Appendix — Southwestern Life Insurance v. United States

Supreme Court. U. 8.

f FILED )

FER 10 978 |

M 0

L_MICHAEL RODAK, JR, CLERK

— — /

In THE

Supreme Court of the Anited States

OcToBer TERM, 1977

— * ** *

SOUTHWESTERN LIFE INSURANCE COMPANY,

Petitioner,

US.

UNITED STATES OF AMERICA,

Respondent.

APPENDIX TO

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS FOR

THE FIFTH CIRCUIT

(CONTAINING OPINIONS OF THE COURTS BELOW )

LaRRY L. BEAN

Sam G. WIN. GAD

JACKSON, WALKER, WINSTEAD,

CANTWELL & MILLER

4300 First National Bank Building

Dallas, Texas 75202

Counsel for Petitioner

February 1978.

A-1l

APPENDIX A

SOUTHWESTERN LIFE INSURANCE

COMPANY,

Plaintiff-Appellee-Cross-A ppellant,

v.

UNITED STATES of America,

Defendant-A ppellant-Cross- Appellee.

No. 75-2675.

United States Court of Appeals,

Fifth Circuit.

Oct. 5, 1977.

Appeals from the United States District

Court for the Northern District of Texas.

Before TUTTLE, GOLDBERG and

CLARK, Circuit Judges.

TUTTLE, Circuit Judge:

This appeal presents for consideration the

correctness of the trial court’s judgment in

a suit for refund filed by the insurance

company by which judgment the trial court

resolved several of the contested issues in

favor of, the taxpayer and the remaining

issues in favor of the Commissioner. Since

the parties are not content to leave the split

A-2

solution where it stands, it is necessary for

us to give separate consideration to each of

the many points at issue in the trial court

We shall first discuss the five issues which

thé trial court resolved in favor of the

taxpayer, and which the Government has

raised on its direet appeal to this Court.

We then turn to the issues resolved in favor

of the Commissioner and brought before us

here by cross-appeal by the insurance com-

pany. Fortunately, both for the Court and

for those affected by the opinion of this

Court, counsel for the appellees followed

the pattern of the Government’s brief in

discussing the several issues and, with an

effort to get quickly to the merits of the

controversy, counsel for the appellees fol-

lowed almost verbatim the wording of the

Government's brief in positing the issues

which, on the Government's direct appeal,

we state as follows:

I. ISSUES ON DIRECT APPEAL

I. Whether the district court erred in

holding that it had jurisdiction to con-

sider the merits of taxpayer’s argu-

ment concerning its claimed deduc-

tion under Section 80%d\5) of the

Internal Revenue Code of 1954 for

the increase in its reserves for non-

participating contracts.

2 Assuming arguendo that the court

was correct in determining that it

had jurisdiction, whether Section

&99(d\(5) which provides an additional

A-3

10-percent deduction for increases in

life insurance reserves attributable to

nonparticipating contracts, is subject

to the Section 810 “spread rule” to

the extent that the increase is due to

reserve strengthening.

3. Whether the district court erred in

holding that mortgage escrow funds,

taxes and other amounts withheld

from taxpayer's employees and vari-

ous other amounts received or re-

tained by taxpayer during the years

in issue did not constitute “assets” of

the taxpayer within the meaning of

Section 8050b) of the Code.

4. Whether the district court also erred

in holding that due and unpaid acci-

dent and health premiums were not

includible in taxpayer’s assets.

5. Whether the district court erred in

holding that amounts paid by taxpay-

er to pension plans as “excess inter-

est” on certain life insurance and an-

nuity contracts constituted “amounts

in the nature of interest” within the

meaning of Section 805(e2) of the

Code.

IL NATURE OF THE CASE

The issues in this case arise under the

Life Insurance Company Income Tax Act of

1959, 26 U.S.C. § 801 through 820. Con-

gress has long recognized the difficulties in

accurately establishing life insurance com-

A-4

pany annual income and, as reflected in the

legislative -history, S.Rep.No. 291, 86th

Cong., Ist Sess., p. 5 (1959-2 Cum. Bull. 770-

775) an apparent. tax advantage is allowed

to such companies on account of the nature

of their long-term contracts which make it

possible that what might appear to be in-

come in the current year could conceivably

be required later to fulfill insurance con-

tracts. It is not deemed necessary for our

consideration of the several issues involved

to outline the precise method by which tax-

able income of life insurance companies is

measured. It can be assumed, of course,

from the fact that the issues are raised that

their resolution will affect the ultimate in-

come tax liability of the taxpayer.

III. ISSUES NUMBERS 1 AND 2—RE-

SERVE STRENGTHENING UNDER

SECTION 809(dX5)

These issues are treated together, be-

cause it is the Government’s position that

the Commissioner’s disallowance of the ten

percent deduction for increases in life insur-

ance reserves attributable to nonparticipat-

ing contracts under Section 809(dX5) was

not challenged by the taxpayer by a claim

for refund before the filing of the suit now

before the Court. If we find this conten-

tion to be correct, we do not reach the

merits of the question.

The “ground” for the taxpayer's conten-

tion that it is entitled to a refund as to this

A-5

item arises from the unique provisions of

the Code dealing with the treatment of

certain reserves which is not brought about

by normal additions to reserves. The Code

authorizes the deduction in the tax year by

an insurance company of the total amount

normally added to reserves. In a case of

“reserve strengthening” that is, when the

company elects to increase its reserves be-

yond those required by § 808 of the Act, the

Code requires that the deduction of the

amount, here $820,068, be made over a peri-

od of 10 years, beginning the following

year. This is called the “spread” rule. The

statute further authorizes the deduction of

an additional 10% of the amount of any

reserve increase attributable to nonpartici-

pating contracts. The taxpayer claims, and

the trial court held, that this 10% could all

be deducted for the tax year because it was

not covered by the “spread” rule. The

government contends, to the contrary, that

the statute requires the same treatment of

this additional 10% as is given to the princi-

pal amount itself: None is deducted in the

tax year but deductions must be spread

over the succeeding 10 years. Resolution of

this issue depends upon the construction of

§ 80%d\2), 80%d\5) and 810(d) of the Code.

Section 7422 of the Internal Revenue Act

of 1957 provides as follows:

“No Suit prior to filing claim for re-

fund—No suit or proceeding shall be

maintained in any court for the recovery

A-6

of any internal revenue tax alleged to

have been erroneously or illegally as-

sessed or collected, or of any penalty

claimed to have been collected without

authority, or of any sum alleged to have

been excessive or in any manner wrong-

fully collected, until a claim for refund or

credit has been duly filed with the Secre-

tary or his delegate, according to the

provisions of law in that regard, and the

regulations of the Secretary or his dele-

gate established in pursuance thereof.”

26 U.S.C. § 7422(a)

The Supreme Court has long since held

that a failure to raise factual and legal

grounds in a claim for refund bars a recov-

ery on such a claim in a subsequently filed

suit for refund, United States v. Felt &

Tarrant Manufacturing Co., 283 U.S. 269,

51 S.Ct. 376, 75 L.Ed. 1025 (1931); Angelus

Milling Co. v. Commissioner of Internal

Revenue, 325 U.S. 293, 65 S.Ct. 1162, 89

L.Ed. 1619 (1945). This Court has stated in

Alabama By-Products Corp. v. Patterson,

258 F.2d 892, 900 (1958):

“All grounds upon which a taxpayer

relies must be stated in the original claim

for refund so as to apprise the Commis-

sioner of what to look into. The Commis-

sioner can take the claim at its face value

and examine only those points to which

attention is necessarily directed.

Anything not raised at that time cannot

be raised later in a suit for refund.

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A-7

In this case it is clear that the taxpayer

has in no way raised the reserve strength-

ening issue as to the extra ten percent in

the claim for refund which it filed for the

year 1958. The only basis upon which the

taxpayer could contend to the contrary is in

a document denominated “Rider o. 8” to

the 1958 claim. For the better under-

standing of the holding on this issue we

duplicate this rider herewith:

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A-8

The taxpayer contended that item

listed (b) “reserves of policies which became

participating during the year,” had been

treated erroneously, and should be changed

by increasing the deduction for nonpartici-

pating contracts by the sum of $2,949,993.

In the tabulation shown above, it listed the

item of $820,068 under this general heading

for the computation of the deduction for

nonparticipating contracts but it made no

claim thereabout. It plainly indicated that

the taxpayer made no contest with respect

to disallowance of the bracketed amount,

since it showed the amount both at the end

of the year and the beginning of the year.

There is nothing on this schedule or any

other part of the claim or any document

submitted to the trial court by which the

taxpayer raised the contention which it now

seeks to raise in the suit for refund that the

Commissioner had improperly disallowed

the item of 10% of $820,068 during the tax

year 1958. The trial court’s response to the

Government’s challenge to its jurisdiction to

consider this claim was “the Government

has been well advised of taxpayer’s claim

on this issue, through both the claim for

refund and conferences with its agents.

Accordingly, the issue is properl before

this Court and this Court has jurisdiction

over the subject matter.” The Commission-

er contends that there is no basis for that

part of the trial court’s statement that the

Government was well advised “through

A-9

conferences with its agents.“ Ap-

pellees only response to this is that:

“In Rider 8, the adjustment was listed

as erroneously have been determined by

the agent as occurring in 1957 rather

than 1958. There is also no question but

that on the examination of taxpayer's

claim for refund the examining agent

changed his position and recognized the

reserve increase as occurring in 1958 but

reduced the amount of increase in reserve

on which the Section 80%d5) deduction

was based by the amount of $820,068.

All of these facts are clearly disclosed by

taxpayer’s 1958 income tax return, its

claim for refund, Rider 8, and by the fact

that the examining agent changed his

position that the reserve increase oc-

curred in 1958, not 1957. He could not

have made the change without knowing

that taxpayer was making a claim with

respect to this issue in its claim for re-

fund which was different from that as-

serted by the Government. Thus, the

district court’s fact finding is not clearly

erroneous.”

This statement is faulty in several re-

spects. In the first place, in Rider 8, the

adjustment was not listed as erroneously

having been determined by the agent as

occurring in 1957 rather than 1958. It was

simply listed as having been “considered as

being made at 12-31-57.” The fact that on

examination of taxpayer’s claim for. refund

the examining agent changed hi: sition

A-10

and recognized the increase as occurring in

1958 does not indicate that anything was

done or said with respect to taxpayer’s con-

tention that 10% or $820,068 could be de-

ducted during the tax year rather than over

& ten year period following the tax year in

question. Nothing stated by defendants in-

dicates that the taxpayer met the require.

ments of the statute, as interpreted by the

courts, that a written claim calling specific

attention to the alleged error and the bas,

on which the claim was being made ua,

ever communicated to the Commissioner

We must conclude, therefore, that th,

trial court did not have jurisdiction to con.

sider the Section 809(d\(5) claim on the mer.

its. This, then, disposes of issues numbered

1 and 2, supra.

IV. ISSUE NUMBER 3—MORTGAGE

ESCROW FUNDS” AND OTHER

AMOUNTS HELD IN CASH BY TAX.

PAYER FOR EMPLOYEES AS “As.

SETS”

(a) Mortgage Escrow Funds. Fer

simplification, we adopt the formula as

stated in the government’s brief to give an

indication of the importance of ascertaining

whether certain items carried on the tax-

payer’s books as assets are “assets” as

defined in § 805(b\4) and as used to com-

pute taxpayer’s tax liability under the act.

There is an exclusion for the policyholder’s

share of the investment income as a step in

A-11

the computation of the tax. In highly sim-

plified form, the excluded portion of a com-

pany's investment income is computed as

follows:

Investment Yield = Earnings Rate

Assets

Earnings Rate X Reserves (adjusted) +

interest paid = exclusion

It is clear that the higher the amount of

the company’s assets in this formula, the

lower is its earnings rate and thus the high-

er would be its taxable share of investment

income.

The mortgage escrow funds, represented

by bank deposits in the general bank

accounts of the taxpayer, are claimed by

the company not to fall within the defini-

tion of assets for the purpose of this compu-

tation. The trial court accepted this view

of the matter and concluded that Liberty

National Life Insurance Company v. United

States, 463 F.2d 1027 (5th Cir. 1972) re

quired this result.

During the years in question, the taxpay-

er held substantial amounts of mortgages

on real estate, some having been made di-

rectly between the taxpayer and the bor-

rower and others having been made

through mortgage loan correspondents or

servicing agents who serviced the loans pur-

suant to written contracts entered into with

taxpayer. Under the standard contracts

employed by the taxpayer, the mortgagor

A-12

was required to make monthly payments

which consisted of a rcduction of principal,

interest, and a sum sufficient when added

to subsequent monthly payments to enable

the taxpayer to pay the year’s property

taxes and insurance when these items

should come due. The items other than

principal and interest are called by both

parties “mortgage escrow funds.” These

funds were deposited in the general check-

ing accounts of the taxpayer. During the

tax years, the cash of the taxpayers, which

included the escrow items, was deposited in

approximately 1500 different banks, which

held annually reported balances varying

from a few hundred dollars to approximate-

ly one million dollars.

The amount of “mortgage escrows” was

substantial, amounting on December 31,

1958 to $333,036.18 and increasing thereaft-

er to $674,608.89 in 1965.

In addition, correspondents or servicing

agents had on deposit in their general bank

accounts much more substantial amounts of

cash in 1963, 1964, and 1965 all subject to

the control of the taxpayer. The amounts

of these escrows for the tax years follows:

A-13

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All of these amounts were included as as-

sets on the Annual Statement of the tax-

payer.

A-14

Section 805(b\4) contains a definition of

the term “assets” for purposes of determin:

ing an insurance company’s earnings rate:

“For purposes of this part, the term

‘assets’ means all assets of the company

(including non-admitted assets), other

than real and personal property (exclud-

ing money) used by it in carrying on an

insurance trade or business.”

This Court has held in Liberty National

Life Insurance Co., supra, that monies held

by life insurance companies in trust belong

to someone else and are not assets of the

insurance company. Furthermore, the

Court determined that as to the escrow

funds there before the Court the company

“serves as trustee.” The Court did not

refer to the actual language of the mort-

gage instruments to show the basis for its

determination that “the monies received are

held for the use of the mortgagors. Liberty

cannot lawfully disburse these funds for

any purpose other than in satisfaction of

the trust arrangements.” 463 F.2d at 1029.

The difficulty here is that we do not

know what was stated in the mortgage

documents referred to in the Liberty Na-

tional case to cause the court to hold that

the monthly payments of the escrow

amounts created a trust for the mortgagor

with the insurance company as trustee;

nor, in this case, do we know the terms of

the agreements between mortgagors and

insurance company. The company, as

plaintiff in this refund suit, did not deem it

A-15

necessary to prove the terms under which

these payments were made to the taxpayer.

Thus, proof is lacking on whether the

agreement created a trust of the kind allud-

ed to in Liberty or merely created the rela-

tion of debtor and creditor. There is no

evidence in this record of a single document

that creates an express trust, although both

parties treated the matter as we know it

actually occurred, that is, that each dollar

deposited in the mortgage escrow account

represented a payment made by a mortga-

gor against the company’s later payment of

certain items that were payable once a

year.

Moreover, the government’s brief states

that the taxpayer has conceded in a trial“

brief that none of the mortgage documents

created an express trust. This statement is

not challenged by any of the subsequent

briefs filed by the taxpayer. Since it is

clear that the money was paid under a

written agreement and since the company

does not undertake to claim that it has

breached any trust relationship by which it

got possession of these funds or mishandled

them after receiving them, we fail to see

how a constructive trust could be impressed

on the funds as against the company. See,

e. g., Blanke nship v. Citizens Nationa] Bank

of Lubbock, 449 S. W. 2d 77, 79 (Tex. Civ. App.

1965); Nichols v. Acers Co., 415 S. W. 2d 683

(Tex. Civ. App. 1967) So far as the record

discloses the company had every right to

consider that its receipt of these funds from

A-16

the various mortgagors created merely an

obligation to pay the taxes and insurance

when they became due, a contractual obli-

gation and nothing more.

