Supplemental Brief for the United States — Franklin Life Insurance v. United States

In the Supreme Gourt of the United States

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Vrvpnnant te Rate 2409) of the Rules af this Court,

Wo file Cgbs daemoranetin to tiforma the Court that the

Max Court, on RPebruary 24, TYGQ) issued al supple

raventaal eypeetatarte Un Western National Late laxmranee

Co of Tenis v. Cormusstoner, SIE TRCL Noo St, modit

shar JORG. 288. A copy of the supplemental opinion ts

Printod ges an appendin hereto,

The petition for a writ of certiorari asserted Cp.

19) that the original opinion in Western National was

in eonthet with the deeimion of the Seventh Cireuit

heme, As stated in our Brief in Opposition Cp, 16),

Western National had not vet become final, having

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been held open on the Commissioner’s motior for

reconsideration.

In the opinion of February 24, the Tax Court

adopted the position of petitioner on the question

whether the amount described 2s “loading’’ should

be subtracted in determining the amount of deferred

and uncollected premium included in the “assets’’ of

life insurance companies in the “phase ]’’ computa-

tion under Section 805(b) (4). The opinion expressly

reserves, however, the other premium questien pre-

sented in the instant case, i.e., whether the amount

which petitioner calls “increase in loading”’ should be

excluded from the deterred and uncollected portion in

“oross premiums’’ in the “phase II” computation

under Section 809(c)(1). Thus the opinion states

(App. p. 12):

We do not believe it necessarily follows that

because loading is required to be included in

gross premiums and is not deductible in

the computation of the phase I tax, it must

also be included in assets for computation of

the phase I tax. As we understand it the phase

II compvtation is designed to tax the insurance

companies’ gain on operating income including -

gain on the very charges we are discussing, 1.e.,

the loading charges. There is ro question that

any gain on such charges is intended to be taxed

to the insurance company, either ir ie year of

“accrual”? or when actually realized.

2The motion for reconsideration of the original decision was

accompanied by a request for review by the full Tax Court. By

footnote to the supplemental opinion, Chief Judge Drennen de-

nied the request for review by the full Tax Court (App. p. 5).

3

For the reasons stated in our Brief in Opposition

(pp. 9-18) we adhere to the view that the Seventh

Circuit correctly held that the full amoust of pre-

miums deferred and uncollected should be inciuded

both in premium income and in assets without an off-

set for the amounts described as “loading’’. And we

are unable to perceive a rational basis for the treat-

ment suggested by the language quoted above from

the supplemental opinion in ‘Western National, te.

that an adjustment for loading may be allowed in ¢al-

culating assets but not in determining gain from

operations.

At all events, the disagreement between the Tax

Court and the Seventh Circuit does not give rise to

a conflict in decisions that independently justifies re-

view in this Court. The decision in Western National

remains subject to appellate review, which, in due

course, would occur in the Court ef Appeals for the

Fifth Cireuit. Plenary consideration in this Court

should await the development of a conflict of opinion

among the circuits if one should ultimately occur.

Respectfully submitted.

ERWIN N. Griswo p,

Solicitor General.

FEBRUARY 1969.

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APPENDIX

51 T.C. No. 81

TAX COURT OF THE UNITED STATES

WESTERN NatTionaL LiFE INsuRANCE CoMPANY OF

Texas, PETITIONER v. COMMISSIONER OF INTERNAL

REVENUE, RESPONDENT

Docket No. 1621-64 Filed February 24, 1969.

Upon reconsideration,

Held: That net “deferred and uncollected premi-

ums” 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 acccrdingly; affirmed on all other issues.

J. W. Bullion, for the petitioner.

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

spondent.

SUPPLEMENTAL OPINION

DRENNEN, Judge: Respondent filed a timely Motion

for Reconsideration and Revision of the original opin-

ion filed by this Court in this proceeding on May 13,

1968, reported in 50 T.C. 285.* The motion was that

the Court “modify said opinion by deciding the gross

deferred.and uncollected and gross due and unpaid

* Respondent also filed a Request for Review by Full Court,

which is denied.

(5)

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6

premium asset issues (Issues Nos. 2, 3, and 4 in the

Opinion) in accord with the contention of the respond-

ent.”’ Respondent’s motion was set down for oral argu-

ment on August 7, 1968. and the Court invited coun-

sel* for the American Life Convention and the Life

Insurance Association of Ameriea to participate as

amici curiae. In addition to the oral argument, ex-

tensive briefs were filed by the amici curiae as well

as by petitioner and respondent. In the light of the

_argmpents. presgated, end thederision of tke United

States Court of Appeals for the Seventh Cireuit in

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

2d 757, certiorari applied for Nov. 27, 1968, promul-

gated subsequent 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 Re-

consideration and Revision was granted.

