Debt Instruments with Original Issue Discount; Annuity Contracts

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[FI-33-94]

RIN 1545-AS76

Debt Instruments with Original Issue Discount; Annuity Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

[[Page 17732]] federal income tax treatment of annuity contracts not

issued by insurance companies. Under the proposed regulations, certain

annuity contracts are taxed as debt instruments for purposes of the

original issue discount provisions of the Internal Revenue Code. The

proposed regulations provide guidance to sellers and buyers of these

contracts. This document also provides a notice of a public hearing on

the proposed regulations.

DATES: Written comments must be received by Tuesday, July 18, 1995.

Requests to appear and outlines of topics to be discussed at the public

hearing scheduled for Tuesday, August 8, 1995, at 10 a.m. also must be

received by Tuesday, July 18, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (FI-33-94), room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, submissions may be hand delivered between

the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (FI-33-94),

Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,

Washington, DC. A public hearing has been scheduled for Tuesday, August

8, 1995, at 10 a.m. in the Auditorium, Internal Revenue Building, 1111

Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Andrew C.

Kittler, (202) 622-3940, or Jeffrey W. Maddrey, (202) 622-3940;

concerning submissions and the hearing, Michael Slaughter, (202) 622-

7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Sections 163(e) and 1271 through 1275 of the Internal Revenue Code

of 1986 (Code) provide rules for the treatment of debt instruments that

have original issue discount (OID). On February 2, 1994, the IRS

published in the Federal Register final regulations under these

sections (59 FR 4799). This document contains proposed amendments to

Sec. 1.1275-1(d) relating to the definition of a debt instrument for

purposes of the OID provisions of the Code.

Explanation of Provisions

Section 1275(a)(1)(A) provides that the term debt instrument means

a bond, debenture, note, or certificate or other evidence of

indebtedness. Under Sec. 1.1275-1(d), the term debt instrument means

any instrument or contractual arrangement that constitutes indebtedness

under general principles of federal income tax law (including, for

example, a certificate of deposit or a loan).

Certain annuity contracts, however, are excluded from the

definition of a debt instrument for purposes of the OID provisions.

Under section 1275(a)(1)(B)(ii), an annuity contract to which section

72 applies and which is issued by an insurance company is generally

excluded from the definition of debt instrument if the circumstances of

its issuance meet certain broad statutory requirements. By contrast,

section 1275(a)(1)(B)(i) provides a more limited exception from the

definition of debt instrument for an annuity contract to which section

72 applies and which is not issued by an insurance company. The section

1275(a)(1)(B)(i) exception applies if the annuity contract depends (in

whole or in substantial part) on the life expectancy of one or more

individuals. Thus, if a contract is both a debt instrument and an

annuity contract not issued by an insurance company, it is subject to

taxation as a debt instrument under the OID provisions rather than as

an annuity contract under section 72, unless it qualifies for the

exception provided in section 1275(a)(1)(B)(i).

If a debt instrument has OID, section 1272 generally requires the

holder of the debt instrument to include OID in income currently on a

constant yield basis, regardless of the holder's overall method of

accounting. This mandatory accrual is intended, in part, to provide an

economically accurate reflection of income and to prevent a mismatch of

issuer deductions and holder inclusions. In the case of a debt

instrument that does not pay interest on a current basis, this mismatch

would occur if the holder were allowed to defer including OID in income

until the year in which it is actually paid. See H.R. Rep. No. 413

(Part I), 91st Cong., 1st Sess. 109 (1969); H.R. Rep. No. 432 (Part

II), 98th Cong., 2d Sess. 1242-43 (1984).

By contrast, the holder of an annuity contract to which section 72

applies is allowed to defer including economically earned income until

distributions on the contract are made. Generally, under section 72(b),

the holder of an annuity contract includes the earnings on the contract

in income on a pro rata basis as distributions are made.

The disparity between the tax treatment of debt instruments and

that of annuity contracts is most pronounced in the case of an annuity

contract that provides for distributions to commence significantly

after the date of initial investment. In that case, a substantial

portion of the value of the annuity contract when distributions begin

may be attributable to income economically earned prior to that time.

If the contract is taxed as an annuity contract under section 72, the

income economically earned prior to the commencement of distributions

is not taxed to the holder until distributions are made. If the same

contract, instead, is taxed under the OID provisions as a debt

instrument, income is taxed to the holder in the year it is earned,

regardless of when distributions are made.

Differences between the tax treatment of debt instruments and

annuity contracts also exist when an annuity contract provides for

distributions commencing on or near the date of initial investment.

Although the holder of the contract has income inclusions over the

entire term of the contract, the rate of inclusion under section 72 is

different from that under the OID provisions. In general, the rules of

section 72 provide a less economically accurate recognition of income

than the OID provisions. The difference in the rate of inclusion,

however, is most significant in the case of an annuity contract that

has deferred payments or payments that increase in amount over the life

of the contract.

The IRS has determined that the exception contained in section

1275(a)(1)(B)(i) does not apply to annuity contracts that provide for

significant deferral of income, that is, those contracts that provide

for no distributions, or for relatively small distributions, in the

early years of the contract. Since 1969, when Congress first required

current inclusion of OID by holders, one of the principal purposes of

the OID rules has been to provide a more economically accurate

reflection of income. See H.R. Rep. No. 413 (Part I), 91st Cong., 1st

Sess. 109 (1969); H.R. Rep. No. 432 (Part II), 98th Cong., 2d Sess.