Not only did the taxpayer fail to prove

that these funds actually belonged to others

than the mortgagor by producing an agree-

ment to that effect but also the company’s

treatment of the funds was clearly incon-

sistent with its present contention that they

were trust funds. It is clear that taxpayer

did not deal with these funds in the manner

required of trustees by the Texas statutes,

article 7425b, § 10, p. 228. In Langford v.

Shamburger, 392 F.2d 939 (5th Cir. 1968),

this Court construed this statute and we

there held that it forbids a trustee from

comingling trust funds with its own, citing

and construing the Texas case, Langford v.

Shamburger, 417 S.W.2d 438 (Tex.Civ.App.

Ft. Worth, 1967, writ ref'd n. r. e.) which

in turn cites Bogert on Trusts as follows:

“The trustee may violate the duty of

loyalty by lending trust funds to himself.

He thus brings into play a conflict of

private and representative interests 4.

lender it is his duty to get the best + rm :

possible as to interest, security, and —.,

turity. As debtor his impulse is natur., 15

in che direction of getting the money :

the lowest rate and often on other tr;

not advantageous to the lender. If he

lends to himself, he cannot give an imp r-

tial judgment as to the adequacy of the

security offered.

A-17

If there is no formal loan but a trust

mingles the trust funds with his own and

uses them in his private business, the

transaction can be treated as a breach of

trust on either of two theories, namely,

that of conversion of the trust property,

or disloyalty. Bogert Trusts and Trus-

tees, 2d Ed. § 543(J), p. 548.”

417 S.W.2d at 444.

This Court then said:

Under section 10 of the Tex.

as Trust Act, the section quoted with

approval from Bogert, and the language

in Wichita Royalty Company, supra

[Wichita Royalty Co. v. City Nat. Bank,

127 Tex. 158, 89 S.W.2d 394], it is improp-

er for trustees to comingle trust funds

with personal funds and to retain large

sums of trust money in personal bank

accounts even after trust bank accounts

have been opened. To say nothing of the

cases and commentary, both practices fly

in the face of the Act’s provision against

loans of trust funds by a non-corporate

trustee to himself. (Footnote omitted).”

Furthermore, in Langford, this Court

held that Texas law mandated a holding

that the borrowing of trust funds (which

includes depositing such funds in the per-

sonal account of the borrower) constitutes

illegal self-deating “because the trustee in-

evitebly benefits, and, just as inevitably,

the beneficiaries suffer.” Id. at 944.

In Liberty, even though the Court deter-

mined that the funds there were trust

A-18

funds, we pointed out that if such funds

were used for the benefit of the insurance

company, we would consider them to be

assets within the meaning of § 805(r‘*).

We said:

“Unless it could be shown that the es-

crow funds actually were used for invest-

ment or that they had indirectly served to

permit Liberty to invest more assets than

it ordinarily could, we cannot see how it

can be said that the escrow funds were

assets of tne company. In our view the

only type of benefit which Liberty might

receive from the escrow funds, which in

turn would result in our holding that the

funds were assets within the meaning of

§ 805(bX4) would be the freeing up of

other assets Yor invesiment. Because we

find no evidence ind.cating that such ben-

efit inured to Liberty, we hold the district

court’s contrary finding to be clearly er-

roneous.”

463 F.2d at 1031.

This Court had previously held in Lang-

ford, supra, that under Texas law, which

controls here, the legal consequences of the

relationship between mortgagor and mort-

gagee here—such comingling of funds—

confer a benefit on the comingler. In that

case we said:

“In developing this idea, we will as-

sume the cash balances in the trustees’

accounts never fell below the amounts

owing from their accounts to the trusts.

(Footnote omitted). We note first that it

A-19

is both a decided advantage and an un-

usual occurrence for a person to have

large sums of money from outside sources

in his bank account for a period of years

on an interest-free basis. As part of the

same picture, we observe that those from

whom these funds are withheld are the

iosers because their money is earning no

interest. Even though the borrower nev-

er spends the money but rather lets it

stand idle so that he can always pay

whatever he owes, certain benefits never-

theless accrue to him: With a larger

account, he can borrow money from the

bank at lower interest rates, reduce the

service charges on his account, and per-

haps even become a director of the bank.

In short, the borrowed funds serve as a

cushion for his account. While the bor-

rower has this cushion, the one from

whom the money is borrowed has no op-

portunity to let his money either appreci-

ate by investment or earn interest in a

savings account. With the advantages

inherent on one side and disadvantages

on the other, it would be unthinkable for

courts to say that a trustee, on whom the

highest duty of loyalty is imposed, can be

the borrower and his trust the lender.”

Id. at 944.

Of course, we do not hold that if the

taxpayer should violate the Texas statute

with regard to the handling of trust funds

it necessarily Yollows that such funds are

not indeed trust funds. We point to this

BEST GOPY AVAILABLE

A-20

handling of the matter by the taxpayer

only to indicate that on this record which is

otherwise silent as to the existence of a

trust, the company’s conduct was inconsist-

ent with its present contention that these

funds “belong to someone else.”

Not only was the handling of these funds

by the taxpayer inconsistent with its claim

that they were trust funds but a further

distinction appears from the fact situation

which was discussed by the court in Liber-

ty. That is, that there is proof in this

record that the general funds of the compa-

ny, including the mortgage escrow

amounts, were scattered over some 1500

different banks, apparently in every ham-

let, town and village in a large area of the

southwest. It would seem that this use of

the escrow funds must have been for some

business purpose which would, of course, be

a benefit to the taxpayer which the Liberty

court found lacking.

Essentially, we have a simple issue:

Were these funds assets of the insurance

company or did they belong to someone

else? The presumption of correctness that

follows the deficiency notice places the bur-

den on the taxpayer of establishing all mat-

ters necessary to show that it does not owe

the taxes in question. Helvering v. Taylor,

293 U.S. 507, 55 S.Ct 287, 79 L. Ed. 623;

Gibbs v. Tomlinson, 362 F.2d 394 (5th Cir.

1966).

A-21

We conclude that not only did the tax-

payer not carry this burden by proof that

the money carried in these bank accounts

were not assets but the proof, such as it

was, is to the contrary. The trial court

erred in holding that these funds were not

assets of the company within the contem-

plation of the statute.

(b) Amounts Withheld from Taxpayer's

Employees and Misce!laneous Other Funds

Held by Taxpayer. These items, which to-

gether would add something over one mil-

lion dollars to the assets reportable for 1962

and in excess of two hundred thousand dol-

lars in the years 1963, 1964 and 1965, includ-

ed an item denorninated “liability for cash

held in escrow—Roberts,” “withholding

taxes—federal, state, and city,” “mortgage

participation—Sun Ray,” “amounts deduct-

ed from employees’ pay to be used for vari-

ous items” and “miscellaneous.” The

government contends that these items

should all be treated in the same manner as

are the mortgage escrow funds. The tax-

payer says with respect to these items.

“These same principles [the principles appli-

cable to treatment of ‘mortgage escrow

funds] and arguments apply with respect

to amounts withheld from taxpayer’s em-

ployees and miscellaneous other funds held

by taxpayer as agent or trustee. See

§ 7501 and Arcnell [Artnell] v. Commission-

er, 18 [48] Tax Ct 411 (1967).”

Reference to § 7501 makes it plain

that so far as the amounts included any

A-22

federal internal revenue tax, these amounts

were held by the company in trust for the

benefit of the United States. Title 26

U.S.C. § 7501 provides:

“(a) General rule—Whenever any per-

son is required to collect or withhold any

internal revenue tax from any other per-

son and to pay over such tax to the

United States, the amount of tax so col-

lected or withheld shall be held to be a

special fund in trust for the United

States. The amount of such fund shall be

assessed, collected, and paid in the same

manner and subject to the same provi-

sions and limitations (including penalties)

as are applicable with respect to the tax-

es from which such fund arose.”

The government says that this section does

not mean What it says and that it does not

create a true trust. It takes the position

that it is only when the amounts become

due and become unpaid that a true trust

relationship is created. Although the tay.

payer does not undertake to respond to thi,

argument, we are not impressed with the

idea that once the government requires the

collection by an employer of part of the

taxes owed by his employee, by deducting

the amount from the employees’ compensa.

tion and states that such amounts “shall be

held to be a special fund in trust for the

United States” it doesn’t mean precisely

what it says. Se far as these amounts an

concerned, they are not part of the taxpay.

er's assets.

A-23

In view of the fact that the taxpay-

er agrees that the same considerations that

apply to the mortgage escrow funds shail

be applied to these other items, and does

not undertake to distinguish between them,

we treat them in that manner, except for

the withheld federal internal revenue taxes.

The trial court therefore erred in excluding

such items from the company’s assets for

the tax years in question.

V. ISSUE NUMBER 4: “DUE” AND

“UNPAID” ACCIDENT AND HEALTH

PREMIUMS AS “ASSETS.”

During the tax years in question, taxpay-

er sold both cancellable and non cancellable

accident and health insurance policies in

addition to its life insurance business. The

policies typically provide for a grace period

of 31 days during which the policy remains

in force notwithstanding the failure of the

insured to pay the premium on the due

date. As of the end of each of the years in

issue, taxpayer had a substantial number of

policies in force by virtue of the grace peri-

od provision. The premiums which would

ultimately be paid on these if they were

kept in force are referred to by the taxpay-

er on its books and statements as “due and

unpaid.”

Even though taxpayer had no legal claim

or entitlement to these amounts if the poli-

cyholders should elect not to renew them,

experience had dictated that a very sub-

stantial number were actually paid and the

A-24

taxpayer included them in “admitted as-

sets” in its annual statement for the years

in question. Due and unpaid accident and

health premiums are also included in tax-

payer’s “gross premiums” in the summary

of operations section of its annual state-

ments and in its gross premiums for federal

income tax purposes. However, for the

purpose of computing its assets under

§ 805(b) of the Code, taxpayer did not in-

clude any portion of the due and unpaid

premiums.

Although the trial court held in the

government's favor as to a seemingly simi-

lar item of “due and unpaid” life insurance

premiums, which judgment has since sub-

mission of this case been partially approved

by the Supreme Court’s decision in Commis-

sioner of Internal Revenue v. Standard Life

& Accident Ins. Co. (No. 75-1771) —— U.S.

, 97 S.Ct 2523, 53 L.Ed.2d 653, dec.

June 23, 1977, the court concluded that due

and unpaid accident and health premiums

did not constitute assets based on its find-

ing that:

“No life insurance reserves are main-

tained or established as a result of the

due and uncollected premiums on acci-

dent and health policies, therefore, they

differ from deferred and uncollected pre-

miums on life insurance contracts.”

It is true that in the formula used in

determining life insurance company taxes,

the term “reserves” in the equation refers

to “life insurance reserves.” The govern-

ment concedes that there is no proof on this

A-25

record that Southwestern Life Insurance

Company set aside as a part of its life

insurance reserves any amount representing

the ordinary accident and health policies.

The taxpayer, however, concedes that such

amounts were set aside for some non-can-

cellable health and accident insurance con-

tracts.

While the taxpayer contends that

the amount set aside for such “few” policies

are entitled to a different treatment, the

trial court did not make this determination.

It found that no such reserves were set

aside even for non-cancellable policies.

This is evidently wrong. The thrust of the

Court’s opinion in Standard Life, supra, is

that if the taxpayer benefitted taxwise

from setting aside the amount as reserves,

then it must be treated uniformly when its

inclusion favors the tax gatherer. This is-

sue must be remanded to the trial court to

determine whether, and to what extent, the

setting aside of reserves for these policies

benefitted taxpayer in the several computa-

tions, and then to require a corresponding

inclusion of this amount as assets under

§ 805d).

VI. ISSUE NO. 5: “AMOUNTS IN THE

NATURE OF INTEREST”"—§ 805(e (2).

In addition to the selling of life insur-

ance, Southwestern is in the business of

administering qualified pension and profit

sharing plans. It maintains life insurance

reserves with respect to the contracts set-

ting up these plans. Under state law, the

ee ee

A-26

maximum interest rate taxpayer can use in

computing these reserves is 3½ . In order

to de competitive with banks and Other

financial institutions that administer pen-

sion plans, taxpayer enters into an agree-

ment with the plans that purchase its con-

tracts in which it agrees to pay these plans

an annual amount in excess of the 3'4%

interest used in computing the reserves.

The taxpayer is enabled to do this because

it actually earned on its investments of the

reserves substantially in excess of 34%

This excess, of course, does not become a

part of the reserves; nevertheless, in an

equation’ utilized by the statute to deter-

mine the exclusion from investment earn-

ings of that part of investment income

deemed to be the policyholder’s share, the

statute treats all income derived from re-

serves uniformly. That is to say, the stat-

ute provides for an equation to determine

the exclusion from the taxable investment

income which gives the same effect in the

ultimate determination of tax liability to

that part of the income which is added to

the reserve and to that part which is in

excess of the statutory rate. That equation

is expressed as follows:

“policy and other contract liability

requirements

total investment yield

x

each item of investment

yield

= exclusion for policyholders’ share.”

Nee SaaS

A-27

It will be apparent that an increase in the

numerator of this fraction would increase

the exclusion for the policyholders’ share

and thus decrease the taxable portion of

investment income

The numerator “policy and other contract

liability requirements” is equal to the sum

of three items (§ 805Xa)):

1) the adjusted life insurance reserves,

multiplied by the adjusted reserves

rate,

2) the mean of the pension plan reserves

at the beginning and end of the taxa-

ble year, multiplied by the current

earnings rate, and

3) the interest paid.

Thus far, there appears to be no ambigui-

ty. But § 805(e\2) provides that “the in-

terest paid for any taxable year” includes:

J.. . (2) Amounts in the nature of

interest.— All amounts in the nature of

interest, whether or not guaranteed, for

the taxable year on insurance or annuity

contracts (including contracts supplemen-

tary thereto) which do not involve, at the

time of accrual, life, health, or accident

contingencies.”

It is only under this provision that the

taxpayer claims that the payments of the

“excess interest” are deductible as “interest

paid” as one of the three elements constitu-

ting the numerator of the above fraction.

A-28

The commissioner contends that a proper

interpretation of this section under normal

rules of grammar would preclude the use of

these payments to increase the amount of

“interest paid” and furthermore that any

different construction would, in effect, give

a double benefit to the taxpayer because

the excess earnings on its reserves, as we

have already pointed out, have already been

included in the numerator of the fraction

because al] of the company’s earnings on

reserves, including the excess over the 32%

rate, have been included in the term “the

adjusted life insurance reserves.”

The taxpayer does not deny that its con-

struction of & 805(e\2) provides some in-

creased benefits to the extent that it is

permitted to deduct as interest amounts

which it has never reported as income.

However, it contends that Congress intend-

ed to achieve this result in order to equalize

insurance companies engaged in this busi-

ness with non-insurance company competi-

tors. The record docs not indicate to what

extent the special tax provisions for insur-

ance companies places them in a competi-

tive position with others. We can't simply

construe one provision of the definition of

interest as one part of a complex formula

for determining taxable income for an in-

surance company by comparing it with

some particular part of an ordinary income

tax statute affecting non-insurance compa-

ny taxpayers. ‘Taxpayer also contends that

a proper construction of § 805{eX2) would

yield the result for which it contends.

A-29

The construction argument revolves

around the question whether the words

“which do not involve, at the time of accru-

al, life, health, or accident contingencies”

modify the word “amounts” or the word

“contracts.” The taxnayer cuntends that

the section should be construed to read as

follows: “All amounts in the nature of in-

terest . for the taxable year

which do not involve, at the time of accrual,

life, health or accident contingencies.”