This Court made complete findings of fact and

reviewed the provisions of the Code which are per-

tinent 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 adjust-

ments proposed by respondent in the computation of

petitioner’s so-called phase I tax, or tax on invest-

ment income, imposed under the Life Insurance Com-

pany 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 premi-

wms’’ were not to be included as ‘‘assets’’ within the

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

Henneth L. Kimble. for Life Insurance Association of

America.

7

meaning ef section 805(b)(4) of the Code,’ in com-

puting petitioner’s share (and the policyholders’

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 pur-

poses of the computation only such assets as produced

the net investment income, and that these bookkeep-

ing assets, not being available to petitioner, should

be excluded... .- . ame...

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 com-

putation. The amici agree with respondent that “de-

ferred and uncollected premiums”’ should be included

in assets to avoid distortion in the computation under

the prescribed formula, but that the loading should

not be included. The amici took no position with re-

spect 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 the net ‘‘due and unpaid premi-

ums’’ should be included in assets but that the load-

ing 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

These terms are defined in the original opinion. Briefly,

“deferred 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 (calendar) year, and “due and unpaid premiums” are

premiums on accident and health insurance contracts that are

due but have not been paid at the end of petitioner’s tax year.

EAP ATER PIED COT

8

respect to those two issues, and the conclusions

reached therein with respect to all other issues in-

volved are hereby affirmed.

The legislative history of the Life t.surance Com-

pany Income Tax Act of 1959 indicates that Con-

gress was attempting to tax all of a life insurance

company’s share of its gross income, both investment

income and underwriting income, in a manner as con-

sistent as possible with the accounting procedures re-

quired to be used by the company by State regulatory

agencies. This involves accepting the assumption, even

though it has no basis in fact, that in establishing its

reserves for policyholder liabilities in the taxable vear

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 valua-

tion premiums, i.e., the gross premiims less the load-

ing factor, on all policies in force at the enu of thie

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 pre-

miums,’’ 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.

In the scheme of taxing the insurance company’s

share of its investment income under phase I of the

tax, the reserves above mentioned are used to measure

the policyholders’ share of its investment income. The

policyholders’ reserves are multiplied by the company’s

iY

own curreat 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 investment 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 invest-

ment income to obtain the investment yield. The in-

vestment yield is then divided by the assets of the

company to obtain 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 property (excluding money) used

by it in carrying on an insurance trade or business.

Inasmuch as the fictitious assets “deferred and un-

collected 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 finding

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

real assets and could not possibly be used to produce

investment income.

While it is difficult to understand how amounts

which neither have been received nor are due and col-

lectible as of the end of an accounting year can be

considered accruable in the usual accounting sense

of that term, it is easier to understand that if one

starts with the assumption that these amounts have

all been paid by the end of the year, they would

certainly be accrued if the assumption is accepted as

fact. It is also easier to understand that if the objec-

tive of the phase I tax is to exclude from the tax

on 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 includes in it net valuation premiums

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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 ‘‘acerued’’ assets in the company’s hands for

purposes of determining the current rate and the

company’s share of the investment imeome 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 appor-

tioning investment income between the company and

its policyholders equal and of'setting fictitious

amounts than to accept t'e theory that uncollected

premiums that are not even due can be considered

‘‘assets’’ which produce investment income. To do

otherwise would appear to throw the formula out of

balance and distort the proration.

While we find no specific support for this conelu-

sion in the legislative history of the Act, this fiction

appears to be accepted by all parties here concerned

as a part of the scheme for taxing insurance com-

panies 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 assump-

tions, perhaps this is the only reasonable approach

to the problem. In any event we are now convinced

that net ‘‘deferred and uncollected premiums’’ and

‘due and unpaid premiums’’ must be included in

assets in computing petitioner’s tax under phase I of

the Act, and our former opinion holding to the con-

trary is modified in this respect.

This does not answer the issue entirely, however.

There still remains the question whether the loading

factor included in ‘‘deferred and uncollected pre-

miums” and “due and unpaid premiums’’ must be

11

included in these fictitious assets, Respondent argues

that “loading” should be included, and he is sup-

ported in this position by the Court of Appeals im

the Franklin ease, and by the District Court m Jef-

ferson Standard Life Insurance Co, V. United States,

272 F. Supp. 97 (M.D.N.C. 1967), which is now on

appeal to the Court of Appeals for the Fourth Cir-

cuit. Petitioner and the amici curiae argue that the

loading factor should not be included in assets be-

cause it has a zero basis and to inclide the entire

gross amount of the premiums in assets while only

the net valuation part thereof (gross premiums minus

loading) is tneluded in reserves would weight the for-

mula against the insurance company and distort the

balance sheet and the computation the other way.

