PLR 200016008: Variable contract accounts may look through investment funds

Plain-English summary

Two investment funds were held through insurance company accounts funding variable contracts, with limited holdings by their investment adviser. One fund proposed to invest more than 55 percent of its assets in the other. The IRS ruled that this investment would not stop accounts holding the second fund from looking through to that fund's underlying assets for the section 817(h) diversification test. Accounts investing in the first fund could likewise look through both funds to the second fund's individual assets. The ruling relied on the funds' restricted ownership and access through variable contracts, and it expressly gave no opinion on the separate investor control rules.

Ruling snapshot

• Question: Does one fund's substantial investment in another prevent variable contract accounts from looking through to the underlying assets for diversification?
• Outcome: Approved: the specified accounts may look through to the underlying assets.
• Key authorities: IRC § 817(h); Treas. Reg. § 1.817-5(f).

Full text (IRS public release)

INTERNAL REVENUE SERVICE

Number: 200016008
Release Date: 4/21/2000
U.I.L. No.: 817.08-04

CC:DOM:FI&P:4/PLR-115245-99

January 18, 2000

Legend

Fund A =

Fund B =

State 1 =
Trust =
Corp. X =

Dear

This is in response to your letter dated September 15, 1999 requesting rulings relating to whether the proposed transaction meets the diversification requirements of § 817(h) of the Internal Revenue Code.

Each of Fund A and Fund B is operated as a separate series of Trust, which is an open- end management investment company organized as a State 1 business trust. Trust is registered under the Investment Company Act of 1940, as amended, and its shares are registered under the Securities Act of 1933, as amended, pursuant to an effective registration statement.

Fund A and Fund B are each treated as a separate corporation for federal income tax purposes, pursuant to § 851(g) of the Code. Each Fund’s annual accounting period ends on December 31, and each uses the accrual method of accounting.

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Interests in Fund A and Fund B are available only to segregated asset accounts that fund variable life insurance policies and/or variable annuity contracts (the Variable Contracts) and to Corp. X , the investment advisor to both Fund A and Fund B, which in the past has provided the initial investment capital for these two funds. Some of this investment capital currently remains invested. No shares of either Fund A or Fund B have ever been publicly available, and no interest in the funds is available other than through the purchase of a Variable Contract (except as otherwise permitted under § 1.817-5(f)(3)).

Fund A seeks to make an investment in Fund B that may exceed 55% by value of Fund A’s total assets.

Section 817(h)(1) of the Code provides that, for purposes of subchapter L, § 72 (relating to annuities), and § 7702(a) (relating to definition of life insurance contract), a variable contract (other than a pension contract), which is otherwise described in § 817 and which is based on a segregated asset account, shall not be treated as an annuity, endowment, or life insurance contract for any period (and any subsequent period) for which the investments made by such account are not, in accordance with regulations prescribed by the Secretary, adequately diversified.

Section 817(h)(4) of the Code provides, in certain situations, a “look-through” rule for meeting the diversification requirements. If all of the beneficial interests in a regulated investment company are held by one or more (A) insurance companies (or affiliated companies) in their general account or in segregated asset accounts, or (B) fund managers (or affiliated companies) in connection with the creation or management of the regulated investment company, the diversification requirements of § 817(h)(1) are applied by taking into account the assets held by such regulated investment company.

Section 1.817-5 of the Income Tax Regulations sets forth the diversification requirements for variable contracts. Generally, the investments of a segregated asset account will be considered to be “adequately diversified” for purposes of § 817(h) of the Code and § 1.817-5 of the regulations if no more than 55 percent of the value of the total assets of the account is represented by any one investment, no more than 70 percent by any two investments, no more than 80 percent by any three investments, and no more than 90 percent by any four investments.

Section 1.817-5(f) of the regulations provides a “look-through” rule for the application of the diversification requirements of § 817-5 of the regulations. Section 1.817-5(f)(1) provides that, if the look-through rule applies, a beneficial interest in a regulated investment company will not be treated as a single investment of a segregated asset account; instead, a pro rata portion of each asset of the investment company will be treated for purposes of § 1.817-5, as an asset of the segregated asset account.

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Section 1.817-5(f)(2)(i) of the regulations provides that § 1.817-5(f) shall apply to an investment company if:

(A) All the beneficial interests in the investment company ... (other than those described in § 1.817-5(f)(3)) are held by one or more segregated asset accounts of one or more insurance companies; and

(B) Public access to such investment company ... is available exclusively (except as otherwise permitted in § 1.817-5(f)(3)) through the purchase of a variable contract. Solely for this purpose, the status of the contract as a variable contract will be determined without regard to § 817(h) and § 1.817-5 of the regulations.

Section 1.817-5(e) provides that, for purposes of § 817(h) of the Code and § 1.817-5 of the regulations, “a segregated asset account shall consist of all assets the investment return and market value of which must be allocated in an identical manner to any variable contract invested in any of such assets.”

The funds represent that all of the beneficial interests in each fund are held only by segregated asset accounts of insurance companies that fund Variable Contracts (except as otherwise permitted under § 1.817-5(f)(3)). Additionally, the funds represent that public access to each of the funds is (and will remain) available, (directly or indirectly) exclusively through the purchase of a Variable Contract.

The two conditions for applying the look-through rule of 1.817-5(f) to a segregated asset account of an insurance company that invests in the funds will be satisfied in this case. That is, all the beneficial interests in either fund (other than those described in § 1.817-5(f)(3)) will be held by one or more segregated asset accounts of one or more insurance companies; and public access to such funds will be available exclusively (except as otherwise permitted in § 1.817- 5(f)(3)) through the purchase of a Variable Contract. (Solely for this purpose, the status of the contract as a variable contract is determined without regard to § 817(h) and § 1.817-5 of the regulations.) Thus, for purposes of § 1.817-5, a pro rata portion of each asset of the funds will be treated as an asset of the segregated asset account which directly or indirectly invested in such fund.

Based on the facts and representations made, it is held that:

(1) The investment by Fund A in Fund B will not prevent other separate accounts holding shares of Fund B from looking through to the assets of Fund B for purposes of determining compliance with § 817(h) diversification requirements.

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(2) Following Fund A’s investment in Fund B, separate accounts investing in Fund A will be able to look through to the individual assets of Fund B in determining diversification under § 817(h).

Except as specifically set forth above, no opinion is expressed as to the tax treatment of the proposed transaction under the provisions of any other section of the Code or regulations. Specifically, no opinion is expressed regarding the application of the investor control rules set forth in Christoffersen v. United States, 749 F. 2d 513 (8th Cir. 1984); Rev. Rul. 81-225, 1981-2 C.B. 12, as modified by Rev. Proc. 99-44, 1999-48 I.R.B. 598; Rev. Rul. 80-274, 1980-2 C.B. 27; Rev. Rul. 77-85, 1977-1 C.B. 12.

The rulings contained in this letter are based upon information and representations submitted by the taxpayers and accompanied by a penalty of perjury statement executed by an appropriate party. While this office has not verified any of the material submitted in support of the request for rulings, it is subject to verification on examination.

This ruling is directed only to the taxpayers requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

A copy of this letter must be attached to the federal income tax returns of the taxpayers involved for the taxable year in which the proposed transaction covered by this ruling letter is consummated.

Pursuant to the power of attorney on file with this office, copies of this letter are being sent to your authorized representatives.

Sincerely,

Assistant Chief Counsel
(Financial Institutions and
Products)

By: /s/
Mark Smith
Chief, Branch 4