Appendix — Franklin Life Insurance v. United States

APPENDIX A

51 T. C. No. 81

TAX COURT OF THE UNITED STATES

Docket No. 1621-64.

Western Nationa Lire Insurance Company or Texas,

Petitioner,

—V.—

CoMMISSIONER OF INTERNAL REVENUE,

Respondent.

Filed February 24, 1969.

Upon reconsideration,

Held: That net “deferred and uncollected premiums”

and net “due and unpaid premiums” (exclusive of

loading) are includable in assets for computing tax-

payer’s share of investment income under section 804,

I.R.C. 1954, as amended. Original opinion of this

Court filed May 13, 1968, reported in 50 T.C. 285,

modified accordingly; affirmed on all other issues.

J. W. Bullion, for the petitioner.

John W. Holt and Patrick W. Johnson, for the respon-

dent.

SUPPLEMENTAL OPINION

DRENNEN, Judge: Respondent filed a timely Motion for

Reconsideration and Revision of the original opinion filed

:

2a

by this Court in this proceeding on May 13, 1968, reported

in 50 T.C. 285.1 The motion was that the Court “modify

said opinion by deciding the gross deferred and uncol-

lected and gross due and unpaid premium asset issves

(Issues Nos. 2, 3, and 4 in the Opinion) in accord with

the contention of the respondent.” Respondent’s motion

was set down for oral argument on August 7, 1968, and

the Court invited counsel* for the American Life Conven-

tion and the Life Insurance Association of America to

participate as amici curiae. In addition to the oral argu-

ment, extensive briefs were filed by the amici curiae as

well as by petitioner and respondent. In the light of the

arguments presented, and the decision of the United

States Court of Appeals for the Seventh Circuit in Frank-

lin Lafe Insurance Co. v. United States, 399 F.2d 757,

certiorari applied for Nov. 27, 1968, promulgated sub-

sequent to the original opinion of this Court, we deemed it

appropriate to reconsider the two issues mentioned above

and to revise our opinion as a result thereof. Consequently,

respondent’s Motion for Reconsideration and Revision was

granted.

This Court made complete findings of fact and reviewed

the provisions of the Code which are pertinent to the

issues here under review in its original opinion and will

not repeat them here. Reference is made to the former

opinion of this Court, supra, for the facts involved in this

proceeding.

The only issues before the Court involved adjustments

proposed by respondent in the computation of petitioner’s

1 Respondent also filed a uest for Review by Full Co

which is denied. it i ‘i

? William B. Harman, Jr., for American Life Convention.

Kenneth L. Kimble, for Life Insurance Association of America.

3a

so-called phase I tax, or tax on investment income, imposed

under the Life Insurance Company Income Tax Act of

1959, section 801, et seq., of the 1954 Code as amended.

In its original opinion the Court agreed with petitioner

and held that “deferred and uncollected premiums” and

“due and unpaid premiums” were not to be included as

“assets” within the meaning of section 805(b)(4) of the

Code, in computing petitioner’s share (and the policy-

holders’ share) of its investment income under the formula

provided for that purpose in section 804. The basic premise

upon which the Court based this conclusion was that there

should be included in assets for purposes of the computa-

tion only such assets as produced the net investment in-

come, and that these bookkeeping assets, not being avail-

able to petitioner, should be excluded.

Respondent contends that the entire gross amount of the

“deferred and uncollected premiums” and the “due and

unpaid premiums,” including “loading,” should be included

in assets for purposes of the computation. The amici agree

with respondent that “deferred and uncollected premiums”

should be included in assets to avoid distortion in the com-

putation under the prescribed formula, but that the load-

ing should not be included. The amici took no position

with respect to “due and unpaid premiums.”

Upon further reflection, we agree with the amici that

the net “deferred and uncollected premiums” should be

included in assets but that the “loading” included in such

premiums should not be included; also we conclude that

3 These terms are defined in the original opinion. Briefly, “de-

ferred and uncollected premiums” are premiums that will become

due by the end of the contract year on life insurance contracts

but which are not collected by the end of petitioner’s tax (calen-

dar) year, and “due and unpaid premiums” are premiums on acci-

dent and health insurance contracts that are due but have not

been paid at the end of petitioner’s tax year.

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the net “due and unpaid premiums” should be included in

assets but that the loading included in such premiums

should not be included. Accordingly, the original opinion

of this Court, supra, is modified to reflect the views herein

expressed with respect to those two issues, and the con-

clusions reached therein with respect to all other issues

involved are hereby affirmed.