With all due respect to the Court of Appeals for the

Seventh Cireuit 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 operat-

ing income under section 809, petitioner is required to

take into account as “gain from operation’”’ the gross

amount of premiums and other consideration (inelud-

ing advance premiums, deposits, fees, assessments, and

consideration in respect of assuming liabilities under

contracts not issued by the taxpayer) on insurance

and annuity contracts, less return premiums, and the

premiums and other consideration arising out of re-

insuranee ceded.’ Again using the assumption that all

premiums on policies in force at the end of the year

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

‘This was conceded by the taxpayer in Franklin Life In-

surance Co., 399 F. 2d 757.

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“deferred and uncollected premiums” and “due and

unpaid premiums,’* including the loading factor there-

in, are considered to be xeerued income for the pur-

pose of this computation. (This, despite the fact that

the statute expressly includes “advance premiums, de-

posits, fees,’’ ete., but savs 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 pre-

miums becomes an “accrued” asset.

We do not believe it necessarily follows that because

loading is required to be ineluded in gross premiums

and is not dedigtible in the computation of the phase

TT tax, it must also be included in assets for ecomputa-

tion of the phase T tax. As we understend it the phase

IT computation is designed to tax the insurance com-

panies’ gain on operating income including gain on

the very charges we are discussing, i.e., the loading

charges. There is no question that any gain on such

charges is intended to be taxed to the insurance com-

pany, either in the year of “acerual’’ or when actually

realized. On the other hand the only reason for inelud-

ing 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 comput-

ing the policyholders’ and the insurance companies’

shares of investment yield. We see no reason when

indulging in this fiction to set up, or accrue, an asset

greater in amount than is necessary to offset the over-

stated 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 816(a) that requires a

different conclusion. That section provides that all

computations entering into the determination of the

taxes imposed by this law shall be made (1) under an

13

accrual method of accounting, or (2) to the extent

permitted under the regulations prescribed by the

Secretary or his delegate, under a combination of an

acerual method of accounting with any other method

permitted by this chapter, except the cash method.

Exeept as provided in the preceding sentence, all such

computations shall be made in a manner consistent

with the manner required for 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 accrued under

standard acerual accounting concepts, because they

were not received by the end of the year and were

not collectible unless the insured agreed to pay them.

They could be considered acerved, 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 in-

dulged in for this purpose, we think it should also be

assumed that all commissions and other expenses ccv-

ered by the loading 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 load-

ing charge exceeds the expenses chargeable against

it, there might be some of the loading charge left

available as a fictitious asset. However, that gain

would eventually be taxed under phase ITI 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 load-

ing 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 in carrying

on an insurance trade or business under the definition

contained in section 805(b) (4).

14

We find nothing in the definition of assets in sec-

tion 805(b) (4) that specifically includes loading. The

NAIC accounting excludes it from assets. And we

would not know what adjusted basis, if any, to at-

tribute to this item in any event if it were included

in assets.

Consequently, we conclude that “leading’’ on ‘“‘de-

ferred and uncollected premiums” and on “due and

unpaid premiums’’ is not includable in assets under

805('b) (4) of the Code.

Respondent urges that under section 1.801-4(f) of

his regulations’ if petitioner is permitted to exclude

any part of gross premiums deferred and uncollecteu

and due and unpaid from assets, then a correspond-

ing portion of the net valuation premium must be

excluded from the reserves used in the tax computa-

tion. 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 pur-

poses of this computation. We do not believe any

further adjustment either sheuld be made or is 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 premi-

ums) for purposes of the computation of the phase I

tax petitioner would in effect get a double deduction

for the expenses supposedly covered by the loading

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

the event it is determined on the basis of the facts of a particu-

lar case that premiums deferred and uncollected and premiums

due and unpaid are not properly accruable for the taxable year

under section 809 and, accordinzly, are not properly iacludible

under assets (as defined in section &05(b)(4)) for the taxable

year, appropriate reduction shall be made in the life insurance

reserves. * * *

as pat a a

15

factor when the phase II tax is computed. We do not

agree with respondent’s reasoning in this argument,

but we are happy to say that we have no issue before

us concerning the phase II tax and we choose not to

venture further than need be into this fantasy world

of life insurance company accounting and taxation.

Except as modified herein, the conclusions reached

in our prior opinion stand affirmed.

1S GOVERNMENT PRINTING OFFICE: 1969