed-

Accordingly, apart from the 1959 Act’s postponement of tax
on one-half of the underwriting gains, the approach of the 1959
Act and the pre-1921 law is essentially the same.

The pre-1921 Jaw has been described as follows: “Although
premiums were included as gross income, such part of each pre-
mium as was credited to the policyholder by way of a credit to a
reserve was deducted; and * * * although ali investment income
was includible, that part which was, in effect, credited to policy-
holders as interest on the reserves was deducted.” A Preliminary
Statement of the Facts and Issues with Respect to the Federal
Taxation of Life Insurance Companies, supra, at p. 14.

25

eral income tax computations of a life insurance
company under the 1959 Act are: (1). “reserves,”
(2) “assets,’’ and (3) “gross amount of premiums.”’
As a life insurance company’s ‘‘reserves” increase
relative to its assets and premiums, its tax liability
will correspondingly decrease. Conversely, as the com-
pany’s ‘‘assets’’ and “gross amount of premiums”
increase relative to its reserves, its tax liability will
increase (see pp. 6-7, supra). These three elements,
however, are not independent variables but are func-
tionally interrelated. As premiums are paid, the com-
pany’s “assets” and “gross amounts of premiwms”’
necessarily increase and its ‘‘reserves’’: likewise in-
crease (see pp. 30-31, infra).

The question here involves the extent to which
deferred and uncollected premiums are taken into
account’ for federal tax purposes in determining a
life insurance company’s “reserves,” ‘“assets,’’ and
“gross amount of premiums.’’ It is undisputed that
the company does not actually have such deferred
and uncollected premiums on hand at the end of its
taxable year and does not have any legal right to
compel their payment from the insured.” Nonpay-
ment relieves the company of its liability to pay
death benefits and causes the policy to lapse.

Nevertheless, in computing its ‘‘reserves” on its tax
returns for all three taxable years at issue, respondent
made the traditional assumption of the life insurance

** Upon the lapse of the policy, state law requires the company
to credit the cash surrender value to the account of the policy-
holder. The cash surrender value is calculated on the basis of
premiums actually paid to the date of the lapse. See, e.g., 36 Okla.
Stat. Ann., Sec. 4029H (1958).

26

industry that the full annual premium had been paid
on all its outstanding policies on their anniversary
dates. It thereby increased its ‘‘reserves” for tax pur-
poses by the “net valuation” portion of all annual
premiums, including the deferred and uncollected pre-
miums. Because increases in reserves reduce a life
insurance company’s “taxable investment income” and
“gain from operations,” respondent’s increase in re-
serves based upon its assumption of full premium pay-
ment had the effect of decreasing its tax liability.

However, in computing its “assets” and “gross
amount of premiums”—the related statutory elements
that increase a life insurance company’s tax liabil-
ity—respondent did an about-face and abandoned the
assumption upon which it calculated its reserves, viz.,
that it received the full annual premium on all of its
policies. For those purposes, it included no part of
the deferred and uncollected premiums in “assets”
for 1958 and only the “net valuation” portion of those
premiums for 1959 and 1961. For 1958, 1959, and 1961,
respondent included only the net valuation portion of
its deferred and uncollected premiums in “gross
amount of premiums” (see p. 13, n. 13, supra). Re-
spondent’s exclusion in 1958 of the full amount of
deferred and uncollected premiums from “assets,”
its partial exclusion of such premiums from “gross
amount of premiums” for that year, and its partial
exclusion of such premiums from both “assets’’ and
“gross amount of premiums’’ in 1959 and 1961 re-
duced respondent’s tax liability for those years.

Our submission is that a life insurance company
must adhere to a consistent set of assumptions in com-

— as ae. —<= ae

27

puting its federal tax liability. It cannot first treat its
deferred and uncollected premiums as. having been
paid during the taxable year for purposes of
increasing “reserves” and thereby reduce its tax
base, and then turn around and assert that it has not
received those premiums for purposes of computing
its “assets” and “gross amount of premiums.” The
fundamentai error of the court of appeals is that it si-
multaneously assumed that the deferred and uncol-
lected premiums were both paid and not paid during
the taxable year. Deferred and uncollected premiums
are deemed either to have been paid for purposes of
all of the prescribed computations or not to have been
paid for any of the computations. __ ;

The pertinent Treasury Regulations, which have
been upheld by four courts of appeals, rest upon this
same requirement of consistency. Sections 1.805-5(u)
(4) (ii) and 1.809-4(a) of the Regulations, Appendix,
infra, pp. 20a-23a, respectively provide that a life
insurance company must include its deferred and
uncollected premiums in its “assets” and “gross
amount of premiums” under Sections 805(a)(4) and
809(c)(1). However, in the event that it is deter-
mined that deferred and uncollected premiums are
not properly includable in “assets” and “gross
amount of premiums,’’ Section 1.801-4(f) of the
Regulations, Appendix, infra, pp. 19a-20a, alterna-
tively requires the exclusion of such premiums in
the computation of “reserves.”

3. Viewed in the larger context, these Treasury

Regulations are in accord with the “long-established
226-549— 77-3

28

congressional policy that a taxpayer generally cannot
compute income taxes by reporting annual income on
a cash basis and deductions on an accrual basis”
(Commissioner v. South Texas Co., 333 U.S. 496, 501).
As this Court there recognized (ibid.), “[s]uch a
practice has been uniformly held inadmissible because
it results in a distorted picture which makes a tax
return fail truly to reflect net income.’’ Thus, this
Court has consistently rejected such hybrid methods
of accounting, in which the taxpayer chooses the best
of both worlds. See Helvering v. Wilshire Oil Co., 308
U.S. 9, 96-99; United States v. Catto, 384 U.S. 102,
116-117. See also W. L. Moody Cotton Co. v. Commis-
sioner, 143 F, 2d 712, 714 (C.A, 5).

Moreover, in Mass. Mutual Life Ins. Co. v. United
States, 288 U.S. 269, the Court unanimously held that
this principle of uniformity of accounting assump-
tions applied to the taxation of life insurance com-
panies. There, the Court ruled that a life insurance
company that filed its returns on the cash basis
method of accounting could not claim a current deduc-
tion for unpaid interest owed to policyholders. In so
holding, the Court stated—‘It is settled beyond cavil
that taxpayers other than insurance companies may
not accrue receipts and treat expenditures on a cash
basis, or vice versa. Nor may they accrue a portion of
income and deal with the remainder on a cash basis,
nor take deductions partly on one and partly on the
other basis. Congress we think did not intend to make
an exception of insurance companies” (id. at 273-
274). See also Continental Life Insurance Co. v. Com-
missioner, 5 B.T.A, 407, 412,

The rule of uniformity and consistency announced
in Mass. Mutual Life Ins. Co. applies with equal force
to the deferred and uncollected premiums at issue in
this case. Respondent cannot take those premiums into
account in its ‘‘reserves” when it suits its purpose of
reducing its tax base but turn its back on them when
their inclusion in “assets’’ and “gross amount of pre-
miums” would increase its tax liability. Simply stated,
our position is that such premiums must be consist-
ently deemed to have been paid for all purposes under
the statute or not to have been paid for any purpose.

The concept of a life insurance reserve is funda-
mental to an understanding of the taxation of life in-
surance company income. Before discussing the impact
of deferred and uncollected premiums on the federal
tax computations, we believe it would be helpful to
describe the nature and function of that reserve.

B. A LIFE INSURANCE RESERVE ARISES UPON THE COMPANY'S ASSUMP-
TION OF THE RISK AND THE POLICYHOLDER'S PAYMENT OF PREMIUMS

1. “Historically and commonly insurance involves
risk-shifting and risk-distributing” (Helvering v. Le-
Gierse, 312 U.S, 531, 539). The consideration paid by
an insured for the assumption of the risk by an in-
surance company is the premium. The amount of the
premium is calculated on the assumption that the pre-
miums received by the company will be invested and
earn interest which, when added to the accumulated
premiums, will be sufficient to pay the policyholders’
death claims as they arise. As the standard texts on
life insurance make clear, a life insurance reserve is
made up of the sum of net valuation premiums paid

to date, plus interest at the assumed rate, minus
assumed death claims. See, e.g., MacLean, Life Insur-
ance, 90-116 (9th ed. 1962).”