The government concedes that if this is

the proper construction, then these amounts

do become ailowable as interest. However,

it contends that the section should be con-

strued to read as follows: “All amounts in

the nature of interest . for the

taxable year on insurance or annuity con-

tracts which do not involve, at

the time of accrual [of the amount], life,

health, or accident contingencies.” Citing

Strunk & White, The Elements of Style,

1962 ed., pp. 22-24, the government says it

is a basic rule of English grammar that

modifiers in a sentence should be piaced,

whenever possible, next to the word they

are intended to modify. Under this rule, of

course, the words “which do not involve, at

the time of accrual, life, health or accident

contingencies” would modify the word

“contracts” and would not modify the word

“amounts.” It is clear that if the phrase

modifies “contracts” the trial court was in

error in sustaining the taxpayer's position

A-30

because it is plain that the contracts do

involve life contingencies.

It seems unlikely that in drafting such a

provision as this, Congress would use a

structure that doesn’t make sense, which

would be the case if we construed the sec-

tion to mean “all amounts . which

do not involve . . . contingencies.”

It is not plain how “an amount,” presuma-

bly accrued on the books, could “involve, at

the time of accrual, life, health, or accident

contingencies.” What does this mean?

How does an amount ever involve any-

thing? In order to give it meaning, the

taxpayer must interpret it as saying “all

amounts whose computation does not in-

volve, etc.”

On the contrary, the straightfor-

ward reading of the section points to the

interpretation urged by the commissioner

since it has a complete meaning as written.

That is, “all amounts in the nature of inter-

est on insurance or annuity con-

tracts . . Which do not involve, at

the time of accrual . . . contingen-

cies.” Here it is plain that these contracts

did involve “life, health, or accident contin-

gencies” and, therefore under this interpre-

tation the amounts did not meet the re-

quirements of the section.

Moreover, as pointed out by the commis-

sioner, substantial amounts earned on the

reserves in excess of the 3%% rate, al-

though not required or permitted to be re-

A-31

tained as reserves, were nevertheless uti-

lized by the company as part of the reserves

to increase the size of the numerator of the

fraction. If taxpayer is permitted to add as

a third clement of the numerator in addi-

tion to the life insurance reserves and the

pension plan reserves, an item of interest

which largely corresponds with untaxed in-

vestment income-held for the company’s

use, this would clearly give 2 double benefit

to the taxpayer for this item to the extent

that they were the same.

We conclude, therefore, that a construc-

tion of § 805({e\2) that the words “which do

not involve, at the time of accrual, life,

health, or accident contingencies” modify

the word “contracts” rather than the word

“amounts” is more nearly in accord with

the Congressional purpose. The trial court

erred in holding to the contrary.

VIL ISSUES ON CROSS-APPEAL.

As stated by the taxpayer in its cross-ap-

peal from those parts of the judgment of

the trial court adverse to it, the issues on

cross-appeal are:

(1) Whether the district court erred in

holding that the cost of policies ac-

quired through an assumption reinsu-

rance transaction was not deductible

in full in the year of the transaction;

(2) Whether the district court érred in

holding that unearned interest on so-

called policy loans constitutes taxable

investment income;

Nee rr.

A-32

(3) Whether the district court erred in

holding that in computing the special

deduction for increases in reserves

for non-participating contracts under

Sec. 809(d)\5), the reserves for con-

tracts which become participating

during the taxable year were includ-

able in the beginning of the year

reserves;

(4) Whether the district court erred in

holding that losses for bad debts on

advances to life insurance agents

were not deductible in computing net

investment income under Sec. 805;

(5) Whether the items of deferred and

uncollected premiums on life insur-

ance and annuity contracts, accident

and health premiums due and un-

paid, unearned interest on policy

loans, advances to life insurance

agents, amounts due from reinsurers,

participation interest in reinsurance

pools, unamortized cost of assump-

tion reinsurance, mortgage escrow

funds and amounts held by taxpayer

as agent or trustee for others consti-

tuted “assets” within the meaning of

Sec. 805(b)(4) of the Internal Reve-

nue Code.

VIII. CROSS-APPEAL ISSUE NO. 1:

CURRENT DEDUCTIBILITY OF

AMOUNT PAID FOR ACQUISITION

OF ATLANTIC LIFE INSURANCE

COMPANY STOCK.

A-33

In 1961, taxpayer purchased the entire

capital stock of the Atlantic Life Insurance

Company from its sole stockholder, Life

Companies, Inc. The total price for the

acquisition was $128,226,896 which was rep-

resented by cash of $29,000,000, reserve re-

quirements assumed $94,536,860, other lia-

bilities assumed $4,690,036. Taxpayer re-

ceived tangible assets agreed to have a fair

market value of $118,798,778, leaving an

excess of $9,864,131 which it allocated on its

books to the value of the “insurance in

force” acquired from Atlantic. It is not

-disputed that taxpayer was willing to pay

this amount more than the fair market

value of the assets it received because of its

expectations of profiting in the future from

the insurance contracts which had already

been written by Atlantic. The taxpayer

deducted the full amount of $9,864,131 as

an ordinary and necessary business expense

in the nature of commissions. The Commis-

sioner disallowed the deduction but allowed

ihe taxpayer to amortize the amount over

the average life of the policies, determined

to be ten years. The trial court sustained

the Commissioner’s position.

The Commissioner supports the trial

court’s decision upon the fundamental prin-

ciple of federal taxation that the cost of

acquiring a capital asset may not be cur-

rently deducted but rather must be amor-

tized or depreciated over the useful life of

the asset. On the other hand, the taxpayer

—. . — — . — — — . —

A-34

contends that all costs of “putting policies

on the books” are currently deductible as a

cost of doing business whether such cost is

represented by payments to salesmen cur-

rently selling the company’s policies or in

payment for the 100,000 policies theretofore

vritten by Atlantic.

Treasury Regulation 1.87--4 supports the

Commissioner's view of the matter. Ii pro-

vides:

Special Rules.

(d) Certain other reinsurance trarsgae-

tions.

(ii) In connection with an assurnption

reinsurance (as defined in paragraph

(aX7\ii) of § 1.809-5) transaction, a rein-

after December 31, 1957.

(d) Treat any amount paid to the rein-

sured, to the extent such amount meets

the requirements of section 152, as a de-

ferred expense under section 80%¢\12)

and amortize such amount over the rea-

sonably estimated life (as defined in sub-

division (iii) of this subparagraph) of the

contracts reinsured, irrespective of the

taxable year in which such amount was

paid to the reinsured.”

The taxpayer claims that this regulation

has no statutory support, is contrary to the

clear congressional mandate and is there-

fore invalid.

A-35

It cannot be gainsaid that the govern-

ment’s basie premise is correct. That is, as

stated in Woodward v. Commissioner of In-

ternal Revenue, 397 U.S. 572 at 574, 90

S.Ct. 1302, at 1304, 25 L.Ed.2d 577:

“Since the inception of the present fed-

eral income tax in 1913, capital expendi-

tures have not been deductible. (Foot-

note omitted). See Internal Revenue

Code of 1954, § 263. . . lk an

expense is capital, it cannot be deducted

as ‘ordinary and necessary,’ either as a

business expense under § 162 of the code

or as an expense of ‘management, conser-

vation, or maintenance’ under § 212

(Footnote omitted).”

Thus, it is clear that unless there is some

provision peculiar to the taxation of insur-

ance companies that makes an exception to

this rule the amount paid by the taxpayer

here for the asset represented by the out-

standing policies acquired from A:!sntic

cannot be deducted currently, but mast l=

deducted on an amortized basis as provided

by the approp.icte treasury regulation.“

1. The taxpayer contends that this regulation

does not fit a situation where the amount paid

is not paid to the “reinsurer™ but is paid to the

owner of the reinsured’s capital stock. This

argument, it seems to us, backfires in the sense

that if this agreement, which was a three-way

contract including an agreement with the rein-

sured to reinsure its policies does not fall with-

in the language of the regulations, because the

purchase price was paid to someone other than

the reinsured itself, it is clearly then the price

paid by the taxpayer to acquire the capital

stock of a life insurance company, which by all

definitions would be a capital expenditure.

A-36

Moreover, this Court has heretofore

analyzed the effect of such a contract. In

Mutual Savings Life Ins. Co. v. United

States, 488 F.2d 1142 (C.A.5 1974) we held

expressly that “if the reinsurer has paid

consideration for the policies, the payment

cannot immediately be deducted, but must

be amortized over the estimated life of the

contracts.” 488 F.2d 1142, 1144. Here, it is

plain from the undisputed evidence at the

trial, that the $9,800,000 was paid as consid-

eration for the outstanding policies.

The taxpayer’s effort to equate the cur-

rent deductibility of commissions paid in

the life insurance industry to agents who

put new policies on the books of the compa-

ny with the payment of $9,800,000 for the

acquisition of some 100,000 outstanding pol-

icies is not an apt comparison. Atlantic has

already paid commissions to its agents for

the acquisition of these same policies and

the value of the policies to the taxpayer

here in no way represents that cost of put-

ting the business on the books of the com-

pany. It represents, instead, an estimate of

the current value to the taxpayer that is

represented by having these policies on its

books with the expectation of the continu-

ing premiums to be paid in the future.

This may or may not approximate the total

loading cost to Atlantic. Certainly it can-

not be said to proximate the amounts paid

as commissions when the policies were orig-

inally solicited. Southwestern points to no

statutory provision, other than the general

A-37

statutory authorization for the deduction of

current expenses on which it seeks to rely

as a basis for its broad contention that any

payment that may be required as a cost of

putting the business on the books must be

currently deductible.

The trial court correctly decided this issue

in favor of the government.

IX. CROSS-APPEAL ISSUE NO. 2:

TREATMENT OF ADVANCE IN-

TEREST ON POLICY LOANS.

As provided for by the terms of the

insurance policies issued by the taxpayer,

Southwestern made loans to its policyhold-

ers, the insurance contracts providing such

loans would be made up to the amount of

the cash surrender value of the individual

policy. Under the express terms of the

policy, interest was paid in advance to the

end of the policy year, and annually there-

after, in advance, on the policy anniversary

date for the ensuing year. Payment of

interest in advance could be accomplished in

one of two ways. The policyholder could

pay the company in cash for the year's

interest or the company would advance to

him the amount of the loan requested less

5% for the remaining term of the policy

year. Interest for the ensuing policy year

which was not paid in cash was added in

advance to the amount of the principal

debt. In either event, when cash was not

paid for advance interest, the cash surren-

I

A-38

der value of the policy was reduced by such

amount. Under the policy agreement, any

prepayment of the loan before the end of

the policy year would require repayment by

the taxpayer of the rateable amount of

unearned interest. ‘The same thing oc-

curred if the policyholder should surrender

his policy for the cash value or if he should

die during the policy year.

The taxpayer showed such amounts of

interest for the entire term of the policy

loan on its books as “interest on policy

loans.” Neverthcless, the taxpayer report-

ed only such part of these payments as

represented a ra eable amount of interest

up to the end of the tax year, rather than

the full amount collected as investment in-

come. The government contends, and the

trial court held, that the entire amount

collected by the taxpayer as “interest on

policy loans” was taxable when received or

charged against the policy’s cash surrender

value.

The taxpayer undertakes to support a

thesis that this transaction was not a loan

at all, but merely a return to the taxpayer

of a part of the value of his policy—in other

words, a partial cash surrender.

The method which taxpayer used in keep-

ing its books of account by accruing the

emtire amount oj interest, even though tax-

payer may, in the event of prepayment or

death of the policyholder, be required to

make a repayment of a rateable amount, is

A-39

consistent with the accrual basis of account-

ing. There is no reason to permit the tax-

payer, for tax purposes only, to treat a

transaction which it and the policyholder

expressly considered to be a loan and the

payment of interest to be something entire-

ly different. This is the view taken by the

Court of Appeals for the Fourth Circuit in

Jefferson Standard Life Ins. Co. v. United

States, 498 F.2d 842, 856-857 (C.A.4 1969)

and the Seventh Circuit in what we con-

clude is a comparable situation in Franklin

Life Ins. Co. v. United States, 399 F 94 757,

762-763 (C.A.7 1968).

Even though we were not to hold that

the legal result is as followed by these two

courts, it is true, as the government points

out, that no proof was introduced in this

record to show what proportion of the total

amounts in dispute dealing with this issue

were amounts actually paid in cash by the

policyholder, and thus clearly reportable as

interest and what amount was simply

charged against the cash surrender value of

the policy. The burden is, of course, on the

taxpayer to show his entitlement to recover

in a suit of this kind and such failure of

proof would bar recovery of the amounts

involved in this issue in any event. The

trial court correctly held for the United

States on this issue.

X. CROSS-APPEAL ISSUE NO. 3:

COMPUTATION OF SPECIAL DE-

DUCTION FOR INCREASES IN RE-

A-40

SERVES UNDER § 80%d\5) FOR

THE YEAR DURING WHICH SUC#

CONTRACTS BECOME PARTICI-

PATING CONTRACTS.

The taxpayer’s claim here arises

from a provision of the statute which pro-

vides a special deduction to insurance com-

panies if during the year there is an in-

crease in the company’s reserves for its

nonparticipating contracts. This deduction

amounts to 10 percent of the increase dur-

ing the taxable year in a company’s re-

serves for its nonparticipating contracts.

2. Section §09(d)(5) provides as follows:

0d) Deductions. For purposes of subsection

d)) and (2) there shall be allowed the fol-

lowing deductions: . ..

(5) Certain nonparticipating contracts — An

amount equal to 10 percent of the increase

for the taxable year in the reserves for non-

participating contracts or (if greater) an

amount equal to 3 percent of the premiums

for the taxable year (excluding that portion

of the premiums which is allocable to annuity

features) attributable to nonparticipaung

contracts (other than group contracts) which

are issued or renewed for periods of 5 years

or more. For purposes of this paragraph, the

term “reserves for nonparticipating con-

tracts” means such part of the life insurance

reserves (excluding that portion of the re-

serves which is allocable to annuity features)

as relates to nonparticipating contracts (oth,

er than group contracts). For purposes of

this paragraph and paragraph (6), the term

“premiums” means the net amount of the

premiums and other consideration taken into

account under subsection (cl).

A-41

As pointed out by the taxpayer, Congress

recognized that companies issuing nonpar-

ticipating contracts need an additional re-

serve cushion. The government does not

contest the theory upon which Congress

authorized this additional 10 percent deduc-

tion. It merely questions the manner in

which the annual increase is computed.

The government takes the position that

there is a clearly recognized amount on the

taxpayer’s books at the beginning of the

year representing Reserves for Nonpartici-

pating Contracts and that there is a corre-

sponding figure at the end of the tax year.

If the figure at the end of the year exceeds

that at the beginning of the year, the

government contends, then the 8.09(d)5)

deduction of 10 percent of that difference is

available to the taxpayer. The insurance

company, on the other hand, claims that the

difference should be greater than that ar-

rived at by the simple calculation of sub-

tracting the beginning figure from the clos-

ing figure for the year. It says that the

reserves attributable to those contracts

which are converted from nonparticipating

to participating during the year should be

excluded from the opening amount of capi-

talized reserves for nonparticipating con-

tracts at the beginning of the year because

there will be no reserves attributed to such

contracts at the end of the year because in

the meantime they have become participat-

ing contracts.

A-42

We conclude as did the trial court that

this construction by the taxpayer is not

based on any reasonable construction of the

statute or regulations. Congress was con-

cerned about the impact of an increase in

any reserves required for nonparticipating

contracts in gross, that is to say, it viewed

the financial impact on a stock company,

when compared with mutual insurance com-

panies, by having to increase its reserves

during a particular tax year. In our opin-

ion, it makes no difference what caused the

increase or decrease during the year,

whether increased by the writing of new

business or whether decreased by death of

the policyholder, surrender of the policy or

conversion from 4 nonparticipating to a

participating contract. We conclude that

the opening figure is to be subtracted from

the closing figure and the 80%d)5) deduc-

tion applied to the difference, as was decid-

ed by the trial court.

XI. CROSS-APPEAL ISSUE NO. 4:

LOSSES FOR BAD DEBTS ON AD-

VANCES TO LIFE INSURANCE

AGENTS AS DEDUCTIBLE IN COM-

PUTING NET INVESTMENT IN-

COME.