The legislative history of the Life Insurance Company

Income Tax Act of 1959 indicates that Congress was at-

tempting to tax all of a life insurance company’s share

of its gross income, both investment income and under-

writing income, in a manner as consistent as possible with

the accounting procedures required to be used by the com-

pany by State regulatory agencies. This involves accept-

ing the assumption, even though it has no basis in fact,

that in establishing its reserves for policyholder liabilities

in the taxable year the insurance company must assume

that the gross annual premiums on all policies in force

at the end of the year have been paid in full. Thus the net

valuation premiums, i.e., the gross premiums less the load-

ing factor, on all policies in force at the end of the year

are added to the company’s reserves and are shown on its

balance sheet as liabilities. In order to avoid a distorted

balance sheet resulting from setting up this admittedly

overstated reserve as a liability, the insurance company is

permitted to include in its balance sheet as an offsetting

asset the items “deferred and uncollected premiums” and

“due and unpaid premiums,” which are likewise fictitious

assets. As with the liability, the amount to be included

on the asset side of the balance sheet on the National

Association of Insurance Commissioners (NAIC) forms is

the net valuation portion of the premiums, exclusive of

loading.

es ———— ©

5a

In the scheme of taxing the insurance company’s share

of its investment income under phase I of the tax, the re-

serves above mentioned are used to measure the policy-

holders’ share of its investment income. The policyholders’

reserves are multiplied by the company’s own current or

average investment rate to obtain the policyholders’ share

of the investment yield, which is nontaxable; the balance

of the investment yield is the company’s share of net in-

vestment income which is subject to tax under phase I.

In arriving at the company’s current investment rate,

certain expenses are deducted from its gross investment

income to obtain the investment yield. The investment

yield is then divided by the assets of the company to ob-

tain the current rate. The company assets used in this

computation are defined in section 805(b)(4) as all the

assets of the company other than real and personal prop-

erty (excluding money) used by it in carrying on an in-

surance trade or business. Inasmuch as the fictitious

assets “deferred and uncollected premiums” and “due and

unpaid premiums” are not assets used by the company in

carrying on its insurance business, it would seem that these

“assets” must be included in the computation used in find-

ing the company’s current rate, even though they are not

real assets and could not possibly be used to produce in-

vestment income.

While it is difficult to understand how amounts which

neither have been received nor are due and collectible as

of the end of an accounting year can be considered accrua-

ble in the usual accounting sense of that term, it is easier

to understand that if one starts with the assumption that

these amounts have al! been paid by the end of the year,

they would certainly be accrued if the assumption is ac-

cepted as fact. It is also easier to unaerstand that if the

objective of the phase I tax is to exclude from the tax on

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investment income the policyholders’ share of that income,

and in order to arrive at the amount of that exclusion the

measurement used is an amount (the reserves) which in-

cludes in it net valuation premiums which are assumed to

have been paid in full, it would thereby become necessary,

in order to avoid distortion in this scheme of taxation,

to likewise assume that all net valuation premiums have

been collected and are “accrued” assets in the company’s

hands for purposes of determining the current rate and

the company’s share of the investment income or yield that

is subject to tax. In other words, it is easier to leave for

the moment the practicalities of taxation to include in both

sides of a formula used for apportioning investment in-

come between the company and its policyholders equal and

offsetting fictitious amounts than to accept the theory that

uncollected premiums that are not even due can be con-

sidered “assets” which produce investment income. To do

otherwise would appear to throw the formula out of bal-

ance and distort the proration.

While we find no specific support for this conclusion in

the legislative history of the Act, this fiction appears to

be accepted by ail parties here concerned as a part of the

scheme for taxing insurance companies under the 1959 Act,

and the Court of Appeals for the Seventh Circuit accepted

it in its opinion in Franklin Life Insurance Co., supra.

Inasmuch as the insurance industry operates a good bit

on assumptions, perhaps this is the only reasonable ap-

proach to the problem. In any event we are not convinced

that net “deferred and uncollected premiums” and “due

and unpaid premiums” must be included in assets in com-

puting petitioner’s tax under phase I of the Act, and our

former opinion holding to the contrary is modified in this

respect.

7a

This does not answer the issue entirely, however. There

still remains the question whether the loading factor in-

cluded in “deferred and uncollected premiums” and “due

and unpaid premiums” must be included in these fictitious

assets. Respondent argues that “loading” should be in-

cluded, and he is supported in this position by the Court

of Appeals in the Franklin case, and by the District Court

in Jefferson Standard Life Insurance Co. v. United States,

272 F.Supp. 97 (.D. N.C. 1967), which is ow on appeal

to the Court of Appeals for the Fourth Circuit. Petitioner

and the amic} curiae argue that the loading factor should

not be included in assets because it has a zero basis and

to include the entire gross amount of the premiums in

assets while only the net valuation part thereof (gross

premiums minus loading) is included in reserves would

weight the formula against the insurance company and

distort the balance sheet and the computation the other

way. With ail due respect to the Court of Appeals for

the Seventh Circuit and the District Court in North

Carolina, we must agree with petitioner and the amici.

The reasoning of the Court of Appeals and the argument

of respondent is that in computing phase II of the tax

on petitioner’s underwriting or operating income under

section 809, petitioner is required to take into account as

“gain from operation” the gross amount of premiums

and other consideration (including advance premiums, de-

posits, fees, assessments, and consideration in respect of

assuming liabilities under contracts not issued by the tax-

payer) on insurance and annuity contracts, less return

premiums, and the premiums and other consideration

arising out of reinsurance ceded.‘ Again using the as-

sumption that all premiums on policies in force at the

* This was conceded by the taxpayer in Franklin Life I

Co., 399 F.2d 757. is en

Sa

end of the year have been paid in full by the end of the

year, the “deferred end uncollected premiums” and “due

and unpaid premiums,” including the loading factor therein,

are considered to be accrued income for the purpose of

this computation, (This, despite the fact that the statute

expressly includes “advance premiums, deposits, fees,” ete,,

but says nothing about deferred and unpaid premiums.)