In setting a life insurance premium, the company
first chooses a mortality table 1d assumes an interest
rate for the investment of the premiums. With these
elements established, the net valuation premium can
be calculated. Net valuation premiums, plus interest
at the assumed rate, will be adequate to pay all claims
on the assumption that deaths will occur according
to the mortality table. The gross premium that is
charged the policyholder is determined by adding to
the net valuation premium an amount known in the
aggregate as “loading,’’ which covers the company’s
estimated expenses for agents’ commissions and other
overhead and profits.

The decisions of this Court likewise define a life
insurance reserve for federai tax purposes as derived
from the premiums paid by the policyholder. See, e.g.,
New York Life Ins. Co. v. Edwards, 271 U.S. 109,
115, 119; New York Life Ins. Co. v. Bowers, 283 U.S.
242, 244; Helvering v. Inter-Mountain Life Ins. Co.,
294 U.S. 686, 690. Accord: Williams v. Union Central
Life Insurance Co., 291 U.S. 170, 177. As the Court
more recently observed in United States vy. Atlas Life
Ins. Co., 381 U.S. 233, 247, “[t]he receipt of pre-
miums necessarily entails the creation of reserves and
additions to reserves from investment income. Thus.
the insurance company is not only permitted to in-

‘* While other texts are cast in somewhat more technical terms,
they are to the same effect on this basic point. See, e.g., Huebner
and Black, Life /nsurance 277-279 (9th ed. 1976); Magee, Life
/nsurance 559-562 (3d ed. 1958) ; McGill, Life /neurance 182-185,
218-223 (Rev. ed. 1967).

31

vest, but it must invest; and it must return to the
reserve a large portion of its investment income’”’
(emphasis in original).”

There is accordingly a direct relationship between
the payment of premiums by the policyholder and
the company’s establishment of reserves. Without the
payment of premiums by the policyholder in exchange
for the company’s assumption of the risk, there is no
occasion for the company to establish a reserve. As a
leading text has succinctly stated, the reserve is “buiit
up out of past premium payments and interest to
meet * * * [future policy obligations] determined
mathematically.” Magee, Life Insurance 560 (3d ea.
1958).”

*° While the reserves for most forms of life insurance are com-
puted on the assumption of investment of the net valuation premi-
ums, reserves for short-term casualty insurance are computed
solely on the basis of the pro rata unearned gross premium with-
out any investment element. See Treasury Regulations, Section
1.801-3(e). This latter type of reserve is involved in United States
v. Consumer Life Insurance Co., No. 75-1221; First Railroad &
Banking Co. of Georgia v. United States, No. 75-1260; and United
States v. Penn Security Life Insurance Co., No. 75-1285, argued
December 6, 1976.

* In stating that there is a direct relationship between the pay-
ment of premiums and the establishment of policy reserves, we
assume that the premium charged by the company is sufficient to
meet state statutory minimum reserve requirements. However, if
competitive conditions cause the company to assume a risk and
charge a gross premium that is less than the net valuation premi-
um on the expectation that it will meet its policyholder obligations
from sources other than premiums, the company is required to
establish a supplemental reserve known as a “deficiency reserve.”
This deficiency reserve reflects the excess of the present value of
required future net premiums over the present value of future
actual premiums. See Huebner and Black, Life /nsurance 289
(9th ed. 1976). However, Section 801(b) (4) of the Code excludes
such deficiency reserves from the definition of “life insurance
reserves.”

82

Life insurance reserves are sometimes described as
“funds” held for the benefit of policyholders, How-
ever, a life insurance company does not actually seg-
regate or set aside any portion of its assets in a
varticular reserve fund, All of an insurance company’s
assets are subject to policy claims when they mature.
Thus, the reserve is not an asset or a fund of any kind.
It is simply a calculation of projected liabilities estab-
lished as a measuring device in order to determine the
assets that the company must maintain in order to
meet its future commitments under the policies it has
issued, Greider and Beadles, Principles of Life In
surance 68-69 (Rev. ed. 1972).

‘While the reserve is ‘represented by assets which
the company invests * * * [it] is, in fact, a company
liability.” Magee, supra, at 560. If the net assets of
the company fall below the reserves so computed, the
company is deemed insolvent and may no longer
engage in business.

Finally, a life insurance reserve may be defined
either prospectively or retrospectively, yielding the
same mathematical result. McGill, Life Insurance 219
(Rev. ed. 1967) ; Magee, supra, p. 560. When a policy
is issued, the discounted or present value of the future
benefits is exactly equal to the present value of all of
the net valuation premiums to be paid. However, at
any given time after the date of issue, the present
value of the benefits to be paid under the policy will
increase because the date of payment of the policy
benefits has drawn closer. Viewed prospectively, the
reserve is equal to the difference between the present
value of the benefits and the present value of the fu-

33

ture net premiums.” Viewed retrospectively, the re-
serve is equal to the amount of net valuation pre-
miums, plus interest at the assumed rate, less assumed
death claims. See MacLean, Life Insurance 111-115
(9th ed. 1962); Huebner and Black, Life Insurance
278-285 (9th ed. 1976). Thus, at any give time, the
amount of a company’s reserves can be expressed
either in terms of the premiums it already has
received or the premiums it expects to receive.

2. In view of the direct relationship between the
policyholders’ payment of premiums and the com-
pany’s establishment of reserves, the treatment of
deferred and uncollected premiums would seem to be
a relatively simple matter. The policyholders have
not paid such premiums and are not subject to any
legal obligation to pay them. Moreover, the company
has not assumed any liability for periods of unpaid
coverage.” In the absence of payment, the policy
lapses. Likewise, until premiums are paid, the com-

** State statutes generally employ the prospective definition of
reserve. Thus, the Oklahoma Standard Valuation Law (36 Okla.
Stat. Ann., Sec. 1510(E) (2) (1958)), to which respondent was
subject, states—

“* * * Reserves for the life insurance and endowment benefits
of policies providing for a uniform amount of insurance and
requiring the payment of uniform premiums shall be the excess,
if any, of the present value, at the date of valuation, of such
future guaranteed benefits provided for by such policies, over the
then present value of any future modified net premiums therefor.”

* If a policyholder dies during the 31-day grace period when
the policy is still in force, the state statutes permit the company to
deduct the uncollected premium from the policy proceeds. See,
¢.g-, 36 Okla. Stat, Ann., Sec, 4008 (1958). This withholding
procedure enables the company to recover the unpaid premium.

3A

pany will not be required to set aside any portion of
such premiums for the payment of future benefits.
Logic would appear to dictate that deferred and
uncollected premiums not be taken into account for
any of the federal tax computations of “reserves,”
‘‘assets,’’ or ‘“‘gross amount of premiums.” But the
inclusion of deferred and uncollected premiums for
purposes of all of the computations of “reserves,’’
“assets,” and “gross amount of premiums,” as pro-
vided by the primary position of the Treasury Regu-
lations, is grounded upon its own internal logic.
Moreover, it is traceable to the historical practice of
the life insurance industry to include the net valua-
tion portion of such premiums for financial report-
ing purposes when computing its reserves.
Pursuant to the practice adopted by the First Ses-
sion of the National Insurance Convention in 1871,”
life insurance companies have computed their aggre-
gate reserves as stated on their financial statements on
the assumption that the full annual premiums on all
outstanding policies have been paid on the policy an-
niversary dates. See Offictal Report of the Proceed-
ings of the National Insurance Convention of the
United States 68-70 (1871). The 1871 Report acknowl-

** The National Insurance Convention is the predecessor organ- —

ization of the National Association of Insurance Commissioners
(NAIC). It is “a purely voluntary association without any legal
status or authority. Because, however, every State Insurance
Commissioner has recognized its value and has, at all times, given
to it unstinted cooperation, the Association has, to a broad extent,
heen able to secure much uniformity in the regulation of insurance
matters throughout the United States.” Wightman, Life /neur-
ance Statements and Accounts 27 (1952 ed.).