During the years 1961 through 1965,

Southwestern charged off as worthless bad

debts, advances it had previously made to

former life insurance agents no longer em-

ployed by the company. These amounts

were substantial. Taxpayer claims a de-

duction of these amounts as for bad debt

A-43

losses from gross investment income in de-

termining net investment vield.

The taxpayer found it necessary in en-

gaging life insurance agents to make ad-

vances to them until such time as they were

producing enough commissions to maintain

their standard of living. All income from

the taxpayer earned by an agent is repre-

sented by commissions based on life insur-

ance business written. The agents contin-

ued to receive such advances until such time

as their commission exceeded their monthly

advances and thereafter the excess over the

monthly advance was applied to reduce the

balance which had been accumulated. Only

one out of three agents continue with the

company for more than two years. There-

fore many agents terminate their relation-

ship before the entire amount of advances

has been recovered by the taxpayer. It is

clear from the record that when these ad-

vances are originally made they are made

as a loan to the agent. The company

charges 4 percent interest on the outstand-

ing balances of the advances and sends a

letter to the agent each month showing the

state of his account. Following the termi-

nation oi an agent, it is the taxpayer's

policy and practice to leave all unpaid ad-

vances outstanding until such time as all

commissions have been collected and ap-

plied to the account. Thereafter, for some

period of time, a monthly statement is sent

to the agent showing the amount of the

unpaid advances and the amount of his

commissions, if any. When the taxpayer

A-44

has credited an agent’s account with all of

the commissions to which he is entitled, the

agent is so advised in a letter as folluws:

“Since the advances we made to you as

an agent for our Company were in the

form of a Joan against your future com-

missions, we are required by the Internal

Revenue Service to report as income to

you, in the year in which it charged off,

the portion of the indebtedness that was

not repaid by the commissions credited to

your account. [Emphasis add-

ed.]

With respect to this matter, the trial

court made the following findings of fact:

‘{Tyhe Court finds that in January of

the year after all commissions generated

by agents who have been disassociated

with the company are applied against the

balances due from the advances previous-

ly made, the taxpayer writes off those

balances as bad debts. . . . The

Court further finds that it is an industry-

wide practice to make these advances to

new agents and that it is well understood

within the industry that the insurance

company will not proceed against agents

to collect unrepaid balances following dis-

association.”

It is without dispute that no effort is

made by the company either to ascertain

the solvency and ability of such agents to

repay to the company the amount of these

advances or to collect them. The company

does not even demand repayment, but in-

stead merely cancels the amount on the

A-45

books and notifies the former agent that it

is reporting the cancellation for income tax

purposes as though the amounts were being

paid as income to the former agent.

From this state of the record, the trial

court found that the taxpayer could not

take a bad debt loss deduction for these

sums in the tax year when the debts were

forgiven.

“The question of the worthlessness of

[a] debt zs essentially one of

fact. The burden rests on the petitioner

to establish this fact by a preponderance

of the evidence. Lunsford v. Commis-

sioner of Internal Revenue, 5th Cir. 1954,

212 F.2d 878.”

Eagle v. Commissioner of Internal Reve-

nue, 242 F.2d 685 (5th Cir. 1957).

While the trial court did not an-

nounce a conclusion in his conclusions of

law dealing with the deductibility of these

items as bad debts, its judgment in favor of

the government of the amounts represented

by this issue was tantamount to a finding

of fact that the plaintiff taxpayer had

failed to meet this standard of proof. The

trial court could not have found otherwise.

The taxpayer elected to call this advance a

loan and treated it as a loan bearing inter-

est at 4 percent. The forgiveness of the

amount was also described in the last com-

munication from the company to the agent

as a “loan.” While it is not required that

A-46

legal action to enforce collection be taken to

establish worthlessness where there is a fac.

tual basis for the finder of facts to deter-

mine that a debt is worthless and uncolleeti-

ble, Treasury Regulations § 1.166 -2(b),

there is no justification for the theory that

a debt can be deducted as worthless under

§ 166 merely because the creditor elects not

to enforce the obligation. See for discus-

sion, 5 Mehrten's Law of Federal Income

Taxation, § 30.39, pp. 98-99.

Furthermore, there is no more merit in

taxpayer’s contention as an alternative, if

the Court holds that a bad debt deduction is

not available, then the advances should be

considered as additional compensation to

the former agents at the time payments

were made. These payments were not in-

tended by the parties to be compensation

when the advances were made, but were

considered by the parties to be the creation

of adebt. To be sure the forgiveness of the

debt, at a period considerably later, after

termination of employment, did create an

obligation on the part of the former agent

to report a forgiveness of the debt as in-

come to him at the time it occurred. That

is the only year in which the debt was

translated into additional compensation to

the former agent.

The trial court’s judgment against the

taxpayer with respect to this item was cor-

rect.

A-47

XII. CROSS-APPEAL ISSUE NO. 3:

ARE (A) DEFERRED AND UNCOL-

LECTED PREMIUMS ON LIFE IN-

SURANCE AND ANNUITY CON-

TRACTS (B) “UNEARNED” INTER-

EST ON POLICY LOANS; (C) AD-

VANCES TO INSURANCE AGENTS;

(D) AMOUNTS DUE FROM REIN-

SURERS; (E) TAXPAYER’S PAR-

TICIPATION INTEREST IN REIN-

SURANCE POOLS; AND (F) THE

UNAMORTIZED COST OF INSUR-

ANCE POLICIES IN FORCE AC-

QUIRED FROM ATLANTIC LIFE

“ASSETS” OF THE TAXPAYER

WITHIN THE MEANING OF § 80)

OF THE CODE?

In stating this issue, we have utilized the

statement from the government’s brief

rather than that of the cross-appellant, be-

cause the taxpayer lumps together under

this issue two other items with which we

have already treated in this opinion, to-wit:

(1) whether accident and health premiums

due and unpaid and (2) mortgage escrow

funds in amounts held by taxpayer as agent

or trustee for others are “assets” within the

meaning of 5 805b).

Southwestern makes an underlying argu-

ment in its attack on the government's pasi-

tion that these items are to be considered

within the definition of “assets” under

§ 805(b). This argument, briefly put, is

that the term “assets” as used in this sec-

tion was intended to include only those

A-48

items of property which actually produced

income and were includable as investments

under § 804(b), plus money belonging to the

company; that items which do not actually

rontribute to investment income, as this

argument goes, arise out of the insurance

trade or business, and therefore under the

definition section do not belong to the tax-

payer or do not constitute property and are

excludable from the asset definition. As

was the trial court, we remain unconvinced

that the legislative history requires a con-

struction of the definition of assets so limit-

ed as propounded by the taxpayer. How-

ever, we no longer need consider this ques-

tion, because it has been answered defini-

tively by the Supreme Court in Commis-

sioner of Internal Revenue v. Standard Life

& Accident Insurance Co. (No. 75-1771),

— US. , 97 S.Ct. 2523, 53 L.Ed.2d

653, dec. June 23, 1977. This follows inevi-

tably from the decision of the Supreme

Court which held that the “net valuation”

portion of unpaid life insurance premiums

must be ineluded in a life insurance compa-

ny's assets, the i:sue discussed infra under

A. It is clear that no part of such unpaid

premiums produce any income for the tax-

payer, yet the court found them to be as-

sets.

A. Deferred and Uncollected Premiums.

As is common in the life insurance

industry, taxpayer's policyholders may elect

to pay premiums on life insurance and an-

A-49

nuity contracts in semi-annual, quarterly or

monthly installments. The portions of the

gross annual premiums which are not due

until after December 31 of each year, and

which in fact remain unpaid as of that time,

are generally referred to as “deferred” pre-

miums. Furthermore, as a general rule

such contracts provide for a grace period

during which the policy remains in force

notwithstanding the failure of the insured

to pay the required premium. At the end

of fhe years in issue, taxpayer had a num-

ber of policies in force by virtue of the

grace period provision. Premiums owing

but uncollected with respect to those poli-

cies as of December 31 of each year are

normally referred to as “due and unpaid.”

We refer to these two classifications as

“deferred and uncollected” premiums. The

method of dealing with these items for tax

purposes has been much mooted in the

courts, this Court in Western National Life

Insurance Co. of Texas v. Commissioner of

Internal Revenue, 432 F.2d 298 (5th Cir.

1970) having held that Since the insurance

companies accrued these items in comput-

ing their. reserves they would have to ac-

crue them for all other purposes, including

inclusion as assets under § 805(bX3). Other

Circuits arrived at the same conclusion, see

Jefferson Standard Life Ins. Co. v. United

States, 408 F.2d 842 (C.A.4 1969), cert. de-

nied 396 U.S. 828, 90 S.Ct. 77, 24 LEd2d

78; Western & Southern Life Ins. Co. v.

Commissioner of Internal Revenue, 460

A-50

F.2d 8 (6th Cir. 1972), cert. denied 409 U.S.

1063, 93 S.Ct. 555, 34 L.Ed.2d 517; Franklin

Life Ins. Co. v. United States, 399 F.2d 757

(7th Cir. 1968). The Court of Appeals for

the Tenth Circuit disagreed, Standard Life

& Accident Ins. Co. v. Commissioner of

Internal Revenue, 525 F.2d 786 (10th Cir.

1976), and created a conflict which has now

been resolved by the Supreme Court.

The Supreme Court recognized that the

statute which in § 818 provided for the use

for computation purposes either of an ac-

crual method of accounting or a combina-

tion of an accrual method with any other

except cash receipts and disbursements fur-

ther provided “except as provided in the

preceding sentence, all such computations

shall be made in a manner consistent with

the manner required for purposes of annual

statement approved by the National Associ-

ation of Insurance Commissioners.” The

Court then said:

The legislative history makes it clear

that the accounting procedures estab-

lished by the NAIC apply if they are ‘not

inconsistent’ with accrual accounting

rules. (Footnote omitted). In other

words, except when the rules of accrual

accounting dictate a contrary result

NAIC procedures ‘shall’ apply. (Footnote

omitted).” —— US. at , 97 S.Ct. at

2529.

Commissioner of Internal Revenue v.

Standard Life & Accident Ins. Co., supra.

A-51

The NAIC procedure as to the treatment

of deferred and unpaid premiums is to re-

quire the inclusion of the “net valuation”

portion of such premiums but not the “load-

ing” portion in the reserves and also in the

assets. The “net valuation premium” is

that part of the premium determined under

mortality and interest assumptions that

must be held to assure that the company

will have sufficient funds to pay death ben-

efits. The rest of the premium is called

“loading” and covers profits and expenses

such as salesmen’s commissions, state taxes,

and overhead.

The trial court’s treatment of this item

was in accord with our earlier decision in

the Western National Life case which has

now been partially overruled. The final

disposition of the amounts involved under

this issue can, however, be readily as-

certained, since the Court has now mandat-

ed the treatment of this item for tax pur-

poses in the same manner as is required to

be accounted for in the statement pre-

scribed by NAIC.

B. “Unearned” Interest on Policy Loans.

In Part IX, supra, we held that the

amount charged by the company as interest

on policy loans to its policyholders is includ-

able in taxpayer’s investment income. In

doing so, we rejected taxpayer’s argument

that such amounts were not truly interest

because the policy loans were not real loans.

A-52

Taxpayer here argues that such accrua! a-

terest is not includable as an asset fur the

same reason. We reject this argument for

the same reason.

We have heretofore held that such inter-

est is to be accounted for as income be

such policy loans are to be treated for tax

purposes as the “loan” which the company

says they are in its dealings with its policy-

holders.

The trial court therefore correctly held

that this item should be included in the

§ 805(b) assets.

C. Advances to Insurance Agents; (D)

Amounts Due From Reinsurers; (E)

Taxpayer's Participation Interest in

Reinsurance Pools; and (F) The Un-

amortized Cost of Insurance Policies

in Force Acquired from. Atlantic

Life.

Aside from its underlying argu-

ment, previously discussed, to the effect

that only those assets which produced in-

come are to be included under § 80X(b), an

argument now foreclosed by Standard Life,

supra, taxpayer cites no authority for its

contention that the trial court erred in its

disposition of these four last issues) The

amounts representing each of these items,

as recognized by the trial court, must be

included in assets because of the broad defi-

nition of the term used in the statute and

A-53

the underlying regulations as interpreted

by the courts. See Je Terson Standard Life

Ins. Co. v. United States, 408 F.2d 842 (4th

Cir. 1969) and regulations § 1.805-

SaX4Xiii), § 1.805-5(aX4 Xi).

The judgment is +: cated and the case is

remanded to the trial court for further pro-

ceedings consietent with this opinion. Each

party shall bear its own costs.

B-1

APPENDIX B

Southwestern Life Insurance Company, Plaintiff

v. United States of America, Defendant.

Southwestern Life Insurance Company, Plaintiff v.

United States of America, Defendant.

U. S. District Court, No. Dist. Tex, Dallas

Div., Civil Action Nos. CA-3-3003-D, CA-3-3210-D,

1/29/75.

Findings of Fact and Conclusions of Law

(THIS PAGE LEFT BLANK INTENTIONALLY] Hm, District Judge: This action was

tried before the Court without a jury. After

considering the pleadings, stipulations of

the parties, testimony, documents admitted,

and arguments of counsel, the Court makes

and enters its findings of fact and conclu-

sions of law as follows:

Findings of Fact

1. This is an action for recovery of fed-

eral income taxes and interest paid by the

plaintiff, Southwestern Life Insurance Com-

pany (hereinafter referred to as “tax-

payer”), for its calendar years 1958 through

1965. Taxpayer is organized and operated

as a life insurance company, and was in-

corporated under the laws of Texas on

March 10, 1903, with its offices and prin-

cipal place of business at Dallas, Texas.

Defendant is the United States of America.

B-2

2 The taxpayer timely filed its federal

income tax return for the year 1958 on

Form 1120L, and paid the amount of in-

come tax liability shown to be due thereon

of $882,679.88. After examination, the Gov-

ernment assessed a deficiency in the amount

of $1,250,137.36 ($1,052,340.58 in tax and

assessed interest of $197,796.78), which was

paid on November 2, 1962 (the tax), and

on December 18, 1962 (the interest). On

June 1, 1964, taxpayer filed with the District

Director of Internal Revenue a claim for

refund in the amount of $1,043,205.16 (tax

only; assessed interest with respect thereto

was claimed but not specifically computed).

This claim for refund has never been de-

nied by the Government, but more than

six months has elapsed since its filing.

3. Taxpayer timely filed its federal in-

come tax return for the year 1959 on Form

1120L, and paid the amount of income tax

liability shown to be due thereon of

$1,217,775.93. Following examination of

that return, the Government assessed a de-

ficiency of $1,723,933 ($1,488,886.13 in tax

and $235,046.87 in assessed interest). On

November 2, 1962, taxpayer paid the de-

ficiency in tax and on December 18 the

interest, and on June 1, 1964, it filed with

the District Director of Internal Revenue

a claim for refund in the amount of

$1,310,612.60. (This amount was for assessed

tax only. Although taxpayer claimed also

assessed interest with respect thereto, it

did not compute the amount.) That claim

for refund has never been denied by the

B-3

Government, but more than six months has

elapsed since it was filed. On January 17,

1969, an over-assessment in the amount of

$64,644.96 ($55,824.64 in tax and $8,820.32

in interest) was credited to the taxpayer’s

account with respect to the 1959 assess-

ment.

4. Taxpayer timely filed its federal in-

come tax return for the year 1960 on Form

1120L and paid the amount of income tax

liability shown to be due thereon of

$1,003,778.38. Following examination, the

Government assessed a deficiency in the

amount of $1,808,095.18 ($1,612,001.34 in tax

and $196,093.84 in assessed interest). These

deficiencies were paid on four dates. Tax

in the amount of $1,184,726.58 was paid on

November 2, 1962. Interest in the amount

of $116,064.72 was paid on December 18,

1962. Tax in the amount of $427,274.76 was

paid on April 29, 1964, and interest in the

amount of $80,029.12 was paid on May 13,

1964. On or about June 1, 1964, taxpayer

filed with the District Director of Internal

Revenue a claim for refund for the year

1960 in the amount of $1,648,711 ($1,452,617

in tax and $196,094 in assessed interest).