1242-43 (1984). Given the well-established Congressional preference for

current inclusion, it would be inappropriate to interpret the exception

in section 1275(a)(1)(B)(i) as permitting section 72 rather than the

OID provisions to govern the holder's tax treatment of annuity

contracts that provide for significant deferral.

The proposed regulations provide that an annuity contract qualifies

for the exception described in section 1275(a)(1)(B)(i) only if all

payments under the contract are periodic payments that (1) are made at

least annually for the life (or lives) of one or more individuals, (2)

do not increase at any time during the term of the contract, and (3)

are part of a series of payments that begins within one year of the

date of the initial investment in the contract. [[Page 17733]] The

proposed regulations further provide that an annuity contract that is

otherwise described in the preceding sentence does not fail to qualify

for the section 1275(a)(1)(B)(i) exception merely because it also

provides for a payment (or payments) made by reason of the death of one

or more individuals.

The proposed regulations only apply to annuity contracts that are

also debt instruments under general principles of federal income tax

law. An annuity contract that is not a debt instrument for federal

income tax purposes is not subject to the OID provisions. See the

general rule of section 1275(a)(1)(A). It is, therefore, unnecessary to

inquire whether such an annuity contract is described in section

1275(a)(1)(B). For example, an annuity contract under which payments

are wholly contingent on the continued life of an individual generally

is not a debt instrument for federal income tax purposes. As a result,

such a contract will continue to be taxed as an annuity contract under

section 72. No inference is intended under the proposed regulations as

to whether a particular annuity contract constitutes a debt instrument

for federal income tax purposes.

Although the proposed regulations do not apply to an annuity

contract that is not a debt instrument because it does not provide for

a guaranteed return, the OID provisions nevertheless may apply if a

return is guaranteed by another instrument. Thus, for example, it is

anticipated that the Commissioner's anti-abuse authority under

Sec. 1.1275-2T would be invoked to apply the OID provisions to the

combination of an annuity contract that is not a debt instrument and a

life insurance contract that, together, effectively provide for a

guaranteed return.

Comments are requested on whether certain annuity contracts other

than those described in the proposed regulations should qualify for the

section 1275(a)(1)(B)(i) exception.

Proposed Effective Date

The proposed regulations are proposed to be effective for annuity

contracts held on or after the date that is 30 days after final

regulations are published in the Federal Register. However, the

proposed regulations will not apply to an annuity contract that is

purchased prior to April 7, 1995. For purposes of the proposed

regulations, any additional investment in a contract made on or after

April 7, 1995, will be treated as the purchase of a contract after

April 7, 1995, unless the investment is required to be made under a

binding contractual obligation that was entered into prior to April 7,

1995.

If an annuity contract purchased before the effective date of the

regulations is subject to the OID provisions, after the effective date

the holder of the contract may account for pre- effective date accruals

on the contract, on a prospective basis, in any reasonable manner.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and, therefore, a Regulatory

Flexibility Analysis is not required. Pursuant to section 7805(f) of

the Internal Revenue Code, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for Tuesday, August 8, 1995, at

10 a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution

Avenue NW., Washington, DC. Because of access restrictions, visitors

will not be admitted beyond the Internal Revenue Building lobby more

than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments, an outline of topics to be discussed and the

time to be devoted to each topic (signed original and eight (8) copies)

by Tuesday, July 18, 1995.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information: The principal author of these regulations

is Jeffrey W. Maddrey, Office of Assistant Chief Counsel (Financial

Institutions and Products). However, other personnel from the IRS

and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.1275-1 is amended by:

1. Redesignating the text of paragraph (d) following the heading as

paragraph (d)(1) and adding a heading for newly designated paragraph

(d)(1).

2. Adding paragraph (d)(2).

The additions read as follows:

Sec. 1.1275-1 Definitions.

* * * * *

(d) Debt instrument--(1) In general. * * *

(2) Certain annuity contracts--(i) General rule. An annuity

contract qualifies for the exception described in section

1275(a)(1)(B)(i) only if all payments under the contract are periodic

payments that--

(A) Are made at least annually for the life (or lives) of one or

more individuals;

(B) Do not increase at any time during the term of the contract;

and

(C) Are part of a series of payments that begins within one year of

the date of the initial investment in the contract.

(ii) Certain death benefits permissible. An annuity contract that

is otherwise described in paragraph (d)(2)(i) of this section does not

fail to be described in that paragraph merely because it also provides

for a payment (or payments) made by reason of the death of one or more

individuals.

(iii) Effective date. This paragraph (d)(2) is effective for

annuity contracts held on or after the date that is 30 days after final

regulations are published in the Federal Register. However, this

paragraph (d)(2) does not apply to an annuity contract that is

purchased prior to April 7, 1995. For purposes of this paragraph

(d)(2)(iii), any additional investment in a contract made on or after

April 7, 1995, is treated as the purchase of a contract after April 7,

1995, unless the investment is required to be made under a binding

contractual [[Page 17734]] obligation that was entered into prior to

April 7, 1995.

* * * * *

Michael P. Dolan,

Commissioner of Internal Revenue.

[FR Doc. 95-8523 Filed 4-6 -95; 8:45 am]

BILLING CODE 4830-01-U