35

edged that this assumption results in an overstate-
ment of the company’s reserves to the extent of the
net valuation portion of the deferred and uncollected
premiums. The Report submitted to the Convention
therefore recognized that “it is very clear that * * *
[the company] should have a corresponding credit
given for the portion of the premium remaining un-
paid’’ (id. at 69).

The Report first considered the practicability of
“taking the whole item of ‘deferred premiums’ out of
the list of ‘assets’ and correspondingly reducing the
policy liability [i.e., the reserve]” (ibid.). After con-
cluding that the actuarial work involved in such a
method would be burdensome, the Convention’s Report
prescribed “a substitute bringing us to substantially
the same result,” viz., creating a ‘‘deferred premiums”
asset “to the same extent as that liability [reserve]
has been thereby increased, but no farther’’ (ibid.).
However, the Report further explained that the
proper amount of the credit to the asset account was
not the entire amount of the deferred premium, but
the deferred premium offset by the loading element,
1.¢., the net valuation portion of the premium.”

The Report made it clear that the “deferred pre-
mium” asset had no intrinsic value as an asset; it

** The Insurance Convention adopted the assumption of full
premium payment in order to avoid the burdensome actuarial work
involved in computing the total reserves on a policy-by-policy
basis by taking into account only premiums actually paid. Since
the annual premiums on most policies were paid in full at the time,
it was easier to adopt the assumption of full premium payment for
all policies and to correct the resulting overstatement of reserves
by the creation of an offsetting asset.

36

was included on the company’s statement “for the sole
purpose of cancelling an equal amount of the liability
[reserve] with which the company is charged in the
policy valuation [reserve computation]” (id. at 70).
By creating a “quasi-asset” (ibid.) consisting of the
net deferred and uncollected premiums to offset the
overstatement of the reserves, the solution devised by
the Convention baieneed the company’s annual state-

ment. It further r * the company of the necessity
of covering the © “rent of its reserves with
actual assets, and © us avoided impairment of the

comany’s surplus.

This financial reporting method for deferred and
uncollected premiums developed more than a century
ago by the National Insurance Convention is still em-
ployed today. Thus, on its annual statements, respond-
ent con:puted its reserves on the majority of its policies
on the assumption that the annual premiums were
paid in full as of the policies’ anniversary dates, even
though this was not in fact the case (Pet. App. B
lla). (See also Pet. App. A 3a; Stip. par. 11, A 17.)
Respondent offset the resulting overstatement of its
reserves by entering the same amount (t+ net valua-
tion portion of the deferred and uncw ected pre-
miums) in an asset account entitled “Li’e insurance
premiums and annuity considerations deferred and
uncollected” (Exs. E, F, H, A. 60, 75, 90).

*° Respondent made a similar adjustment on the “Summary of
Operations” part of its annual financial statements designed to
offset the overstatement of its reserves by the net valuation portion
of its deferred and uncollected premiums. It included the gross
deferred and uncollected premiums as part of its “Premiums and

37

But this accounting treatment is nothing more than
a device to permit the assumption of full premium
payment and the concomitant overstatement of re-
serves without distorting the picture of the company’s
solvency projected by the annual financial report. As
one authoritative insurance text states, ‘“‘In order to
offset the overstatement of the aggregate reserves be-
cause of the failure of the assumption upon which
they were computed to conform with the actual facts
in all cases, a company was and is still permitted to
include in its assets the entire amount of all * * *
[deferred and uncollected] net premiums computed
as of the year-end. Obviously this is merely a correc-
tive adjustment of the assets to offset an overstate-
ment of the liabilities.” Wightman, Life Insurance
Statements and Accounts 43-44 (1952 ed.).” See also
id. at 155, 545; MacLean, supra, at 318-319; Ernst &
Ernst, GAAP [Generally Accepted Accounting Prin-
ciples]-Stock Life Companies 449-450 (1974) ; Beards-
ley, Life Company Annual Statement Handbook I1I-
15 (1962).

3. The history of the life insurance industry’s finan-
cial reporting treatment of deferred and uncollected

Annuity Considerations” and offset the remaining loading element
by a deduction for “Increase in loading on and cost of collection
in excess of loading on deferred and uncollected premiums” (see
Pet. App. A 5a; Exs. E, F, H, A. 62,77, 92).

** Wightman characterizes the device of overstating reserves
and assets in equal amounts as “unnecessarily clumsy.” In his view,
a much simpler method would be to deduct the overstatement of
the reserves from the aggregate reserves before entering the
reserve liability on the annual statement. See Wightman, supra,
at 454’.

premiums shows that the inclusion of the net valua-
tion portion of deferred and uncollected premiums in
reserves does not reflect an actual liability of the com-
pany but is in fact an overstatement that must be off-
set by an artificial asset. As a matter of absolute logic
deferred and uncollected premiums should therefore
be excluded altogether from the federal tax computa-
tions of ‘‘assets,” ‘“‘gross amount of premiums,” and
‘“‘reserves.” That is the alternative approach pre-
scribed by Section 1.801-4(f) of the Treasury
Regulations.

However, the primary portion of the Regulations
does not require total exclusion of the deferred and
uncollected premiums. Instead, it prescribes the in-
clusion of the gross amount of deferred and uncol-
lected premiums in “assets” and “gross amount of
premiums.” In so providing, Sections 1.805-5(a) (4)
and 1.809-4(a)(1) of the Regulations accept the in-
dustry’s convention of overstating the reserves by the
amount of the net valuation portion of the deferred
and uncollected premiums. But since that overstate-
ment rests upon the assumption that all premiums are
paid as of the anniversary dates of the policies in
force, the full amount of the deferred and uncollected
premiums must likewise be included in “assets” and
“gross amount of premiums”’ by virtue of the selfsame
assumption. We turn now to a detailed analysis of
the impact of deferred and uncollected premiums
upon the prescribed federal tax computations of “as-
sets” and “gross amount of premiums.”

C. A LIFE INSURANCE COMPANY THAT INCREASES ITS “RESERVES” BY
THE NET VALUATION PORTION OF ITS DEFERRED AND UNCOLLECTED
PREMIUMS MUST INCLUDE THE GROSS AMOUNT OF SUCH PREMIUMS
IN ITS COMPUTATION OF “ASSETS” UNDER SECTION 805(b) (4)

1. As we have described supra, pp. 5-7, the Phase I
computation of a life insurance company’s taxable
investment income involves a division of the com-
pany’s investment income into two parts—the tax-free
policyholders’ share and the taxable company’s share.
See United States v. Atlas Life Ins. Co., supra, 381
U.S. at 236-237. The Act accomplishes this allocation
by dividing the company’s “investment yield’ (Sec-
tion 804(c)) by its total ‘‘assets’”’ (Section 805(b) (4) )
to derive the company’s actual earnings rate. This rate,
after adjustment,” is then multiplied by the company’s
adjusted life insurance reserves.” The resulting figure
is the ‘‘policy and other contract liability require-
ments”? (Sections 804(a)(1) and 805(a)), the term
employed by the Act to describe the total amount of

28 Section 805(b) provides that adjusted earnings rate (called
the “adjusted reserves rate”) is the lower of the current earnings
rate or the average of the current earnings rate and those for the
preceding four years (see p. 5, n. 5, supra).

2° Pursuant to Section 805(c)(1), the reserves are adjusted
under the “Menge Formula,” named after its principal industry
proponent. This formula provides that the company’s reserves wil!
be reduced 10 percent for each percentage point that its “adjusted
reserves rate” exceeds the assumed rate of interest used by the
company in setting up and calculating its reserve. Conversely, if
the company’s assumed rate of interest exceeds its adjusted earn-
ings rate, the company’s reserve will be increased 10 percent for
each percentage point of the excess. See H.R. Rep. No. 34, supra,
at 11; S. Rep. No. 291, supra, at 15-16. See also McGill, supra,
at 915-916.