Although this claim for refund has never

been denied by the Government, more than

six months has elapsed since it was filed.

5. Taxpayer timely filed its federal in-

come tax return for the year 1961 on Form

1120L and paid the amount of income tax

liability shown to be due thereon of

$2,062,774.17. Following examination, the

Government assessed a deficiency of

B-4

$1,320,748.08 ($1,086,255.61 in tax and

$234,492.47 in interest). This amount was

paid on March 3, 1969. Taxpayer filed its

claim for refund on May 22, 1969, in the

amount of $1,320,748 ($1,086,256 in tax and

$234,492 in interest). This claim was denied

by letter of May 22, 1969.

6. Taxpayer timely filed its federal in-

come tax return for the year 1962 on Form

1120L and paid the amount of income tax

liability shown to be due thereon of

$2,513,127.66. Following examination, the

Government assessed a _ deficiency of

$652,224.65 ($533,606.13 in tax and

$118,618.52 in interest). Taxpayer paid the

deficiency on March 6, 1969. Taxpayer filed

its claim for refund on May 22, 1969, for

the full amount of deficiency assessed and

collected, which claim was denied by letter

of that same date.

7. Taxpayer timely filed its federal in-

come tax return for the year 1963 on Form

1120L and pzid the amount of income tax

liability shown to be due thereon of

$2,604,701.66. After examination, the Gov-

ernment assessed a deficiency in the amount

of $815,120.11 ($631,715.06 in tax and

$183,405.05 in interest), which was paid by

taxpayer March 6, 1969. On May 22, 1969,

taxpayer filed with the District Director of

Internal Revenue a claim for refund for the

year 1963 in the total amount of the defi-

ciency. This claim was denied by letter of

May 22, 1969.

8 Taxpayer timely filed its federal in-

come tax return for the year 1964 on Form

B-5

1120L and paid the amount of income tax

liability shown to be due thereon of

$2,366,322.94. Following examination of the

tax return, the Commissioner of Internal

Revenue assessed a deficiency of $557,109.83

($452,813.79 in tax and $104,296.04 in inter-

est), which was paid by taxpayer on March

6, 1969. On May 22, 1969, taxpayer filed

with the District Director of Internal Reve-

nue a claim for refund for the year 1964 in

the full amount of the deficiency assessed.

That claim was denied by letter of May

22, 1969.

9. Taxpayer timely filed its federal in-

come tax return for the year 1965 on Form

1120L and paid the amount of income tax

ability shown to be due thereon of

$2,714,064.13. Following examination, the

Government assessed a _ deficiency of

$454,075.75 ($387,989.91 in tax and $66,085.34

in assessed interest). This amount was paid

by taxpayer on March 3, 1969. On May 22,

1969, taxpayer filed a claim for refund of

the entire amount of deficiency, which was

denied by letter of that same date.

10. The total amount in issue in this

lawsuit raised by taxpayer’s claims for re-

fund is $8,579,563. However, taxpayer’s

claims for refund do not make any refer-

ence to one issue nuw sought to be raised

by it for the years 1958 through 1960. This

issue concerns whether unearned interest

on policy loans should be included in com-

puting net investment income under Sec-

tion 804(c) of the Internal Revenue Code

B-6 B-7

7. 855 5

ot 1954. (All statutory references herein- . 22 — a 8 3 5

after will be to the Internal Revenue Code > io 4 > a 2 a 2 8 8 8 ¥ 2

of 1954 unless otherwise specifically identi- fo xo PE ge PE FE 7 ef

fied.) Taxpayer admits that this issue was ~* g®8 57 PS PH BS Pa PA

not raised by its claims for refund or the ian 23 2 12 uz ye 17 1 UF

years 1958, 1959, and i960. Accordingly, 8. 1 8a BP Bi 2 5 4 1

this Court does not have jurisdiction to 24 826 ae ee

consider this issue. a. 3 ya 8 1 f a +

2 B% 4

11. This case involves over twenty sub- „ 2 : +

Stantive issues, of which the parties have Re 1

agreed on some eight. Five of the agree- ao 2 = 7 : n

ments are in the nature of absolute con- 225 28 > „ „% „ „ 8 5

cessions by the parties, while the other three fa of 8 8 8 3B aS 83 48 5

of the agreements are limited to the extent =: * 29 E BA 8 22 3 2

that judicial authority in the Fifth Circuit ay YB Be £8 88 28 wo A ap

will govern the consequences of this law- +. 5° 3

suit. These eight agreed issues are —_ 2 E. 8 a 1 oa i i le 5

marized in the eight succeeding paragraphs. Nal 2 3 80 92

sos gy fe $F 83 Be be 59 9

12. The first of these issues deals with 22 8 5 8.8 42 28 £5 88 28 88 5

the reserve for immediate payment of death 2222883 5

claims established and maintained by tax- S 3.2.2 F 2

payer as a life insurance reserve under Sec- 2.88 a : 5 * 5 83 8 r

tion 801 (b) and disallowed by the 2K FNr. 88 $3 82 88 5 81 8

Government for the years 1960 through 5.3 a3 1 2 BE 88 88 Eo 85 E

1965. The amounts in issue are as follows: 3 2 8 BS

23 a — 2 & «a 2

Buss F b 6 E oS ue „ [EE

2 2 —_— a 3 28 8 88 4 a5

23 5 Be Ba By Ba BE RE 38 44

9 2 8 8 sa ce of (TEE

38. 2 2 eh oh ak of 88 88 ae 328

=. @ uw 7 ~ :

“i098 &° BY 8 Ba 8B BF RI 5

sce hg ve em 3

3 — 3

cise 8

X 22 1 7

BEST yr Münk

B-8

in reserves attributable to prior taxable

periods must be spread equally over a 10-

year period commencing the year after the

initial establishment of the reserve in 1959.

13. During the year 1961, taxpayer estab-

lished and maintained a reserve for dis-

ability benefits on active lives as follows:

Reserves at begin- Reserves at end

ning of year of year

$2,086,401 $2, 208, 885

Required Interest at

Mean Reserves 3% percent

$2,147,643 $75,167.50

The Government now concedes with re-

spect to all years following 1961 that the

disability benefit on active life reserve is a

life insurance reserve under Section 801(b),

but with respect to the year 1961 the Gov-

ernment contends and taxpayer concedes

that the reserve does not comply with the

requirements of Section 801(b); to the ex-

tent that the 1961 reserve does not comply

with 801 (b), it must be excluded from the

reserve computations.

14. With respect to taxpayer's claimed

reserves ſor resisted and unreported claims,

the Government is willing to allow reserves

to be maintained upon the basis of taxpay-

er’s historical experience with respect to

actual payouts of such resisted and unre-

ported claims, but the taxpayer does not

wish to introduce any evidence with respect

to this issue; therefore, taxpayer having

BEST GOPY AVAILABLE

B-9

failed in carrying its burden of proof with

respect to this issue, no recovery is allow-

able.

15. With respect to the issue of whether

or not taxpayer is entitled to a deduction

for the increase in loading on deferred and

uncollectible premiums, taxpayer concedes

the issue.

16. Certain of the items contained within

plaintiff's Exhibit D, remittances and un-

allocated items, are duplications of assets

already included in the computation. Others

of the items are not duplications and must

de included in the computation of assets.

The parties are agreed on which of those

items reflected in plaintiff's Exhibit D are

duplications and which are not and are also

agreed that amounts listed as “Totals—

Suspense accounts which cause duplication

of assets” on the plaintiff's Exhibit D are

the amounts which are to be excluded from

assets for each of the years involved, and

no further finding by this Court is required.

[Issues Settled By Precedent]

17. The issue of whether or not life

insurance and annuity premiums deferred

and uncollected (net) must be included in

assets has been decided by the United

States Court of Appeals for the Fifth Cir-

cuit in Western National Life Insurance Co. v.

Commissioner [70-2 ustc 9625], 432 F. 2d

298 (1970), and although taxpayer does not

desire to concede the issue, both parties

agree that this Court should decide the

B-10

issue in accordance with the Fifth Circuit's

opinion therein. That being the case, this

Court finds that the amount of life insurance

and annuity premiums deferred and uncollected

(net) must be included in computation of

assets for phase I and phase II purposes.

18. The issue of whether the amount of

loading on life insurance and annuity pre-

miums deferred and uncollected must be

included in assets has previously been de-

cided by the United States Court of Appeals

for the Fifth Circuit in Western National

Life Insurance Co. v. Commissioner, supra.

Although taxpayer does not desire to con-

cede the issue, both parties agree that this

Court should decide the issue in accordance

with the Fifth Circuit’s opinion therein.

That being the case, this Court finds that

the amount of loading on life insurance and

annuity premiums deferred and uncollected

must be included in computation for assets

for Phase I and Phase II.

19. The issue of whether or not mortgage

escrow funds held in trust by taxpayer must

be included in assets has previously been

decided by the United States Court of

Appeals for the Fifth Circuit in Liberty Na-

tional Life Insurance Co. v. Commissioner,

463 F. 2d 1027 (1972). Although the Gov-

ernment does not desire to concede the

issue, both parties agree that this Court

should decide the issue in accordance with

the Fifth Circuit’s opinion.

B-11

[Other “Asset” Issucs]

20. Of the remaining fifteen unagreed is-

sues, seven deal with the question of whether

various accounts must be included by taxpayer

in its computation of “assets” under Section

805 (b) (4). The issue with each of these sepa-

rate accounts is generally the same: whether

the item involved constitutes an asset of the

taxpayer other than real and personal prop-

erty (excluding money) used by it in carry-

ing on its insurance trade or business. Two

unagreed issues involve the question of the

proper computation of reserves maintained

by taxpayer and additions to reserves on an

annual basis. Finally, six unagreed issues

involve generally the various income and

deductions proper in computing taxpayer

investment and operating income under Phase

I and Phase II of the taxation of life insurance

companies section of the Internal Revenue

Code—Subchapter L.

21. Concentrating first on the asset issues,

the amount of assets in dispute for each

of the years 1958 through 1965 for each of

the several categories upon which the parties

are not agreed is as follows:

1963

1962

1960

888,855.43

1,082,188.65 2,228,246.36

‘708, 256.48 805,042.46

1,242,107.31

1,290,253.37 1,497,15384 1,378,495.98 146387389 *

504,110.48

66,303.92 676,302.24

357,964.56 356,529.03 358,430.77 794,809.13

-. $ 37,499.71 § 46,011.53 § 65,457.40 § 161,404.71 § 230,491.15 § 239,020.46 § 338,770.45 § 606,239.15

(3) Remittances and unallocated items 416,551.46 279,161.00 144,400.38

(4) Amounts held as trustee or agent (pri-

Due and unpaid accident and health

(2) Agents’ debit dalan ces

(1)

272,603.38

marily payroll taxes) ..............

Participation in insurance plans:

(5)

5

47,489.20 Sf. 888.027. 36

11,738.52 66,547.21

45,440.51

. 00 95

. Ble 2.616% 33,610.56

1,410.00

2,707.39

4,333.05

3,567.98 3,U2.75

100.00 2,978.67

80,537.98

74,085.30

20,535.00 90,910.00 135,527.00

Reinsurance with Lincoln National .........

(6) Amounts recoverable from reinsurers. .

(7) Unamortized portion of capitalized cost

8,783,603.00 7,850,014.00 6,926,482.00 5,994,837.00 5. 08. 101.00

of insurance purchase (Atlantic Life) .........

(8) Unearned interest on policy louis

1,268,472.00 1,254,238.00 1,293,380.00 1,344,91300 1,447,967.00

B-13

2. Taxpayer follows the industry-wide

Practice of allotting monies to its new

agents in excess of their commissions earned

for a period of time as they become estab-

lished as insurance agents. These monies are

necessary to the insurance agents because,

typically, a new agent will not be able to

sell enough insurance upon which commis-

sions are earned to support himself and his

family until he becomes established in the

business. If the agent stays with the com-

pany, it is expected that his commissions

will eventually reach the point where his

family can subsist upon them rather than

the amounts which were allotted to him

by the company while he was becoming

established as an insurance salesman. To

the extent that his commissions earned in-

crease, the balance of amounts allotted by

the company in earlier times will be deducted

on a ratable basis. Eventually it is expected

with permanent agents of the taxpayer that

the balances of amounts allotted by the

company during the agent’s initial period

will be repaid to the company out of the

commissions earned by the agent following

the initial period. The periodic statements

which each agent receives indicate that the

amounts advanced to the agent are personal

liabilities of the agent.

In some circumstances, the agents become

disassociated with the company prior to the

time that their commissions have been suffi-

cient to cover the balances allotted to them.

After the taxpayer has applied all earned

cominissions generated by a disassociated

B-14

agent against the amounts advanced to him,

the taxpayer claims that it is entitled to

write off the remaining unrepaid balances

as a had debt. Prior to that time, however.

the partics are not in agreement as to the

proper treatment of these balances in com-

puting assets under Section 805(b)(4). Tax-

payer claims that these balances should be

excluded from computation of assets because,

while admittedly assets, they are used in its

insurance trade or business. The Govern-

ment, on the other hand, contends that these

assets are not utilized in the insurance trade

or business. This Court finds that the agents’

balances are not insurance trade or business

assets such as those listed and enumerated

in Treasury Regulations on Income Tax,

Section 1.805-5(a)(4)(i), which generally in-

clude the home office of the company,

including buildings and land, furniture and

equipment utilized in carrying on its life

insurance business, supplies and printed

matter utilized in carrying on its life insurance

business, and automobiles and other depre-

ciable personal property utilized in carrying

on its life insurance business. Rather, the

agents’ balances are accounts receivable, and

must be included in the computation of assets.

23. In common with most insurance com-

panies, taxpayer reinsures many of the policies

which it writes with other life insurance

companies. Commonly, when a claim for

payment on a policy which the taxpayer has

written is made, and that policy is subject

to a reinsurance agreement with another

company, taxpayer will in turn make a

'

'

B-15

claim upon that other company. However,

2 time lag between the date the claim is

made upon the other company and payment

of that claim invariably occurs. During the

period between which a claim is made and

the time in which it is satisfied, the amounts

due from reinsurers constitute an asset of

the taxpayer which is not of that type

enumerated in Treasury Reculations on Income

Tax, Section 1.805-5(a) (4) (i). Accordingly,

the amounts due from reinsurers do not

constitute an asset utilized in taxpayer's

insurance trade or business and are to he

included in assets under Section 805(b) (4).

With respect to the amounts recoverable

from reinsurers, plaintiff keeps its books on

a cash receipts and disbursements method

rather than the mandatory accrual account-

ing method of Section 818(a). That is, it

awaits the receipt of cash from reinsurers

before reflecting these accounts receivable

on its books and records. The recovery of

these amounts from reinsurers is not subject

to dispute and is a routine matter only.

24. Plaintiff engages in a number of joint

insurance plans with other companies. Among

these plans are Federal Employees Group

Life Insurance (FEGII) and other plans

known as the Lincoln National Reinsurance

Plan and the 65 Health Plan. In each of

these plans the plaintiff contributes to a

central pool administerel be an insurance

company for the purpose of insuring sub-

standard risks. The assets of these pools

are invested in income producing properties,

the return on which is utilized to defray

B-16

claims made on the pools under the various

programs. Fach year an accounting is ren-

dered to plaintiff and the other companies

participating in the pools of the current

status of them. As claims are made on the

pools they are reduced until, after a period

of time, the excess, if any, is refunded to

plaintiff and the other companies. These

pools operate much as plaintiff's regular life

insurance reserves which are backed up by

investcd assets. As claims are made on

insurance contracts, the assets must be

liquidated in order to meet the contractual

requirements and life insurance reserves are

consequently reduced. At any one time,

however, plaintiff's interest in the various

pools is measurable and is equivalent to the

total invested assets of those pools less

claims and administrative expenses. These

pools do not constitute one of those items

which make up assets used in plaintiff's life

insurance trade or business.