The argument then points out that the statute does not

allow any deduction for loading; hence the entire amount

of the gross premiums becomes an “accrued” asset.

We do not believe it necessarily follows that because

loading is required to be included in gross pvemiums and

ia not deductible in the computation of the phase II tax,

it must also be included in assets for computation of the

phase | tax. As we understand it the phase II] computa-

tion is designed to tax the insurance companies’ gain on

operating income including gain on the very charges we

are discussing, i.e., the loading charges. There is no ques-

tion that any gain on such charges is intended to be taxed

to the insur®..ve company, either in the year of “acerual”

or when actually realized. On the other hand the only

reason for including deferred and unpaid premiums as

balance sheet assets for purposes of the phase I tax is to

offset the overstated reserves and prevent distortion in

computing the policyholders’ and the insurance companies’

shares of investment yield. We see no reason when indulg-

ing in this fiction to set up, or accrue, an asset greater in

amount than is necessary to offset the overstated liability

on the other side of the balance sheet. To do so would

simply swing the pendulum the other way and distort the

allocation against the petitioner.

We find nothing in section 818(a) that requires a dif-

ferent conclusion, That section provides that all computa-

NT)

tions entering into the determination of the taxes linpored

by this law shall be made (1) under an acerual method of

avcounting, or (2) to the extent permitted under the regu

lations prescribed by the Secretary or his delegate, under

a combination of an accrual method of accounting with

any other method permitted by this chapter, except the

cash method. Exeept as provided in’ the preceding sen

tence, atl such computations shall be made in a manner

consistent with the manner required for the purposes of the

annual statement by the National Association of Insurance

Commissioners,

As pointed out in our prior opinion, the deferred and

unpaid premiums would not be acerued under standard

acerual avcounting concepts, because they were not. re-

ceived by the end of the year and were not collectible un-

less the insured agreed to pay them, They could be con.

sidered accrued, and thus give rise to an accrued asset,

only if the assumption is made that all premiums on

policies in foree had been paid by the end of the year,

If this assumption is indulged in for this purpose, we

think it should also be assumed that all commissions and

other expenses covered by the loveding charge had been

paid by the end of the year, leaving only the net valuation

amount as the value of the asset. We recognize that if

the loading charge exceeds the expenses chargeable against

it, there might be some of the loading charge left avail-

able as a fictitious asset. However, that gain would even-

tually be taxed under phase I] of the tax and we see no

reason to include it as an asset for purposes of the phase

I computation until the amount thereof can be determined.

Furthermore, if the loading factor must be considered an

accrued asset under the assumptions indulged in, we doubt

that it would be an asset other than property used by it

OE EY EE

LO LY NE ROGET I IP ap

10a

in corrying on an insurance trade or business under the

deflaition contained in avetion SOO b) (4),

We find nothing in the definition of asseta in section

BOD) (4) that apecifleally includes loading, The NATC

accounting exeludes it from assets, And we would not

know what adjusted baaia, if any, to attribute to this item

inany event ib it were included in: assets,

Consequently, we eonelide that ‘loading’! on “deferred

and uncollected premiums” and on “due and unpaid pre

mite” is not includable in assets under section SO5(b) (4)

of the Code,

Respondent urges that under section LSOL4(f) of his

regulations’ if petitioner is permitted to exelude any part

of gross premiums deferred and uncoilected and due and

unpaid from assets, then a corresponding portion of the

net valuation premium must be excluded from the re-

serves used in the tax computation, The only portion of

the accrued gross premiums excluded from assets is) the

loading factor, which never becomes a part of the reserves

used for purposes of this computation, We do not believe

any further adjustment either should be made or in called

for by the regulations,

In his memorandum filed in’ support of this motion,

respondent argues that if loading is omitted from assets

(deducted from “accrued” gross premiums) for purposes

of the computation of the phase | tax petitioner would

in effect get a double deduction for the expenses supposedly

* Sec. 1.801-4(f). Adjustments to life insurance reserves. In the

event it is determined on the basis of the facts of a particular

case that premiums deferred and uncoilected and premiums due

and unpaid are not properly accruable for the taxable year under

section 809 and, accordingly, are not properly includible under

assets (as defined in section 805(b)(4)) for the taxable year,

appropriate reduction shall be made in the life insurance re-

serves. ° * °

eovered by the loading factor when the phase TT tax ta

computed, We do not agree with respondent's reasoning

in thin argument, but we are happy to aay that we have

no iaaue before ue concerning the phase Tl tax and we

chooae not te venture further than need be into thin

fantaay world of life insurance company accounting and

taxation,

Except as modifled herein, the conclusions reached in

our prior opinion atand affirmed,

dO a

Qe meyer