40

investment income that is excluded from the com-
pany’s tax base.”

The statutory Phase I computation can be expressed
by the following formulae:

Investment Yield

(1) pm = Earnings Rate

(Section 805(b) )

(2) Earnings RatexReserves=Tax Exclusion
(Section 805(a) )

(3) investment Yield X Reserves = Tax Exclusion
ssets

(Section 805 (a) and (b))
or

Investment Yield x Reserves = Tax Exclusion
ssets

Thus, the computation of a life insurance company’s
taxable investment income depends upon the propor-
tionate relationship between assets and reserves. The
Act therefore “allocates investment income between
[the company’s] life insurance reserves and [the com-
pany’s] surplus, according to the total amount of
each.” H.R. Rep. No. 34, supra, at 10. As the foregoing

* The statutory exclusion for “policy and other contract liability
requirements” also includes amounts necessary to meet the com-
pany’s pension plan reserves and to cover interest paid. See Sec-
tion $05(a). The amount of the exclusion is then determined on an
item-by-item basis by multiplying each item of investment in-
come, including tax-exempt interest, by a fraction equal to the
total exclusion divided by total investment yield. See Section 804
(a)(1); United States y. Atlas Life Ins. Co., supra, 381, U.S.
at 249,

41

formulae demonstrate, the company’s tax exclusion is
directly proportional to its “reserves” and inversely
proportional to its “assets.”

2. If a company makes the traditional assumption
of the life insurance industry that the full premiums
on all of its outstanding policies have been paid and
computes its reserves—the numerator of the frac-
tion—for purposes of the formula on the basis of that
assumption, it would seriously distort the formula if
it did not make the identical assumption in computing
its assets—the denominator of the same fraction. Like
all mathematical formulae, the Phase I computation
can only produce an accurate result if each of its ele-
ments is computed in accordance with a consistent set
of assumptions.

It is therefore hardly surprising that four courts of
appeals have rejected the mathematical imbalance ap-
proved by the decision below. Those courts have uni-
formly held that if a life insurance company assumes
that its premiums are fully paid and thereby over-
states its reserves in its Phase I tax computations,
it must likewise assume that the premiums are part of
its “assets” in that computation. As the Seventh Cir-
cuit first stated in Franklin Life Insurance Co. v.
Uited States, 399 F, 2d 757, 761 (C.A. 7), certiorari
denied, 393 U.S. 1118, the inclusion of deferred and
uncollected premiums in ‘‘reserves” but not in ‘“as-
sets” “would attribute to Congress an intention that in
the same statutory equations, exclusions and deduc-
tions attributable to reserves are to be based on the
assumption that the annual premium is fully paid up

4°

and yet the amounts in the same equation from which
these figures are to be subtracted are to be deter-
mined on the assumption that the annual premium is
not fully paid up. * * * We perceive nothing from
which intent to impose such a dual standard of tax
accounting can be presumed.” Accord: Jefferson
Standard Life Insurance Co. v. United States, 408 F.
2d 842, 854-856 (C.A. 4), certiorari denied, 396 U.S.
828; Western National Life Insurance Co. of Texas v.
Commissioner, 432 F. 2d 298, 301-302 (C.A. 5); West-
ern and Southern Life Insurance Co. v. Commissioner,
460 F. 2d 8, 10-14 (C.A. 6), certiorari denied, 409 U.S.
1063. See also Bankers Union Life Insurance Co. v.
Commissioner, 62 T.C. 661; United Life and Accident
Insurance Co. v. United States, 329 F. Supp. 765
(D. N.H.); Union Mutual Life Insurance Co. v.
United States, No. 74-112 8.D., decided September 14,
1976 (D. Me.) (38 A.F.T.R. 2d 76-5802) ; Midland Na-
tional Life Insurance Co. v. Commissioner, 66 T.C. 550.

Like the prior appellate decisions, the court of ap-
peals in this case correctly recognized that the as-
sumption of full premium payment is a fiction, since
life insurance companies do not in fact receive annual
premiums in full as of the end of the taxable year
(see Pet. App. B 15a). But the court thereupon er-
roneously characterized the prior decisions themselves
as “predicated on a fiction and a desire to achieve
accounting uniformity” (Pet. App. B 16a). In so hold-
ing, the court overlooked the critical fact that the as-
sumption of full premium payment results in an
equally fictional overstatement of reserves. It is this

43

overstatement of reserves that requires the inclusion
of the full premium in “assets,” not simply as a mat-
ter of accounting uniformity, but to preserve the in-
tegrity of the Phase I formula.

As the Fourth Circuit suecinetly put it in Jefferson
Standard Life Insurance Co. vy. United States, supra,
408 F. 2d at 856, ‘‘If the full annual net valuation
premium is treated as a reserve liability under § 804,
the corresponding asset should be the gross annual
premium * * *; else the formula is unbalanced to
the unwarranted benefit of taxpayer.” In sum, if the
assumption of full premium payment is accepted at
all, a company must apply that assumption in com-
puting its ‘‘assets” «= well as its “reserves.” If that
were not the case, the Phase I formula would not
accurately reflect the true proportional relationship
between reserves and assets.

The decision below attempted to refute the analyses
of the four circuits that have upheld the Commis-
sioner’s position on the ground that respondent was
required by Oklahoma law to establish reserves for
each of its policies on the assumption of full premium
payment as of the end of the year. From this premise,
the court concluded that while ‘‘the reserves actually
exist as a liability, the unpaid premiums do not exist
until actually paid” (Pet. App. B 14a). In its view,
the net valuation portions of the deferred and uncol-
lected premiums were therefore required to be in-
cluded in respondent’s reserves while such premiums
could not be included in its ‘‘assets.”

Contrary to the reasoning of the court of appeals,

the reserves of a life insurance company are not book-
226-549—77——-4

44

keeping entries made in a vacuum apart from the
company’s premiums and assets. As we have pointed
out in Part B, supra, pp. 29-33, reserves represent
the company’s liabilities to the policyholders only to
the extent that the policyholders pay premiums which
the company can use to cover its reserves. See, ¢.g.,
New York Life Ins. Co. v. Edwards, supra, 271 U.S.
at 119. Moreover, it is universally recognized that the
inclusion of deferred and uncollected premiums in
the amount of the reserves shown on a company’s
annual statement does not reflect an actual liability
that impairs the company’s surplus (see pp. 36-37,
supra). Thus, even accepting the court of appeals’
assumption that state law required respondent to in-
clude the net valuation portion of its deferred and
uncollected premiums in the computation of its re-
serves," the Commissioner’s Regulations require a
consistent application of the selfsame assumption
upon which that computational requirement is based,
viz., that all of the premiums have been paid as of
the policy anniversary dates.

In sum, there is no justification for the imbalance
created by the contradictory set of assumptions upon

" But cf. Ernst & Ernst, GAA/?—Stock Life Companies, supra,
which states (p. 450) :

“There is no statutory requirement to compute mean reserves,
ie. reserves which assume the receipt of an annual net premium.
But companics continue to do so, primarily for ordinary insur-
ance, in part because this approach is traditional, in part because
published tables of reserve factors use the mean reserve approach,
and in part because the volume of reserve factors which recognize
mode and paid-to date would be so great as to constitute an admin-
istrative problem of monstrous proportions.”

45

which the decision below rests. If the net valuation
portions of the deferred and uncollected premiums
are included in a company’s reserves in the Phase I
computation in accordance with the traditional insur-
ance industry convention, those premiums must be
deemed to have been paid and to be part of the com-
pany’s assets in that computation. Treasury Regula-
tions, Section 1.805-5(a) (4) (ii), Ex. (1).