25. At the end of taxpayer’s annual account-

ing year, a number of payments are received

by it which cannot be physically segregated

into the proper accounts until after the end

of the year. Typically, these payments would

relate to mortgage payments received from

mortgage service agents which cover a

number of different loans and which are

impossible to segregate immediately, and

premium payments on which the premium

notice stub or policy number is absent. In

both cases, the payments are placed into

suspense accounts by taxpayer and cash and

checks are deposited in the taxpayer's bank

account. On the other hand, certain of the

—

B-17

unallocated items do not fall into that cate-

gory: Rather, these are amounts maintained

by taxpayer in its remittances—unallocated

items accounts which do not duplicate any

other asset account. Typically, these include

an account for repairs, foreclosure expenses,

cash with applications for insurance, and a

deferred group (vested retirement benefits)

account. The true suspense accounts are

duplications of already-included assets, pri-

marily mortgage loans receivable and de-

ferred and uncollected premiums. To the

extent that a portion of the remittances and

unallocated ite s constitute duplications of

other asset accounts, they should be ex-

cluded from a computation of assets under

Section 804(b)(4). To the extent that the

remittances and unallocated items do not

constitute duplications of other assets, they

should be included in computation of assets.

26. From time to time, the taxpayer

made loans to its policyholders, the maxi-

mum principal amounts of which were

typically determined by the cash values of

the policies involved. Under the express

terms of taxpayer's policy loan agreements

with borrowers, interest was paid in ad-

vance to the end of the policy year, and

annually thereafter on the policy anni-

versary date for the ensuing year. Interest

which was not paid when it was due was

added to the principal of the existing loan.

The whole or any part of the indebtedness

arising from a policy loan could be repaid

B-18

at any time; if repayment of a policy loan

was made during the policy year, the exact

amount of interest rateably earned by the

taxpayer was retained by it, with the resi-

due returned to the policyholder. If the

policyholder should surrender his policy

for the cash value, then only the exact

amount of prepaid interest rateably earned

was retained by the taxpayer, and the

residue was returned to the policyholder;

and if the policyholder should die, then

only the exact amount of prepaid interest

rateably earned was retained by the tax-

payer, and the residue was paid to the bene-

ficiary of the policy. Unpaid interest added

to principal when it was not actually paid

was similarly retained or returned on the

basis of whether it was rateably earned.

Although the provisions of Section 818(a)

expressly require that computation of life

insurance company income taxes shall be

made under an accrual method of account-

ing, taxpayer reported only such interest

income or assets as it rateably earned.

Whether by means of prepayment at the

time of its making a policy loan, or by

means of capitalizing advance interest in

succeeding years, the taxpayer accrued and

received interest at the time of prepayment

or capitalization. The parties differ as to

the treatment of the accrued but unearned

interest for purposes of inclusion into assets

under Section 804(a)(4), and determination

of investment income under Section 809(a).

The amounts of adjustment in issue (1961

through 1965 only) are as follows:

B-19

10000 3 59.807

3 re 44,766

155 39,142

JyhÜy%ſ coke 51,533

— 103,054

Of the 14,000 policy loans in existence dur-

ing a representative year at issue, there

were only 200 cases in which the loans

were prepaid and some adjustment to pre-

paid interest was made by the taxpayer.

[Interest Paid]

27. In computing the amount of “Interest

Paid” under Section 805(e) for determining

the amount of “Policy and Other Contract

Liability Requirements”, the taxpayer in-

cluded herein amounts it paid as excess

interest on certain insurance policies issued

to qualified pension plans. The Government

decreased the amount of “Interest Paid”

for each of the years in the amount of the

taxpayer's payments for excess interest and

has reclassified the payments as policy

dividends as follows:

Interest Paid Decreased

Year Amount

D J 3.188.90

n 1. Na. 2

n 233,414.97

D 282.793.59

Er 543,594.00

n 728.627. 2

een 6.917. 72

Fan I 770.388. 22

The adjustment for claimed excess in-

terest results from payments made by the

B-20

taxpayer to qualified pension plans which

have purchased certain contracts. Under

state law, the maximum interest rate the

taxpayer can use in determining the re-

serves for these contracts is 344%. Tax-

payer enters into an agreement with the

pension plans that it will pay directly to

the plans an amount in excess of the 34%

interest rate used in computing the te-

serves.

Taxpayer developed what it calls the

“excess interest formula” by which each

pension fund is allowed a return on its

invested funds in excess of the rate stipu-

lated in the contract. The excess interest

formula operates in the following manner:

(a) Taxpayer determines what is known

as the investment generation of new

moncy approach. Taxpayer is continu-

ously placing funds into income producing

investments. Each year it determines

the investment yield in terms of a percent-

age rate of return on funds invested during

the course of the year. This percentage

rate is referred to as the new money in-

terest factor.

(b) Taxpayer reduces the new money

interest factor by % of 1% as a man-

agement fee.

(c) The new money interest factor

(after reduction for management fee) is

then reduced by the amount of guaran-

teed interest in the policy. Thus, for

example, if the new money factor was

44% and the guaranteed interest rate

was J. the excess interest rate is

14%. The excess interest rate is then

B-21

multiplied by the current mean reserve

of the policies still in force and this is

the amount of excess interest.

(d) From the amount of excess in-

terest, there is charged a calculation fee

of excess interest, there is charged a

calculation fee of $100 plus S¢ for each

policy in force; the net amount con-

stitutes the amount which is actually paid

by taxpayer to the pension plan.

An example of how a calculation is made

is shown by the following illustration. As-

sume a plan acquired an annuity contract

in 1960 and seven original participants are

still covered by the plan. To determine the

amount of excess interest to be paid for

the year 1965, the calculation is as follows:

No. of New

Policies Money Guaranteed

Year of Issued & Interest Valuation

Issue In Force Factors Interest Rate

REL 7 .0464 .0300

. 1 0460 .0390

ie 1 .0455 .0300

I 2 0451 .0350

1964........ 0 0449 -0350

Current Excess

Excess Mean Reserve Interest

Interest Rate of Policies Col. 5 x

Col. Col. 4 Still In Force Col. 16

.0164 $10,000 $164.00

.0160 600 9.60

0155 400 6.20

0101 900 9.09

0099 0 00

$183.89

Less: Calculation charge of $100 plus (11 x 50 100.55

Excess Interest Paid......... .................... 3 83.34

B-22

Taxpayer’s excess interest formula gen-

erates excess interest payments only from

taxpayer’s investment earnings andl the

formula does not contemplate or consider

any element of mortality, morbidity or ex-

pense savings. The amounts paid as excess

interest do not involve at the time of their

accrual life, health or accident contigencies.

The contracts which taxpayer issues on

which excess interest is pail are (a) the

pension trust annuity contracts, (b) the

group permanent annuity contracts, (c)

the pension trust life contracts and (d) the

group permanent life contract.

All reserve requirements for the annuity

contracts and life contracts are computed

at the time the policies are issued and the

reserves for these contracts, at the time

they are computed, involve life, health and

accident contigencics.

28. The accident and health insurance

policies written by taxpayer contain a 3l-

day grace period following the due dates

of the premium. This means that taxpayer

is bound to continue a policy in effect for

31 days after the premium becomes duc

although it has no legal right to force col-

lection of the premium then due. On De-

cember 31 of any ycar, taxpayer has a number

of policies in the grace period and con-

tinues to carry the policies on its books and

shows the amount of premiums unpaid as

“Due and Uncollected Premiums.”

Uncollected or due and unpaid premiums

on accident and health policies, as those

B-23

terms are used in the insurance industry,

mean those premiums payable on policies

under the insured’s selected mode of pay-

ment where the premiums have not been

collected but the policies are carried on

taxpayer's books as being in full force. If

a premium is due in December, the unpaid

portion of the premium for the policy which

was due in December is carried as due and

uncollected as of December 31.

Taxpayer has no legal enforceable right

to collect due and unpaid premiums on its

policies, as premiums which have not

actually been paid to taxpayer are not con-

tractually due from its policyholders. The

provision for the payment of premiums

does not afford a cause of action to tax-

payer to collect from its policyholders be-

cause the payment of premiums is at the

sole election of the insured who may decide

to keep his policy in force by payment of

premiums within the grace period, or elect

to abandon or otherwise permit his policy

to lapse by non-payment of premiums.

No life insurance reserves are maintained

or established as à result of the due and

uncollected premiums on accident and

health policies. Therefore, they differ from

deferred and uncollected premiums on life

insurance contracts.

Due and uncollected premiums on acci-

dent and health policies are not property

since taxpayer has no legal right to make

collection.

29. In connection with servicing its

mortgage loans, either by the company or

B-24

through mortgage servicing agents, certain

amounts are collected from the mortgagors

each month for the purpose of paying in-

surance premiums and ad valorem taxes on

the mortgaged property when they become

due. These funds are generally referred

to as mortgage escrow funds. Taxpayer

holds these funds in trust for the mort-

gagors and, therefore, said funds are not

assets of nor belong to the taxpayer.

30. Taxpayer, either by law or con-

tractual agreement, is required to retain

certain amounts as trustee or agent for

the payee or third party. Generally, these

amounts consist of withheld taxes due to

Federal, State or City governments. The

amounts so held by taxpayer as trustee or

agent for others do not represent assets

of taxpayer.

[Deductions]

31. There remain two issues dealing

with proper computation of reserves to be

settled by the Court. The first of these

deals with whether or not beginning re-

serves of certain nonparticipating contracts

may be excluded from computation of addi-

tions to reserves under Section 809(d)(5)

by taxpayer. Taxpayer issues contracts

which are not participating as to dividends

as part of its normal business. Many of

these contracts provide that upon a certain

policy date the contract of insurance will

become participating. Typically this might

be on the 20th policy anniversary. In com-

puting the additions to reserves for pur-

—— #

B-25

poses of the special deduction allowed

nonparticipating contracts pursuant to Sec-

tion 809(d), the parties differ as to the

proper treatment of reserves maintained

with respect to the nonparticipating con-

tracts which became participating during

the policy years in question. The taxpayer

maintains that when it computed allowable

additions to reserves for purposes of the

special deduction of Section 809(d)(5) it

was entitled to exclude from beginning bal-

ances of the reserves the beginning balances

of all nonparticipating contracts which be-

came participating during taxpayer’s annual

period. Because the allowable additions to

reserves are computed by deducting the

beginning balances from the ending bal-

ances, any reduction in the beginning bal-

ances results in a larger addition to reserves,

and therefore a larger Section 809(d)(5)

special deduction. The Government, on

the other hand, maintains that there is

no statutory or regulatory authority for

excluding the beginning balances of non-

participating contracts which become par-

ticipating during the year in calculating the

amount of allowable additions to reserves.

32. During the year 1957, taxpayer be-

came licensed to sell insurance in the State

of California. After it had filed its 1957

annual statement in 1958, the State of

California required taxpayer to change its

method of computing reserves for certain

non-participating life insurance contracts.

The following schedule sets forth the de-

tails of the change in the method of com-

puting reserves:

1eꝛ04

Feupio—uransul 1

B-26 B-27

Taxpayer in computing its special de-

duction on its 1958 income tax return for

ten per cent of the increase in reserves on

nonparticipating contracts under Section

809(d)(5) included the full amount of the

increase in reserve resulting from the

change in the method of computation.

On initial examination of taxpayer's 1958

tax return, the Examining Agent took the

position that the reserve strengthening oc-

curred in 1957 and not in 1958. Taxpayer

paid the tax and timely filed a claim for

refund listing the adjustment on Rider 8.

This adjustment was listed as erroneously

having been determined by the Agent as

rei

uonenfe JO uonhdho sd

—— — — — l- 2 2 — —

' £yeuypso—souesnsul 71

E ) occurring in 1957 rather than 1958. On

RP RP RP |

ox examination of taxpayer’s claim for refund,

ur ofl 8 the Examining Agent changed his position

ae and recognized the reserve strengthening

A as occurring in 1958 but reduced the amount

of increase in reserve on which the Section

809(d)(5) deduction was based by the

amount of $820,068. The Government has

allowed a ratable deduction over a ten year

mam PY att | period commencing in 1959.

1 Pg 85 5 ag 7 [Remaining Issues]

a :

33. The final area for this Court to decide

deals with income and deduction issues for

/ both phase I and phase II, and consists

of six nonagreed issues. The facts concern-

ing three of these issues have already been

; set out in previous paragraphs because the

| items involved are also involved in comput-

ing assets under Section 805(b)(4). The

first of these three issues concerns whether

Jy Ul asvalduy

aaiasay ſehem

aZuvyD o 319d

B-28

unearned but accrued interest on policy

loans must be included in investment in-

come for purposes of Section $09(a). For

a full discussion of the facts on this issue,

see paragraph 26 above. The taxpayer

maintains that it is entitled to exclude

unearned but accrued interest from computa-

tion in investment income, while the Gov-

ernment maintains that it must include that

interest in computing its investment income

for Section 809(a) purposes.

34. The second of these issues that has

been referred to previously is whether the

taxpayer may deduct the uncollectible bal-

ances of amounts allotted to beginning

agents in determining net investment yield

under Section 804(c). Taxpayer maintains

that it is entitled to deduct these balances

in the year in which it chooses to write

them off as bad debts in determining a

Phase I adjustment, net investment yield.

The Government, on the other hand, denies

that a taxpayer is entitled to write these

sums off as bad debts, but has allowed a

deduction under Section 809(a) for Phase

II purposes in computing operating income.

This issue was previously treated in the

assets portion of these findings in para-

graph 22. In addition to those findings,

the Court finds that in January of the year

after all commissions generated by agents

who have been disassociated with the com-

pany are applied against the balances due

from the advances previously made, the

taxpayer writes off those balances as bad

debts. [It does so without regard to any

—U— ee eee ee — —

a

B-29

determination as to the financial ability of

the ex-agents to repay the amounts which

have been advanced to them, and without

any effort to collect those amounts through

court proceedings, through hiring of col-

lection agents, or even through dunning

letters and the other procedures ordinarily

resorted to by creditors to collect debts.

The Court does find that in some cases

efforts are made to collect as a punitive

step to deter ex-agents from pirating away

business developed while associated with

taxpayer. The Court further finds that it

is an industry-wide practice to make these

advances to new agents and that it is well-

understood within the industry that the

insurance company will not proceed against

agents to collect unrepaid balances follow-

ing disassociation.

35. Taxpayer, as part of its investment

program, began purchasing oil payments

during the year 1959. In these transactions,

taxpayer, for a specified sum, purchased oil

production until such time as it had re-

covered the amount of its costs, plus an

amount known as an “interest equivalent

element” which was applied at a specified

rate on the amount of unrecovered costs.

Taxpayer’s investment and the return thereon

were recovered solely from oil production.

Prior to January 1, 1964, the taxpayer had

computed its allowable cost depletion under

that method known as “declining balance.”

Sometime during 1963 there was a change

in the taxpayer’s personnel in charge of

calculating oil payments and associated

matters. The new person in charge decided

0

B-30

that it would be more advantageous to

switch to a different method of computing

allowable depletion, the “sum of the dol-

lars” method which he proceeded to do.

Following that corporate decision, the

Treasury promulgated a Technical Informa-

tion Release in late 1964 allowing compu-

tation of depletion under either the declining

balance or sum of the dollars method. How-

ever, the taxpayer’s decision to change was

made prior to the promulgation of that

T. I. R and could not have been in reliance

upon it. In addition to computing depletion

on its newly acquired oil payments under

the sum of the dollars depletion method,

the taxpayer, on an ex post facto basis,

changed its method of calculating depletion

on all amounts received subsequent to 1958

to the sum of the dollars method. The addi-

tional depletion deductions claimed by virtue

of that change are as follows:

Depletion Deduc-

Year tion in issue

D 3 W. 783

Dee 83,616

esse 17.611

165,302

eee eee 198,965

— 248.8895

rere 244.925

. $1,086,557

The difference in dollar amounts set out

above refiects that the two methods of cost

depletion produced differing amounts of

cost depletion deductions over different peri-

ods of time and constitute different account-

ing methods. Taxpayer at no time either

B-31

requested or received consent of the

tary of the Treasury or his *

effecting the change in accounting method.