3. a. The error of the decision below is underlined
by the fact that the life insurance industry itself has
never taken the extreme position of the court of ap-
peals. In all of the appellate litigation to date under
the Life Insurance Company Income Tax Act of
1959, the industry has not contended that deferred
and uncollected premiums could be excluded in their
entirety from “assets” under Section 805(b) (4)
in the Phase I computation. To the contrary, the in-
dustry has acknowledged that deferred and uncollected
premiums are includable in “assets,’”’ at least to the
extent of the net valuation portion of those premiums.

The industry’s position is shown by the sequence of
events in Western National Life Insurance Co. of
Texas v. Commissioner, supra. There, the Tax Court
originally held, in conformity with the decision below
in this case (50 T.C. 285, 297-300), that all deferred
and uncollected premiums were excludable from
“assets.’’ However, on the Commissioner’s motion for
reconsideration, the Tax Court modified its decisign
and adopted the position of the Life Insurers Con-
ference, the American Life Convention, and the Life

46

Insurance Association of America as amici curiae
that deferred and uncollected premiums were includ-
able in “assets’’ only to the extent of the net valua-
tion portion of those premiums (51 T.C, 824). The
Fifth Cireuit reversed the Tax Court and upheld the
Commissioner’s position that the full amount of the
deferred and uncollected premiums was includable
in “assets.” In so holding, it noted that the Tax
Court’s decision was in conformity with the industry’s
views (see 432 I’, 2d at 301).”

The Life Insurance Council of America intends to
file an amicus brief in this case. It has advised us that
it will likewise contend that deferred and uncollected
premiums be included in “assets’’ only to the extent
of the net valuation portion of such premiums. In the
industry’s view, as expressed in its briefs in the prior
cases, the net valuation portion of the deferred and
uncollected premiums should be included in ‘‘assets”’
to offset the reserves that are determined on a net
valuation annual premium basis, but the loading ele-
ment of those premiums should be excluded from
‘‘assets.”” In support of this treatment, the industry
has relied upon the annual statement form approved
by the National Association of Insurance Commis-

" After four circuits had rejected the approach of its modified
decisiofPin Western National Life Insurance Co. (51 T.C, 824),
the Tax Court s ibsequently upheld the Commissioner's position
in Bankers Union Life Insurance Co. v. Commissioner, 62 T.C. 661.
Its holding here was on the authority of that latter decision (Pet.
App. A 7a-8a).

“The American Life Convention and the Life Insurance Asso-
ciation of America have merged. The successor organization is the
Life Insurance Council of America.

47

sioners and employed by the insurance departments of
most States (see Exs. KE, F, H, A. 60-61, 75-76, °°-91).

Pursuant to the NAIC form, an insurance company
offsets the overstatement of its reserves in the amount
of the net valuation portion of the deferred and wn-
collected premiums by creating an asset equal in
amount called “Life insurance premiums and an-
nuity considerations deferred and uncollected.” This
asset is the gross amount of these premiums minus the
loading element. However, as we pointed out in our
discussion of the origins of this accounting convention
(see pp. 34-37, supra), the sole consideration underly-
ing the NAIC form is to provide an accurate picture
of the company’s solvency. Thus, if the company as-
sumes receipt of the full annual premium and thereby
overstates its reserves by the net valuation portion of
those premiums, the solution devised by the NAIC
form is to establish an asset to offset the overstate-
ment of the reserves. The net effect of such offsetting
entries is the same as if the deferred and uncollected
premiums were disregarded for all purposes on the
company’s annual statement. See Wightman, supra,
at 373-375.

But the NAIC goal of achieving an accurate report
of a company’s solvency is entirely unrelated to the
purpose of the Phase I tax computation, which is
designed to measure the proportional relationship of
the company’s assets and reserves. As this Court
stated in McCoach v. Insurance Company of North
America, 244 U.S. 585, 589: “The act of Congress, on
the other hand, deals with reserves not particularly in

their bearing upon the solvency of the company, but
as they aid in determining what part of the gross in-
come ought to be treated as net income for purposes
of taxation.”

If a life insurance company assumes that the de-
ferred and uncollected premiums on all of its policies
have been paid as of their anniversary dates and in-
creases its reserves for tax purposes by the net valua-
tion portion of such premiums, that assumption
necessarily stands on the hypothesis that the company
has received the full amount of those premiums and
hot some lesser amount. Put another way, since the
policyholder pays the gross amount of the premium
and not the net valuation portion, it is the gross
premium that must be ineluded in the company’s
‘‘assets,’”*

b. Nor does Section 818(a) of the Code, upon which
the industry has relied in the prior cases, support a

different result, that statute provides that life insur-
ance companies must make all tax computations
“under an acerual method of accounting.” The last
sentence of Section 818(a) states: “Except as pro-

“ The NAIC financial reporting method is basically incompat-
ible with the Phase I formula. The NAIC inclusion of equal net
valuation amounts in both “reserves” and “assets” for deferred and
uncollected premiums would distort the proportional relationship
of reserves to assets by erroneously assuming that these two ele-
ments increase in numerically equivalent amounts. This contrary-
to-fact assumption would in turn distort the Phase I formula by
Reserves ' ,

— See Franklin Life Insurance Co.
v. United States, supra, 399 ¥. 2d at 760. The result would allocate
a greater portion of investment income to the policyholder reserves

and a lesser amount to the company’s surplus than is justified by
the actual facts.

increasing the fraction

49

vided in the preceding sentence, all such computations
shall be made in a manner consistent with the manner
required for purposes of the annual statement approved
by the National Associatien of Insurance Com-
missioners.” The industry has contended that this
reference to the NAIC. annual statement + provides
statutory authority for the adoption of the NAIC’s
treatment of deferred and uncollected premiums for
tax purposes. tthe | |

But the language of the statute makes clear that
the NAIC treatment of a particular item is only
to be aceepted when it is consistent with an acerual
method of accounting. See H.R. Rep. No. 34, supra,
at 42; S. Rep. No. 291, supra, at 72-73. The NAIC
treatment, however, is not an accrual method of
accounting within the accepted meaning of that term.
It assumes receipt of the gross deferred and un-
collected premiums only for purposes of the reserve
liabilities, but does not correspondingly treat the full
amount of those premiums as receivables on the assets
side of the balance sheet. As the Fifth Cireuit cor-
rectly observed, ‘‘In point of fact, the N....1.C. method
is a hybrid method and not strictly an accrual method.”
Western National Life Insurance Co. of Texas v.
Commissioner, supra, 432 F. 2d at 301. Without the
assumption of full premium payment, deferred and
uncollected premiums would not be properly accruable
under an accrual method of accounting. But once the
assumption of full premium payment is 1ade, an
accrual method of accounting requires that these pre-
miums be taken into account consistently for assets as
well as liabilities.

50

The courts of appeals have therefore correctly re-
jected the insurance industry’s attempt to impose the
NAIC method of accounting upon the Internal Rey-
enue Code. As the Seventh Circuit observed in Frank-
lin Life Insurance Co. v. United States, supra, 399
F. 2d at 760, “The careful and detailed attention given
by Congress throughout Sections 801 through 820 to
definition of the particular items utilized as factors
in the tax formula and in specifying and enumerating
the permissible ueductions and exclusions negates the
existence of any intent on the part of Congress to
relegate the substantive matter of offsetting or ex-
cluding loading on deferred and uncollected pre-
miums, with its concomitant impact on the resulting
tax, to the NAIC.” * Accord: Jefferson Standard Life
Insurance Co. v. United States, supra, 408 F. 2d at

** The limited role of the NAIC method of financial reporting
is confirmed by the position the insurance industry took during
the hearings cu the 1959 Act. At that time, the industry stressed
that the NAIC annual statement and the annua] statement’s Sum-
mary of Operations were “intended only for use * * * as a meas-
ure of solvency and not for use as a year-to-year measure of
earned income for tax purposes.” See Hearings on H.R. 4245 (Tax
Formula for Life Insurance Companies) before the Senate Com-
mittee on Finance, 86th Cong., Ist Sess. 302 (1959) (Statement
of Francis V. Keesling, Jr.). Likewise, Claris Adams, who was
General Counsel of the American Life Convention, stated during
the House hearings (Hearings on the Taxation of Income of Life
Insurance Companies before the Subcommittee on Internal Rev-
enue Taxation of the House Committee on Ways and Means, 85th
Cong., 2d Sess. 56 (1958) :

“Tt follows that the results in any given year, as shown by a life
insurance company’s annual statement, are so much of the product
of estimates of future liabilities based on probabilities that the re-
sults themselves are essentially estimates instead of actualities.