Under this set of facts, the taxpayer con-

tends that it was entitled to change its

method of computing cost depletion on

existing oil payments because it would not

have been allowed by the Internal Revenue

Service to compute cost depletion on the

sum of the dollars method prior to the

promulgation of the T. I. R in question,

and that it was unfair to require the tax-

payer to secure the permission of the Secre-

tary of the Treasury or his delegate prior

to changing the method of computing cost

depletion. The Government, on the other

hand, maintains that (1) the sum of the

dollars method in computing cost depletion

was not forbidden prior to promulgation

of the T. I. R in question; (2) taxpayer

effected the change in computing cost deple-

tion prior to promulgation of the T. I. R

and not in reliance upon it; and (3) in no

event is taxpayer entitled to change its

method of computing depletion even from

an impermissible to a permissible method

without the consent of the Secretary of the

Treasury or his delegate.

36. The next issue to be considered by

this Court deals with of this item is in the

computation. The taxpayer utilized a two-

step method, claiming bad debt losses for

the gross amount suffered, and then short-

term gains for the insurance recoveries; the

Government lumped insurance recoveries

against the gross loss in determining the

B-32

net allowable losses. For the years in issue

(1961 through 1965 only), the amounts of

bad debts losses denied in issue are as

llows:

- Amount of bad debt reduc-

tion (and reduction of

Year short-term capital gain)

een 22 1

D 180,653

e 223,137

1 226,243

eer ee 295, 467

Taxpayer maintains that Treasury Regulations

on Income Tax, Section 1.166-6, do not provide

for inclusion of insurance recoveries in com-

puting bad debts upon mortgage foreclosures.

It is the Government's contention that Section

166 allows deduction of bad debts only after

insurance or other recoveries on the bad debts

are included in the computation, and any

failure to include insurance recoveries in

measuring a bad debt would be in error.

37. Two final issues to be determined by

the Court concern whether the excess of the

purchase price paid for assets received over

their fair market value in acquiring all of

the life insurance in force of another life

insurance company is deductible in the year

of payment and whether, in determining

the amount of policy and other contract

liability requirements, excess of purchase

price over fair market value of assets re-

ceived less amortization allowed should be

included in assets under Section 805(b)(4).

38. In 196] taxpayer purchased the stock

of the Atlantic Life Insurance Company

from its shareholder, Life Companies, Inc.

This the method utilized by taxpayer in

computing its allowable bad debt expenses

ee ee — wets

2 „

B- 33

arising out of foreclosure of mortgages

insured by the Veterans Administration and

Federal Housing Administration. Taxpayer

in its business as a life insurance company

invests money in numerous mortgage loans,

many of which are insured, in turn, by the

FHA or VA. When default is made on one

of these loans, taxpayer commonly instructs

the trustee to bid the property in at or

below the balance of the loan plus certain

associated costs such as attorneys’ fees and

the like. The differences between this total

loan balance and fees and the amount for

which the property is bid is recorded on

the books of taxpayer and claimed by it as

a bad debt loss. Following the time in

which the property is deeded by the trustee

to taxpayer, it, in turn, makes a claim upon

the VA or FHA, as the case may be, for

proceeds pursuant to their guarantees of

insurance. These are typically paid to tax-

payer in the form of bonds which are

recorded by it upon its books at the fair

market value thereof. Taxpayer then re-

ported the fair market value of these bonds

as, typically, short-term capital gain. These

capital gains, in turn, were utilized during

the years in question to wipe out certain

long-term capital losses incurred by tax-

payer which are not related to this issue.

Thus, taxpayer was able to claim bad debt

losses which had a tax benefit at the maxi-

mum ordinary corporate rate upon which

tax was imposed, while the short-term capi-

tal gains reported by taxpayer upon receipt

of the VA and FHA bonds were essentially

taxed at long-term capital gains rates. The

Government, in its deficiency notice, dis-

B-34

allowed taxpayer’s claimed bad debt losses

by an amount equal to that which it received

from the VA and FHA bonds. As a con-

comitant, the Government also reduced

taxpayer’s short-term capital gains which

it had reported by an equal amount. Thus,

the difference in the parties’ treatment

transaction was pursuant to a plan of liqui-

dation of Atlantic into taxpayer pursuant

to the provisions of Sections 332 and 334

(b) (2) of the Internal Revenue Code of

1954. The plan was consummated and At-

lantic was liquidated as of June 30, 196l,

with the consideration paid allocated to the

various assets based upon their fair market

value.

39. The consideration for the transaction

was $128,226.890 paid in cash and through

assumption of liabilities as follows:

re see $ 29,000,000

Reserve Requirements Assumed 94,536,860

Other Liabilities Assumed...... 4,690,036

Total Consideration Pad 2. 28.888

In exchange for this consideration, the tax-

payer received assets having a fair market

value of $118,798,778, leaving an excess of

$9,864,131 which it denominated as “insur-

ance in force.” The complete schedule of

assets was introduced as joint Exhibit 38.

40. The reason taxpayer was willing to

pay $9,864,131 more than the fair market

value of the assets it received was its expec-

tation of profiting from insurance contracts

which had already been written by Atlantic.

Generally, an insurance company is willing

to pay a premium or bonus for insurance

9

B- 35

contracts in force because most of the

expenses of writing such contracts occur

in the first policy year: in succeeding years

there is a higher profit margin than that

which is ordinarily reflected on the books

of an insurance company. Taxpayer's nego-

tiators had estimated the potential value

of acquiring Atlantic's insurance contracts

in force and were willing to pay the

$9,864,131 bonus to acquire the contracts

for that reason. Charles Connally, one of

taxpayer’s negotiators, testified that the

excess purchase price represented this in-

tangible benefit of the insurance in force.

41. Mr. Connally testified that these ben-

efits lasted for the life of those policies

which was between 5 and 15 years for the

various types of insurance involved. No

testimony was adduced by the taxpayer

which would allow this Court to specifically

identify the various types of insurance ac-

quired and to assign specific useful lives

to each type. The Government allowed tax-

payer to amortize the bonus over the aver-

age life of the policies which it reckoned

to be ten years. The taxpayer, in contrast,

has claimed the right to deduct the entire

bonus in the year of its expenditure, 1961.

42. The Government required taxpayer

to inchude in the calculation of assets under

Section 805(b)(4) the unamortized portion

of the bonus. Taxpayer’s primary position

is that it was entitled to deduct the bonus

in 1961; therefore, there would be no un-

amortized portion to be included in assets

in any circumstance. Its secondary position

B-36

is that the unamortized portion of the bonus

should not be included in assets in any

event.

43. The Government allowed a tax de-

duction under Section 809(d)(7) in the year

of the transaction for the increase in total

reserves for the life insurance and other

reserves which included the increase in the

end of 1961 attributable to reserves assumed

by taxpayer in connection with the trans-

action. The Government required taxpayer

to report as income in the year of the

transaction the fair market value of the

assets (other than the bonus“) which it

received in connection with the transaction.

The only question properly before this

Court raised by taxpayer’s claim for refund,

the pleadings, and the pretrial order is

whether “the excess price paid over the

assets obtained is the cost of acquiring life

insurance which is deductible in the year

incurred * *.” (Pretrial Order IV, par. )

44. Any conclusion of law deemed as

properly constituting a finding of fact is

hereby adopted as a finding of fact.

Conclusions of Law

1. This Court has jurisdiction of the

subject matter pursuant to 28 U. S. C.

§ 1346, and of the parties except for the

issue concerning whether accrued but un-

earned interest must be included in invest-

ment income for the years 1958 through

1960. With respect to that issue it was

not included in taxpayer's claims for refund

for the respective periods and thus the

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B-37

Court has no jurisdiction to award any

recovery. With respect to the issue of

spreading the California required strength-

ened reserves upon which the Government

has raised the question of subject matter

jurisdiction, this Court concludes it does

have jurisdiction.

[7ssues Settled by Precedent}

2 This Court in its findings, para hs

12 through 19, set out the —— om

ments of the parties with respect to some

eight issues upon which there is no con-

troversy. This Court concludes that the

Parties agreements with respect to issues

concerning the reserve for immediate pay-

ment of death claims, reserve for disability

benefits, deduction for increase in loading on

deferred and uncollectible premiums, and

inclusion of remittances and unallocated

items are all in accordance with law, and

thereby adopts the parties’ positions with

respect to the issue concerning reserves for

resisted and unreported claims, this Court

conchides that taxpayer has failed in his

burden of Proof, and that, therefore, no

recovery with respect thereto is allowable.

This Court having found that the Parties

agreed that the decisions of the Fifth Cir-

cuit Court of Appeals in Western National

Life Insurance Co. of Texas v. Commissioner

{70-2 uste 19625], 432 F. 2d 298 (1970), and

Liberty National Life Insurance Co. v. Com-

missioner, 463 F. 2d 1027 (1972), control

the issues of whether deferred and uncol-

B-38

lected premiums, including loading, and

mortgage escrow amounts are includable in

assets, respectively, this Court concludes

that it is indeed bound by those decisions

and so holds. Accordingly, amounts denom-

inated as deferred and uncollected premiums

and the loading with respect thereto must

be included in computations of assets from

phases I and II and amounts reflecting mort-

gage escrow funds held by taxpayer and by

its mortgage service agents must be ex-

cluded from computation of assets for

phases I and II.

[Other “Asset” Issues}

3. In the remaining issues dealing with

computation of assets, certain common prin-

ciples apply. Definition of the term “assets”

as utilized in the Life Insurance Company

Taxation Act is governed by Section 805

(b)(4), and lawfully enacted Regulations

thereunder. In order to be included in an

asset, an item must consist of an asset of

the taxpayer (including non- admitted -

sets) other than real and personal property

(excluding money) used by it in carrying

on an insurance trade or business. Thus,

three issues may be presented in any con-

sideration of whether or not a given item

constitutes an asset. In the first place, the

question arises over whether or not an

item is indeed an asset. In the second

place, the question may arise with respect

to items which do constitute assets as to

whether or not the taxpayer is the owner

of those assets. And finally, the question

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B-39

arises of whether or not an asset owned

by a taxpayer consists of real or personal

property (other than money) used by it in

carrying on an insurance trade or business.

With respect to whether or not a given

item is an asset, it must be kept in mind

that all insurance companies are required

by Section 818 to maintain an accrual method

of accounting and, therefore, definition of

an asset must be pursuant to accrual meth-

ods of accounting. Thus, it is not material

that, on the date of computation, the tax-

payer must not have had a legally enforce-

able right to possession of the items in

issue, or that nonpossession of the items in

issue would deny to a taxpayer the right

to invest the same. The question with re-

spect to whether an asset exists must gen-

erally be whether under accrual principles

of accounting the items in question must be

included in computation of the taxpayer's

assets.

4. Taxpayer argues that only such assets

as may be available to it for investment

are to be included in the Section 805(b) (4)

definition of “assets.” This Court con-

cludes that taxpayer’s contention is not

well founded. Western National Life Insur-

ance Co. of Texas v. Commissioner, supra;

Jefferson Standard Life Insurance Co. v.

United States (69-1 ustc $9278], 408 F. 2d

842 (C. A. 4, 1969), cert. denied, 396 U. S.

828 (1969); and Franklin Life Insurance Co.

v. United States [68-2 ustc $9459], 399 F.

2d 757 (C. A. 7, 1968), cert. denied, 393

U. S. 1118 (1969). It is the application of

B-40

accrual principles of accounting made man-

datory by Section 818(a) rather than any

distinction between investable or noninvest-

able assets which control. To the extent

that an insurance company is not required

to recognize assets under accrual account-

ing principles because of the inchoateness

of claims on accounts receivable, it must

still treat each item consistently. That is,

if a taxpayer chooses to accrue an item for

one purpose (¢.g., maintenance of life in-

surance or other reserves), then it must

accrue that item consistently for all pur-

poses. In some cases this principle allows

a taxpayer optional treatment, but should

a taxpayer be allowed to accrue for any

purpose and chose to do so, it must accrue

for all without regard to possible tax con-

sequences.

5. The next common issue in determining

inclusion of assets is whether a given item

is under such control of the taxpayer as

to constitute an “asset of the company.”

Whether such control exists will normally

be a question of fact, but it is not necessary

that a taxpayer be a fee owner of an item

in order for it to be classified as one of its

assets. The questions to be decided gen-

erally with respect to this issue will be

whether taxpayer can or does comingle an

asset with other assets which it owns,

whether it can or does utilize an asset in

the conduct of its business, and whether

it can or does invest that asset and, if so,

whether the earnings from such investments

can or do inure to the benefit of the tax-

payer.

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B-41

8 The final general issue to be con-

sidered by the Court in determining as-

sets under Section 805 is whether or

not an asset of the taxpayer consists of

real or personal property (other than cash)

used in its insurance trade or business.

Treasury Regulations on Income Tax, Sec-

tion 1.805-5(a)(4), define the only items to

be excluded from the term “assets” as being

considered to be used by the life insurance

company in carrying on its insurance trade

or business. These are as follows:

(a) The home and b h offi ildi

tacheding load, ranc ce buildings,

(b) furniture and equipment used in those

buildings;

(c) supplies, stationery, and printed mat-

— used in the operations of the company:

an

(d) automobiles and other depreciable

personal property used in connection with

the operations o. the company.

N 7. Applying these principles to the asset

issues, this Court concludes the following:

(a) The amounts representing debit

balances from the new agents constituted

an asset within the meaning of Section 805

as they are accounts receivable owned by

the taxpayer and not utilized by it in its

insurance trade or business. Jefferson Stan-

dard Life Insurance Co. v. Uniled States,

supra; Franklin Life Insurance Co. v. United

States, supra; Western National Life Insur-

ance Co. of Texas v. Commissioner (CCH

B-42

Dec. 28,954], 50 T. C 285 (1968), modified.

[CCH Dec. 29,463] 51 T. C 824 (1969), rev'd

on other issues, [70-2 ustc { 9625] 432 F. 2d

298 (C. A. 5, 1970).

(b) Amounts recoverable from reinsurers

constitute an asset of taxpayer under Sec-

tion 805 as they are accounts receivable and

not utilized in taxpayer’s insurance trade or

business. Occidental Life Insurance Co. of

California v. United States, 70-1 use $9225

(C. D. Calif., Feb. 5, 1970), and Western

National Life Insurance Co. of Texas v. Com-

missioner, supra. The amounts which represent

taxpayer's share of FEGLI, Lincoln Na-

tional Reinsurance Plan, and 65 health plans

constitute assets of the taxpayer under Sec-

tion 805. Jefferson Standard Life Insurance

Co. v. United States, supra; Franklin Life In-

surance Co. v. United States, supra; Western

National Life Insurance Co. of Texas v. Com-

missioncr, supra.

(c) To the extent that remittances and

nonallocated items are duplications of assets

already considered in taxpayer’s computa-

tions, they are to be excluded from assets

under Section 805; to the extent that they

are not duplications of other assets, they are

assets to be included under Section 805.

(d) Accident and health premiums due

and unpaid are not includable in total assets

under Section 805(b)(3).

(e) The amounts held by taxpayer and

its mortgage servicing agents as mortgage

escrow funds are not includable in total as-

sets under Section 805(b) (3).

—— 24 —— Se eed ee 444“! —kW32

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B- 43

(f) Amounts held by taxpayer as trustee

or agent are not includable in total assets

under Section 805(b) (3).

(g) The intangible assets owned by tax-

payer arising out of the transaction wherein

it purchased the stock of the Atlantic Life

Insurance Company, and which were amor-

tized over a 10-year period, constitute an

asset of the taxpayer in the amount of the

unamortized portion. This capitalized por-

tion of an asset of intangible but real na-

ture is not utilized by taxpayer in the

conduct of its insurance trade or business

under Treasury Regulations, Section 1.805-5.

(h) The accrued unearned interest income

on policy loans likewise constitutes an asset

of taxpayer for Section 805(a) purposes.