“As a matter of fact, the annual statement of life insurance
companies as designed by the National Association of Insurance

51

849-850, 856; Western National Life Insurance Co. of
Texas v. Commissioner, supra, 432 F. 2d at 301-302;
Western and Southern Life Insurance Co. v. Com-
missioner, supra, 460 F. 2d at 12-14.

D. A LIFE INSURANCE COMPANY THAT INCLUDES THE NET VALUATION
PORTION OF DEFERRED AND UNCOLLECTED PREMIUMS IN “RESERVES”
MUST INCLUDE THE GROSS AMOUNT OF SUCH PREMIUMS IN ITS COM-
PUTATION OF “GROSS AMOUNT OF PREMIUMS” UNDER SECTION
809(C) (1) a3
1. The necessity for consistency of assumptions ap-

plies with equal force to the Phase II computation of
a life insurance company’s “‘gain from operations’’
under Section 809. As we have pointed out supra, pp.
7-8, the company’s “gain from operations” includes
its income from all sources less certain specified de-
ductions. Since “gain from operations” includes an
element of investment income (see Section 809(b)
(1)(A)), the further computation of “gain from op-
erations” is directed toward taking into account in-
come from other sources, principally underwriting
income. A company has underwriting gains when the
premiums it charges for policies are in excess of its
costs in providing the coverage.

The Section 809 computation of ‘‘gain from opera-
tions’? involves totalling the company’s income
items and offsetting that amount by its deductions i:
essentially the same manner as any other computation
of net income. In addition to the company’s share of

Commissioners does not show, and never was intended to show,
yearly profit and loss on company operations, but has only been
constructed to reflect an overall standard of probable solvency.
It cannot be too strongly emphasized that the annual statement of
life insurance companies «S not a profit-and-loss statement.”

226-549—77—__5

52

investment income, the income items include ‘gross
amount of premiums,”’ net decreases in reserves, and
other amounts (Section 809(c)). The specified deduc-
tions include non-investment expenses, such as under-
writing expenses, salaries, and general overhead, and
claims paid (Section 809(d)). In aecord with the con-
gressiona! decision to exclude from the tax base that
portion of premiums necessary to meet future claims,
Section 809(d)(2) permits a deduction for increases
in reserves that are attributable to premiums included
in income under Section 809(c) (1). After subtracting
the various deductions from the company’s gross
income from all sources, the resulting figure is its
‘gain from operations.”’

The court of appeals’ holding that respondent was
not required to include any part of the deferred and
uncollected premiums in ‘“‘gross amount of premiums”
under Section 809(c)(1) suffers from the same in-
firmity as its exclusion of those premiums from ‘‘as-
sets” under Section 805(b)(4). As the mechanics of
the Phase II computation demonstrate, Section 809
(d)(2) allows a deduction for increases to reserves.
Thus, if an insurance company computes its reserves
on the traditional assumption of full premium pay-
ment and claims a Section 809(d)(2) deduction for
those reserves, it must likewise apply that assump-
tion to the income side of the tax computation and
include the full amount of the deferred and uncol-
lected premiums in “gross amount of premiums” un-
der Section 809(c)(1). Treasury Regulations, Section
1.809-4(a); Franklin Life Insurance Co. v. United
States, supra, 399 F. 2d at 760-761; Jefferson Stand-

53

ard Life Insurance Co. v. United States, supra, 408
F, 2d at 855-856; Western National Life Insurance
Co. of Texas v. Commissioner, supra, 432 F. 2d at
301-302; Western and Southern Life Insurance Co. v.
Commissioner, supra, 460 F. 2d at 11-14. If the de-
ferred and uncollected premiums are not included in
income, there is no warrant for the deduction for re-
serves attributable to such premiums. The integrity
of a computati 1 of net income requires that uniform
assumptions be made with respect to both income and
deduction items.

2. Thus, the decision of the court of appeals cannot
be justified on any rational basis. But the insurance
industry has contended in the prior cases, and pre-
sumably the amicus Life Insurance Council will like-
wise urge here, that it is entitled to a deduction or
offset for loading on deferred and uncollected pre-
miums so that such premiums are included in income
in the Phase II computation only to the extent of the
net valuation portion. In support of this approach,
the industry again invokes the authority of the NAIC
method of financial reporting.

As we have shown with respect to the Phase I com-
putation (see pp. 34-37, 47, supra), the sole concern of
the NAIC method is to project an accurate report of the
company’s solvency. Thus, on the NAIC form entitled
“Summary of Operations,” the company includes its
gross deferred and uncollected premiums in “Pre-
miums and annuity considerations” (line 1.1) and de-
ducts: (1) the net valuation portion in “Increase in
aggregate reserve for policies and contracts with life

54

contingencies” (line 17) ; and (2) the loading element
in ‘‘Increase in loading on * * * deferred and uncol-
lected premiums” (line 25) (see Ex. F, A. 77). The
net effect of these computations is to cancel out any
impact of deferred and uncollected premiums on the
company’s income statement because the additions on
the income side exactly equal the subtractions on the
deductions side.

The courts of appeals have properly rejected, as
inconsistent with the language of the statute, the in-
dustry’s position that only the net valuation portion of
the deferred and uncollected premiums be included in
income. Section 809(c) (1) requires the inclusion in in-
come of the “gross amount of premiums’ and not any
lesser amount. Moreover, the NAIC deduction for the
company’s increase in loading on deferred and uncol-
lected premiums is not one of the deductible items
specified in Section 809(d). Since “a taxpayer seek-
ing a deduction must be able to point to an applicable
statute and show that he comes within its terms”
(New Colonial Co. v. Helvering, 292 U.S. 435, 440),”
there is no basis for the industry’s claim to a non-
statutory tax deduction for theffet increase in loading.

E. ALTERNATIVELY, IF DEFERRED AND UNCOLLECTED PREMIUMS ARE
NOT INCLUDED IN “ASSETS” AND “GROSS AMOUNT OF PREMIUMS,”
THE NET VALUATION PORTION OF THOSE PREMIUMS MUST LIKEWISE
BE EXCLUDED FROM “RESERVES”

The core of our submission in this case is that a life
insurance company must treat its deferred and uncol-

%6 The Court has likewise invoked the principle that deductions
must be supported by a particular statute in connection with the
taxation of life insurance companies. See Helvering v. Independent
Life Ins. Co., 292 U.S. 371, 381.

55

lected premiums for federal tax purposes in accord-
ance with a consistent set of assumptions. Recognizing
the industry-wide assumption that premiums have
been paid in full as of the anniversary dates of the
policies and that the computation of reserves will be
made in accordance with that assumption, the perti-
nent Treasury Regulations (Sections 1.805-5(a) (4)
(ii) and 1.809-4(a)) likewise properly require that
deferred and uncollected premiums be included in ‘‘as-
sets” and “gross amount of premiums.” In this man-
ner, the assumption of full premium payment will be
given effect for all of the elements of the federal tax
computations.

As noted (pp. 34-37, supra), the asumption of full
premium payment is a financial reporting convention
adopted by the life insurance industry to simplify the
actuarial determinations of its year-end reserves. To
the extent that the reserves reflect the net valuation
portion of the deferred and uncollected premiums,
they: are overstated and represent no actual liability
of the company. The company is only liable to pay the
benefits for periods with respect to which the pre-
miums have actually been paid. Indeed, the NAIC ac-
counting device of creating a “quasi-asset’’ equal to
the net valuation portion of the deferred and uncol-
lected premiums to offset the overstatement of the
reserves convincingly demonstrates that the overstate-
ment of the reserves does not encumber any real assets
of the company.