These items constitute accounts reccivable

of the taxpayer not used by it in the con-

duct of its insurance trade or business. Jeff-

erton Standard Life Insurance Co. v. United

States, supra; Franklin Life Insurance Co. v.

United States, supra.

[Interest Paid]

& The amounts paid as excess interest by

taxpayer to qualified pension plans with re-

gard to pension trust annuity contracts and

pension trust life contracts not involve

life, health or accident contingencies. Sec-

tion 805(e) provides that in determining the

amount excluded for policyholders’ share

of investment income, all interest paid is to

be taken into account, including amounts in

the nature of interest which do not involve

life, health or accident contingencies. The

amounts paid in the nature of interest which

B-44

do involve life, heaivh or accident contingen-

cies are treated as dividends to policyholders

under Section 812, but amounts paid in the

nature of interest which do not involve life,

health or accident contingencies at the time

of accrual or payment are to be treated as

interest as provided under Section 805(e)(2).

The amounts paid by taxpayer as excess

interest to its pension plans constitute

amounts in the nature of interest under

Section 805(e)(2) and not dividends to

policyholders. The reserves, when com-

puted for the contracts in issue, do involve

life, health and accident contingencies and,

therefore, the reserves are life insurance

reserves under Section 801(d).

[Deductions]

9. Taxpayer, in its exclusion of begining

balances of nonparticipating contracts from

the computations necessary to its special

deduction under Section 809(b)(5), has no

legal authority for its position. In comput-

ing the additions to reserves pursuant to the

provisions of Treasury Regulations on In-

come Tax, Section 1. 809-5) (S) (v), there

is no provision for exclusion of beginning

balances of nonparticipating contracts which

become participating during the year. Only

those adjustments allowed by Treasury

Regulations, Section 1.809(d)(5)(A)(S) (itt),

are allowable, and exclusion from beginning

balances is not one of those adjustments.

Nor in analogous situations is an out-

calculation of beginning balances in com-

puting additions to Section 801(b) reserves

allowed. Thus, in computing additions to

:

:

i

B-45

reserves for phase II purposes, the taxpayer

may not exclude the beginning reserves of

those policies which mature by reason of

termination or death during the year. There-

fore, taxpayer’s position with respect to

exclusion of beginning balances on non-

Participating contracts is not well-founded.

See United Life & Accident Insurance Co. v.

United States [71-2 uste 1 9620]. 329 F. Supp.

765 (N. H. 1971).

10. The Government has been well ad-

vised of taxpayer’s claim on this issue,

through both the claim for refund and con-

ferences with its agents. Accordingly, the

issue is properly before this Court and

this Court has jurisdiction over the subject

matter.

11. In computing its deduction for increase

in reserves for non-participating contracts

under Section 809(d)(5), for the year 1958,

the entire amount of increase in reserve

resulting from the strengthening required

by the State of California in the amount of

$820,068 is to be included and is not to

be spread ratably over the next ten years

as provided by Section 810(d).

[Remaining Issucs]

12 Just as accrued but unearned interest in-

come on policy loans must be included in

computation of assets, it must be included

in investment income, under Section 804(b).

Jefferson Standard Life Insurance Co. cv.

United States, supra; Franklin Life Insurance

Co. v. United States, supra.

B-46

13 The fact that taxpayer utilized a

method of accounting for cost depletion

other than the “sum of the dollars” method

prior to January 1, 1964, and did not receive

the permission of the Secretary of the

Treasury or his delegate to change such

such method precludes it from utilizing the

“sum of the dollars” method for any pay-

ments received on oil payments purchased

prior to January 1, 1964. The consent of

the Secretary is absolutely necessary for

taxpayer to change its method of accounting

for cost depletion; this taxpayer neither re-

quested nor received. Section 446; Rev. Rul.

65-10, 1965-1 Cum. Bull. 254.

14. In computing the allowable amount

of bad debt loss incurred by taxpayer upon

foreclosure of certain mortgages insured

by the Federal Housing Administration or

Veterans Administration, taxpayer must

follow the procedure of Rev. Rul. 61-35,

1961-1 Cum. Bull 48, which provides that

the amount of bad debt loss realized on a

defaulted insured loan is the difference be-

tween the adjusted tax basis of the loan and

the fair market value of the FHA or VA

debentures received in payment of the in-

surance obligation, and that the loss is real-

ized at the time the debentures are received.

This Revenue Ruling is in accord with gen-

erally recognized principles that measure-

ment of bad debt loss is made following

receipt of all recoveries, including those of

guarantors, comakers, cosigners, and other-

wise. It would distort taxpayer’s income

and deductions to allow it to take a gross

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B-47

bad debt loss as ordinary income while re-

porting the fair market value of the deben-

tures received from the FHA and VA as

short-term capital gain which may be and

was offset against long-term capital loss.

Accordingly, Treasury Regulz ions on In-

come Tax, Section 1.166-6, may not be read

for the provision that taxpayer’s position

on calculation of its allowable bad debts

ia well-founded. Secs. 1011 and 1016(a)(1).

Taxpayer’s reliance upon Treasury Regu-

lations on Income Taxes, § 1.166-6, Sale of

mortgaged or pledged property, is misplaced.

Taxpayer reads subsection (b) of that Reg-

ulation as controlling in the measurement

of the amount of allowable loss which would

not take into account insurance recoveries.

However, subsection (b) may be utilized

only if the requirements of subsection (a)

have been met and that section makes man-

datory a showing by the taxpayer that “the

portion of the indebtedness remaining un-

satisfied after the sale is wholly or partially

uncollectible * * . Because a deficiency

after a mortgage sale cannot be shown to

be wholly or partially uncollectible while

an insurance claim against the FHA or VA

is still outstanding, plaintiff may not utilize

the provisions of subsection (b). Of course,

any deficiencies remaining may be deducted

by plaintiff pursuant to subsection (b) as

2 Section 166 business loss.

15. Having filed its claim for refund, tax-

Payer may not add to or vary from the

grounds set out therein if it is to prevail

B-48

in this action. Real Estate Title Co. v.

United States, 309 U. S. 13 (1940); Alabama

By-Products Corp. v. Patterson [8-2 ustc

19799}, 258 F. 2d 892 (C. A. 5, 1958). Tax-

payer’s claim for refund, which is reflected

in turn in its complaint, and the pretrial

order set out those grounds which this

Court has jurisdiction to consider. In its

most succinct statement in the pretrial

order (par. IV, par. 8), the issue is formu-

lated as follows:

Plaintiff contends that the excess price

paid over the assets obtained is the cost

of acquiring life insurance which is de-

ductible in the year incurred * *.

16. It is axiomatic that the taxpayer in

a federal tax refund action must plead and

prove its case. The burden is on the tax-

payer to show that a deduction it claims,

for example, is clearly within the language

and intent of the taxing statute. United

States v. Olympic Radio & Television [55-1

ustc £9459], 349 U. S. 232 (1955); White v.

United States [38-2 ustc 19600], 305 U. S.

281 (1938). They are made with respect to the

applicability of Treasury Regulations on In-

come Tax, § 1.817-4(d)(2) and (3) (26

C. F. R), which bear upon the tax treatment

of reinsurance transactions. The taxpayer has

taken the basic position that there is no writ in

the statute for the promulgation of those regu-

latory sections, and, therefore, the Gov-

ernment was in error in denying the claimed

immediate deduction for the bonus. The

law, however, puts the burden squarely on

the plaintiff here to cite a section of the

232228 8

—— —

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— sii e

B-49

Internal Revenue Code and to show that

its transaction falls within the purview of

that section. This, taxpayer has not done.

17. Treasury Regulations to Section 817

cited above, set out the rules with respect

to acquisition of blocks of insurance. These

rules indicate that taxpayer’s transaction

falls with Example (2) of Section 1.817-4

(d) (3). Inasmuch as that regulation denies

immediate deduction of bonuses and re-

quires amortization of such bonuses over

the useful life of the contracts, this Court

concludes that the only statutory or regu-

latory authority to which it has been cited

is against the taxpayer.

18 This Court concludes that the deci-

sion in Mutual Savings Life Insurance Co. v.

United States (741 ustc 1 9208]. 488 F. 2d

1142 (C. A. 5, 1974), construing those regu-

lations, controls the issue as framed by tax-

payers claims and the pretrial order. In

Mutual Savings the court examined the tax

consequences of one life insurance company

acquiring a block of policies from another

im a reinsurance transaction. The court

stated first the gencral rules applying to

both the reinsured (here, Atlantic) and the

reinsurer (here, taxpayer) companies. These

rules provide that the reinsurer, upon ac-

quiring the policies, must increase its re-

serves, which increase in reserves is treated

as an immediate tax deduction. Any con-

sideration received in the transaction, how-

ever, must be immediately reported as

income. Finally, at page 1144, the Fifth

Circuit considered the proper treatment by

B-50

the reinsurer upon the payment of addi-

tional .consideration:

But if the reinsurer has paid consideration

for the policies, the payment cannot im-

mediately be deducted, but must be amor-

tized over the estimated life of the

contracts.

19. This Court concludes that the rein-

surance transaction here is analogous to

the Florida Life transaction considered by

the Fifth Circuit in Mutual Savings. There,

the taxpayer’s consideration consisted of

two items: Assumption of reserve liabilities

and payment of a cash bonus. There were

no assets transferred to it in connection

with the policies which would have resulted

in a taxable income. (Here, the considera-

tion paid by the taxpayer also falls into two

categories: Assumption of reserve require-

ments and other liabilities and the payment

of the $29 million bonus.) The Court held

that the taxpayer was entitled to the deduc-

tion for the addition to reserves portion of

the consideration paid under Section 809(d)

(7), but required the amortization of the

bonus paid. Here, the result ought to be no

different. Taxpayer is entitled to a deduc-

tion for the reserves assumed (which has

already been allowed by the Government),

but must amortize the portion of the cash

bonus paid over and above the fair market

value of assets received.

20. The latest position of the taxpayer,

as related in its brief, constitutes a variance

from the issue as framed in paragraph 14

above, and as determined by the Fifth Cir-

cuit in Mutual Savings. For that reason

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B-51

alone, this Court does not have jurisdiction

to consider new grounds relied upon now by

the taxpayer. Real Estate Title Co. v. United

States, supra. Nevertheless, this Court con-

cludes that the position of the taxpayer

advanced in its brief, even if independently

examined, would not support a judgment.

21. Taxpayer’s present argument is that

some part of the bonus it paid for the

Atlantic Life Company should be attributed

to its stock rather than to the block acquisi-

tion of insurance. There are two formidable

obstacles to this argument to be overcome.

The first of these is the general proposition

that acquisition of or investment in a busi-

ness is a capital expenditure which may not

be currently deducted or even amortize

over a period of time. Higgins v. Commis-

stoner (41-1 ustc 1 9233]. 312 U. S. 212

(1941); Woodward v. Commissioner [70-1

ustc J 9348}, 397 U. S. 572 (1970).

22. Taxpayer's major point, however, ap-

pears to be directed at splitting the $29

million in cash consideration paid by it

into separate elements applicable to the

reinsurance of Atlantic’s contracts and the

purchase of Atlantic’s stock. The purpose

of this appears to be to reduce the assets

received in the amount of $118,798,778 by a

figure of more than $30 million through

ascribing some of those assets to stock

rather than as listed on joint Exhibit 38.

If this is taxpayer’s position, it is directly

contrary to the provisions of Section 334(b)

(2). In examining that section, it should

be realized that taxpayer’s acquisition of the

B-52

Atlantic stock was pursuant to a plan under

Sections 332 and 33 of the Code.

23. Section 334(b)(2) is a codification of

the Fifth Circuit's decision in Kimbell-Dia-

mond Milling Co. v. Commissioner [CCH

Dec. 17,454], 14 T. C. 74 (1950), aff'd per

curiom, [51-1 ustc 19201] 187 F. 2d 718

(C. A. 5, 1951), cert. denied, 342 U. S. 827

(1951). The thrust of Section 334(b)(2) is

to ignore the purchase of corporate stock

where the purchasing corporation liquidates

the acquired corporation within two years

of acquisition (as was done here). Section

334(b)(2) treats such a transaction as if the

purchasing corporation acquired the assets

of the acquired corporation rather than its

stock. See 3A Mertens, Law of Federal In-

come Taxation, par. 21.167, pp. 475-482.

24. Here the taxpayer conformed to the

requirements of Section 334 in all respects.

It allocated the entire purchase price

($128,662,909.97) among the fair market

value of the various assets received, includ-

ing the intangible “insurance in force.” To

attempt now to reallocate the purchase

price in a manner other than required by

the statute is rot supportable.

25. Nor is there any true distinction be-

tween the Fifth Circuit’s decision in Mutual

Savings and the present case on the basis

that in Mutual Savings there was a straight

acquisition of a block of insurance, whereas

here there was acquisition of the company

holding the block of insurance. Section 332

(5) (2) and the Kimbell-Diamond doctrine

strike through any such distinction.

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B-53

2. Nor do taxpayer’s points with re-

spect to industry practices, accounting, or

Congressional intent convince the Court to

ignore the principles set forth above. The

first of taxpayer’s points may be met with

the simple Statement that insurance indus-

try practices do not control this Court;

rather, the Internal Revenue Code is the

applicable law. To the extent that insur-

ance industry practices are not in accord

with the Code, they must be ignored.

— — tie 1 Ins. Co. of Texas v.

Ommissioner ustc J 9625], ;

298 (C. A. 5, 1970). e *

2. Secondly, accrual accounting princi-

ples provide for the matching of revenues

and expenses with each other without regard

to the actual time of receipt or expenditure

of cash. United States v. Anderson {1 ustc

1155]. 269 U. S. 422 (1926). Accordingly,

under the matching principles of accrual

accounting, the cost of acquisition of insur-

ance policies must be amortized over the

useful life of those policies.

2 Finally, taxpayer’s citation to S. R

No. 291, 86th Cong., Ist Sess. (1959-2 —

Bull. 770 776, 784), gives no support to its

claimed treatment of block assumption of

msurance contracts or the acquisition of

one life insurance company by the other.

29. It follows that because taxpayer ma

not deduct the bonus in the year "Of —

ment, the unamortized portion of the bonus

must be dealt with for the purposes of

B-54

Section 805(b)(4). That section defines

“assets” for the purposes of inclusion in

the Phase I Computation of an insurance

company’s tax liability. That section and

the Treasury Regulations thereunder define

assets in an all inclusive manner with

certain stated exceptions. This Court con-

cludes that the unamortized portion of the

bonus paid for acquisition of the Atlantic

Life policies constitutes such an asset which

is reflected (as it must be) on the books of

taxpayer.

30. This Court further concludes that

Treasury Regulations on Income Tax,

8 — re do * in — * —

ceptions, include such an asset as un-

— jĩ— On baum oot Certainly,

the unamortized portion of the bonus does

not fit within the exception of Treasury

Regulations on Income Tax, § 1.805-5(a)(4)-

(i) (d), “automobiles and other depreciable

personal property used in connection with

the operations conducted in the home office

see”

31. Accordingly, this Court concludes

that the bonus paid must be amortized over

the useful life of the policies (10 years)

and the unamortized portion of the bonus

must be included in “assets” under Section

805.

32. Any finding of fact deemed as prop-

erly constituting a conclusion of law is

hereby adopted as a conclusion of law.

The parties will draw a judgment in

conformity with these findings of fact and

conclusions of law.

se e os

„

r

C-1

APPENDIX C

In THE

UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

No. 75-2675

SOUTHWESTERN LIFE INSURANCE COMPANY,

Plaintiff-Appellee,

Cross-Appellant,

versus

UNITED STATES OF AMERICA,

Defendant-Appellant,

Cross-Appellee.

Appeal from the United States District Court for the

Northern District of Texas

ON PETITION FOR REHEARING

(December 2, 1977)

Before TUTTLE, GOLDBERG and CLARK, Circuit Judges.

PER CURIAM:

Ir is ORDERED that the petition for rehearing filed in the

above entitled and numbered cause be and the same is

hereby denied.

ENTERED For THE Court:

/s/ EDWARD W. WapsworTH

United States Circuit Judge