If the industry-wide assumption of full. premium
payment were disregarded for purposes of the federal .
tax computation, consistency could neyertheless be

56

achieved by excluding deferred and uncollected pre-
miums from ‘‘reserves,” “assets,” and “gross amount
of premiums.” This alternative approach is set forth
in Treasury Regulations, Section 1.801-4(f), which
provides that if it is determined that deferred and
uncollected premiums are not properly includable in
‘‘oross amount of premiums” and ‘‘assets,” then “ap-
porpriate reduction shall be made in the life insurance
reserves.”

In prescribing this alternative method, the Regula-
tions make certain that if deferred and uncollected
premiums are not to be included in “assets” and
“gross amount of premiums,” as the decision below
has held, the net valuation portion of those premiums
cannot be included in ‘‘reserves.’’ Thus, the alterna-
tive approach would continue to guarantee the in-
tegrity of the tax computations.

The exclusion of deferred and uncollected premiums
altogether from “assets,” “gross amount of pre-
miums,” and “reserves” is arguably more consistent
with the decisions of the Court recognizing that a
life insurance reserve arises only upon the payment
of premiums (see pp. 29-31, supra). Since the policy-
holder has not paid the deferred and uncollected
premiums and has no legal obligation to do so, there
are in fact no premiums to be included in “assets”
or “gross amount of premiums.” Likewise there are
no amounts which are “set aside” (Section 801(b) (1)
(B)) or “reserved from premiums” that would sup-
port the existence of a reserve. See New York Life
Ins. Co. v. Edwards, supra, 271 U.S. at 119.

57

Thus, the exclusion of deferred and uncollected pre-
miums from these three elements in the tax computa-
tions has much to commend it as a matter of absolute
logic. Moreover, the seminal opinion of the Seventh
Circuit in Franklin Life Insurance Co. v. United
States, supra, 399 F. 2d at 761, acknowledged that
“Ti]f the fictional assumption were not indulged and only
those reserves were accrued as were attributable to
paid up portions of annual premiums, then the prob-
lem from an accrual standpoint would be simpler.”

On this dual rationale of logic and simplicity, a
trial judge of the Court of Claims has recently held
that deferred and uncollected premiums are not in-
cludable in “assets,” “gross amount of premiums,”
or “reserves,” in accord with .... alternative approach
of Treasury Regulations, Section 1.801-4(f). See
Monumental Life Insurance Co. v. United States,
No. 71-73, decided November 19, 1976 (Ct. Cl.) (76-2
U.S.T.C. { 9787). But despite the logic and simplicity of
total exclusion of deferred and uncollected premiums,
the Commissioner is willing to accept the life in-
surance industry’s fictional assumption of full pre-
mium payment and consequent overstatement of re-
serves as long as the same assumption is consistently
applied in computing the other elements of the tax
formula.

Hence, our primary posticu, as set forth in Trea-
sury Regulations, Sections 1.805-5(a)(4)(ii) and
1,809-4(a)(1), is that gross deferred and uncollected
premiums must be included in “assets” and “gross
amount of premiums” if the net valuation por-

58

tion of such premiums is to be included in “re-
serves.” However, if the Court disagrees with our
submission that the full amount of deferred and un-
collected premiums be included in “assets’’ and “gross
amount of premiums,” the proper disposition of this
case would be to exclude such premiums entirely from
the tax compviations, in accordance with Treasury
Regulations Section 1.801-4(f).

CONCLUSION

For the reasons stated, the judgment of the court
of appeals should be reversed.
Respectfully submitted.

Rosert H. Bork,
Solicitor General.

Myron C. Baum,
Acting Assistant Attorney General.

Stuart A. SMITH,
Assistant to the Solicitor General.

Gary R. ALLEN,
STEPHEN M. GELBER,
Attorneys.

JEANNE L. Dopres,
Attorney,

Internal Revenue Service.

JANUARY 1977.

APPENDIX

Internal Revenue Code of 1954 (26 U.S.C. (1958
ed., Supp. IT)):

Sec. 801 [as added by Sec. 2(a), Life Insurance
Company Income Tax Act of 1959, P.L. 86-69, 73
Stat. 112]. DEFINITION OF LIFE INSURANCE
COMPANY.

* * . ” *

(b) Life Insurance Reserves Defined.—
(1) In general.—For purposes of this part, the
term “life insurance reserves’’ means amounts—

(A) which are computed or estimated on
the basis of recognized mortality or mor-
bidity tables.and assumed rates of interest,
and

(B) which are set aside to mature or
liquidate, either by payment or reinsurance,
future unaccrued claims arising from life
insurance, annuity, and noncancellable health
and accident insurance contracts (including
life insurance or annuity contracts combined
with noneancellable health and accident in-
surance) involving, at the time with respect
to which the reserve is computed, life, health,
or accident contingencies.

(2) Reserves must be required by law.—
Except—

(A) in the case of policies covering life,
health, and accident insurance combined in
one policy issued on the weekly premium

(1a)

226-549-776

2a

payment plan, continuing for life and not
subject to cancellation,

(B) in the ease of policies issued by an
organization which meets the requirements
of section 501(c)(9) other than the require-
ment of subparagraph (B) thereof, and

(C) as provided in paragraph (3),

in addition to the requirements set forth in para-
graph (1), life insurance reserves must be re-
quired by law.

* * * * *

Sec. 802 [as added by Sec. 2(a), Life Insurance
Company Income Tax Act of 1959 supra.] TAX
IMPOSED.

(a) Tax Imposed.—

(1) In General.—A tax is hereby imposed for
each taxable year beginning after December 31,
1957, on the life insurance company taxable in-
come of every life insurance company. Such tax
shall consist of—

(A) a normal tax on such income com-
puted at the rate provided by section 11
(b), and

(B) a surtax, on so much of such in-
come as exceeds $25,000, computed at the
rate provided by section 11(c).

* * * * *

(b) Life Insurance Company Taxable Income De-
fined.—For purposes of this part, the term “life in-
surance company taxable income’”’ means the sum of—

(1) the taxable investment income (as
defined in section 804) or, if smaller, the gain
from operations (as defined in section 809),

3A

(2) if the gain from operations exceeds
the taxable investment income, an amount
equal to 50 percent of such excess, plus

(3) the amount subtracted from the policy-
holders surplus account for the taxable year,
as determined under section 815.

Sec. 804 [as added by See 2(a), Life Insurance
Company Income Tax Act of 1959, supra]. TAX-
ABLE INVESTMENT INCOME.

(a) In General.—

(1) Exclusion of policyholders’ share of invest-
ment yield.—The policyholders’ share of each and
every item of investment yield (including tax-
exempt interest, partially tax-exempt interest, and
dividends received) of any life insurance com-
pany shall not be included in taxable investment
income. For purposes of the preceding sentence,
the policyholders’ share of any item shall be that
percentage obtained by dividing the policy and
other contract liability requirements by the in-
vestment yield; except that if the policy and
other contract liability requirements exceed the
investment yield, then the policyholders’ share
of any item shall be 100 percent.

(2) Taxable investment income defined.—For
purposes of this part, the taxable investment in-
come for any taxable year shall be an amount
(not less than zero) equal to the sum of the life
insurance company’s share of each and every item
of investment yield (including tax-exempt inter-
est, partially tax-exempt interest, and dividends
received), reduced by—

(A) the sum of—

(i) the life insurance company’s share
of interest which under section 103 is
excluded from gross income,

4a

(ii) the deduction for partially tax-
exempt interest provided by section 242
(as modified by paragraph (3)) com-
puted with respect to the life insurance

company’s share of such interest, and
(iii) the deductions for dividends re-
ceived provided by sections 243, 244, and
245 (as modified by paragraph (5)) com-
puted with respect to the life insurance
company’s share of the dividends re-

ceived; and
(B) the small business deduction provided
by paragraph (4).

For purposes of the preceding sentence, the life
insurance company’s share of any item shall be
that percentage which, when added to the percent-
age obtained under the second sentence of para-

graph (1), equals 100 percent.

(b) Gross Investment Income.—For purposes
of this part, the term “gross investment income”
means the sum of the following:

(1) Interest, etc-—The gross amount of in-
come from—

(A) interest, dividends, rents, and:

royalities,

(B) the entering into of any lease,
mortgage, or other instrument or agree-
ment from which the life insurance com-
pany derives interest, rents, or royalties,
and

(C) the alteration or termination of
any instrument or agreement described

in subparagraph (B).

5a

(2) Short-term capital gain.—In the case
of a taxable year beginning after December
31, 1958, the amount (if any) by which the
net short-term capital gain exceeds the net
long-term capital loss.

(3) Trade or business tncome.—The gross
income from any trade or business (other
than an insurance business) carried on by
the insurance company, or by a partnership
of which the life insurance company is a part-
ner. In computing gross income under this
paragraph, there shall be excluded any item
described in paragraph (1).

Except as provided in paragraph (2), in comput-
ing gross investment income under this subsection,
there shall be excluded any gain from the sale or
exchange of a capital asset, and any gain con-
sidered as gain from the sale or exchange of a
capital asset.

(ec) Investment Yield Defined—For purposes
of this part, the term “investment yield” means
the gross investment income less the following
deductions— ‘*

(1) Investment expenses.—liuvestment
expenses for the taxable year. If any gen-
eral expenses are in part assigned to or in-
cluded in the investment expenses, the total
deduction under this paragraph shall not
exceed the sum of—

(A) one-fourth of one pereent of
the mean of the assets (as defined in
section 805(b)(4)) held at the begin-
ing and end of the taxable year,

(B) the amount of the mortgage
service fees for the taxable year, plus

6a

(C) whichever of the following is
the greater:

(i) one-fourth of the amount by
which the investment yield (com-
puted without any deduction for in-
vestment expenses allowed by this
paragraph) exceeds 334 percent of
the mean of the assets (as defined
in section 805(b)(4)) held at the
beginning and end of the taxable
year, reduced by the amount de-
scribed in subparagraph (B), or

(ii) one-fourth of one percent of
the mean of the value of mortgages
held at the beginning and end ef the
taxabie year for which there are no
mortgage service fees for the taxable
year.

(2) Real estate expenses.—The amount of
taxes (as provided in section 164), and other
expenses, for the taxable year exclusively on
or with respect to the real estate owned by
the company. No deduction shall be allowed
under this paragraph for any amount paid
out for new buildings, or for permanent im-
provements or betterments made to increase
the value of any property.

(3) Depreciation.—The deduction allowed
by section 167. The deduction under this para-
graph and paragraph (2) on account of any
real estate owned and occupied for insurance
purposes in whole or in part by a life insur-
ance company shall be limited to an amount
which bears the same ratio to such deduction
(computed without regard to this sentence)

7A

as the rental valve of the space not so oc-
cupied bears to the rental value of the entire
property.

(4) Depletion—-The deduction allowed by
section 611 (relating to depletion). —

(5) Trade or business deductions.—The de- -
ductions allowed by this subtitle (without
regard to this part) which are attributable
to any trade or business (other than an in-
surance business) carried on by the life in-
surance company, or by a partnership of
which the life insurance company is a part-
ner; except that in computing the deduction
under this paragraph— :

(A) There shall be excluded losses—

(i) from (or considered as from)
sales or exchanges of capital assets,

(ii) from sales or exchanges of
property used in the trade or busi-
ness (as defined in section 1231(b)),
and

(iii) from the compulsory or in-.
voluntary conversion (as a result of
destruction, in whole or in part, theft
or seizure, or an exercise of the
power of requisition or condemnation
or the threat or imminence thereof)
of property used in the trade or
business (as so defined).

(B) Any item, to the extent attrib-
utable to the carrying on of the insur-
ance business, shall not be taken into
account.

(C) The deduction for net operating
losses provided in section 172, and the

8a

special deductions for corporations pro-
vided in part VIII of subchapter B, shall
not be allowed.

Src. 805 [as added by Sec. 2(a), Life Insurance
Company Income Tax Act of 1959, supra]. POLICY
AND OTHER CONTRACT LIABILITY RE-
QUIREMENTS.

(a) In General——For purposes of this part,
the term “‘policy and other contract liability re-
quirements’” means, for any taxable year, the
sum of—

(1) the adjusted life imsurance reserves,
multiplied by the adjusted reserves rate,

(2) the mean of the pension plan reserves
at the beginning and end of the taxable year,
multiplied by the current earnings rate, and

(3) the interest paid.

(b) Adjusted Reserves Rate and Earnings
Rates.—

(1) Adjusted reserves rate-—For purposes
of this part, the adjusted reserves rate for
any taxable year is the average earnings rate
or, if lower, the current earnings rate.

(2) Current earnings rate-—For purposes
of this part, the current earnings rate for
any taxable year is the amount determined
by dividing—

(A) the taxpayer’s investment yield
for such taxable year, by

(B) the mean of the taxpayer's assets
at the beginning and end of the taxable
year.

(2) Average earnings rate.—

(A) In general—For purposes of this
part, the average earnings rate for any

Ga

taxable year is the average of the cur-
rent earnings rates for such taxable year
and for each of the 4 taxable years im-
mediately preceding such taxable year
(excluding any of such 4 taxable years
for which the taxpayer was not an in-
surance company ).

(B) Special rules—For purposes of
subparagraph (A)—

(i) the current earnings rate for
any taxable year beginning before
January 1, 1958, shall be determined
as if this part (as in effect for 1958)
and section 381(c)(22) applied to
such taxable year, and

(ii) the current earnings rate for
any taxable year of any company
which, for such year, is an insurance
company (but not a life insurance
company) shall be determined as if
this part applied to such company
for such year.

(4) Assets.—For purposes of this part, the
term “assets” means all assets of the com-
pany (including nonadmitted assets), other
than real and personal property (excluding
money) used by it in carrying on an insur-
ance trade or business. For purposes of this
paragraph, the amount attributable to—

(A) real property and stock shall be
the fair market value thereof, and
(B) any other asset shall be the ad-
justed basis (determined without regard
to fair market value on December 31
1958) of such asset for purposes of y

10A

termining gain on sale or other disposi-
tion.
(c) Adjusted Life Insurance Reserves.—

(1) Adjusted life insurance reserves de-
fined.—For purposes of this part, the term
“adjusted life insurance reserves” means—

(A) the mean of the life insurance
reserves (as defined in section 801(b)),
other than pension plan reserves, at the
beginning and end of the taxable year,
multiplied by

(B) that percentage which equals 100
percent—

(1) inereased by that percentage
which is 10 times the average rate
of interest assumed by the taxpayer
in caleulating such reserves, and

(11) reduced by that percentage
which is 10 times the adjusted re-
serves rate.

(2) Average interest rate assumed.—For
purposes of this part, the average rate of in-
terest assumed in calculating reserves shall
be computed—

(A) by multiplying each assumed rate
of interest by the means of the amounts
of such reserves computed at that rate at
the beginning and end of the taxable
year, and

(B) by dividing (i) the sum of the
products ascertained under subparagraph
(A), by (ii) the mean of the total of
such reserves at the beginning and end
of the taxable year.

11a

Sec. 809 [as added by See. 2(a), Life Insurance
Company Income Tax Act of 1959, supra]. IN
GENERAL.
(a) Exclusion of Share of Investment Yield
Set Aside for Policyholders—

| (1) Amount.—The share of each and
every item of investment yield (including
tax-exempt interest, partially tax-exempt
intere

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385004_0058%3A04. Public record. Not legal advice.