PLR 1309011: IRS approves continued diversification treatment during variable-fund liquidation

Plain-English summary

A foreign life insurance company treated as a domestic corporation for federal tax purposes asked whether two funds supporting variable life insurance contracts would continue to satisfy the section 817(h) diversification requirements during a planned pro rata redemption. The funds could not immediately meet all cash-value requests because underlying investment vehicles had imposed redemption restrictions. The IRS ruled that disposing of underlying assets and distributing cash to contractholders could create a discrepancy in the funds' relative holdings, but that discrepancy would not be caused by acquiring assets. Because each fund was represented to be diversified before the transaction and would not increase or modify its non-cash holdings, the IRS concluded that the discrepancy would not cause either fund to fail the diversification requirements.

Ruling snapshot

• Question: Would an orderly pro rata liquidation and cash distribution cause two funds supporting variable contracts to fail section 817(h) diversification requirements?
• Outcome: Approved.
• Key authorities: IRC §§ 801, 817(d), 817(h), and 953(d); Treas. Reg. §§ 1.817-5(b), (c), (d), and (f).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201309011 Third Party Communication: None
Release Date: 3/1/2013 Date of Communication: Not Applicable
Index Number: 817.00-00
Person To Contact:
----------------------- -------------------------, ID No. -----------------
------------------------------ -----------------------------------------------------
----------------------------------- Telephone Number:
---------------------------------------------------- ----------------------
--------------------------------------------- Refer Reply To:
CC:FIP:B04
PLR-132158-12
Date:
November 29, 2012

Taxpayer = ---------------------------------------------------------------------------
Date 1 = ------------------------
Date 2 = ----------------------
Date 3 = ---------------------------
Foreign Country = --------------
Fund 1 = ------------------------------------------------------------
Fund 2 = ---------------------------------------------------------------
General Partner = -----------------------------------------------------
Parent = -----------------------------------------------
Separate Account 1 = ----------------
Separate Account 2 = ----------------
State Z = --------------
X = ----
Y = ----
Year 1 = -------
Year 2 = -------
Year 3 = -------

Dear --------------------:

   This is in response to the letter submitted by your authorized representatives,

dated July 20, 2012, requesting rulings on whether each of Fund 1 and Fund 2 will be
treated as satisfying the diversification requirements of § 817(h) of the Internal Revenue
Code (the “Code”).

I. FACTS

     Taxpayer

   Taxpayer was incorporated under the laws of Foreign Country. Taxpayer’s

principal office is located in Foreign Country. Taxpayer is licensed to engage in the life
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insurance business in Foreign Country and is not licensed to engage in such business
in any U.S. jurisdiction.

    Pursuant to § 953(d), Taxpayer elected to be treated as a domestic corporation

for federal tax purposes in Year 1. The Internal Revenue Service accepted Taxpayer’s
election in Year 2, effective for Taxpayer’s taxable year commencing on Date 1. As a
result, Taxpayer is taxed as a domestic life insurance company under § 801.

    Taxpayer is a wholly-owned, third-tier subsidiary of Parent. Taxpayer and Parent

file a consolidated federal income tax return with other includible affiliates on an accrual
accounting, calendar year basis.

   Contracts

   As part of its business, Taxpayer issues variable life insurance contracts (the

“Contracts”). Each Contract permits the contractholder to allocate premium payments
among one or more variable investment options. Each variable investment option
corresponds to a segregated asset account. The Separate Accounts include Separate
Account 1 and Separate Account 2 (together, the “Separate Accounts”). The Service
previously recognized that Taxpayer’s separate accounts maintained under the laws of
Foreign Country are segregated from its general asset accounts “pursuant to State law
or regulation” for purposes of § 817(d)(1) in PLR 201027038 (March 31, 2010).

   All amounts invested in the Separate Accounts are invested in corresponding

funds. All amounts invested in Separate Account 1 are invested in Fund 1; all amounts
invested in Separate Account 2 are invested in Fund 2 (together with Fund 1, the
“Funds”).

     Under the Contracts, each contractholder has the right, subject to certain

contractual limitations, to: (1) reallocate Contract values from one variable investment
option to another; (2) withdraw cash from the Contract, and (3) surrender the Contract
for its cash surrender value (collectively, the “Cash Value Requests”). Taxpayer has
represented that as part of the Proposed Transaction a Cash Value Request cannot be
used to reallocate funds from Fund 1 to Fund 2, or vice-versa, and new amounts cannot
be invested in either Fund 1 or Fund 2. Under the Contracts, General Partner in its role
as the manager of each Fund may suspend its obligation to satisfy immediately Cash
Value Requests in the manner described below in order to protect the best interests of
all the investors in each Fund.

   Funds

  Each Fund is a limited partnership under the laws of State Z and is treated as a

partnership for federal income tax purposes. Each Separate Account is a limited
partner in the Fund to which it corresponds, i.e., Separate Account 1 is a limited partner
PLR-132158-12 3

in Fund 1 and Separate Account 2 is a limited partner in Fund 2. General Partner is the
general partner and investment manager of each Fund.

   Except as otherwise permitted by Treas. Reg. § 1.817-5(f)(3), all beneficial

interests in each Fund are held by the corresponding Separate Account and other
segregated accounts of life insurance companies. Public access to each Fund is
available exclusively through the purchase of variable contracts within the meaning of
§ 817(d).

   Underlying Assets

    The Funds primarily invest the amounts received under the Contracts in other

investment pools (e.g., partnerships or limited liability companies) and managed
accounts (the “Investment Vehicles”), as well as other assets (together with the
Investment Vehicles, the “Underlying Assets”). There are two types of Investment
Vehicles: Investment Vehicles that are not managed by General Partner and for which
General Partner is not the general partner (“Unaffiliated Investment Vehicles”), and
Investment Vehicles that are managed by General Partner and for which General
Partner is the general partner (“Affiliated Investment Vehicles”). The recent economic
crisis resulted in significant investment losses for the Investment Vehicles. As a result,
the managers of some of the Unaffiliated Investment Vehicles have suspended or
otherwise restricted the ability of the Funds to redeem the Funds’ investment interests in
the Unaffiliated Investment Vehicles in connection with the liquidation of those
Unaffiliated Investment Vehicles. These redemption restrictions are being imposed on
the Funds, in their capacity as investors in the Unaffiliated Investment Vehicles, by the
managers of the liquidating Unaffiliated Investment Vehicles and are beyond the control
of the Funds or General Partner.

    In addition to the redemption restrictions and suspensions being imposed on the

Funds by the managers of the Unaffiliated Investment Vehicles, General Partner has
suspended redemptions from the Affiliated Investment Vehicles. Under its obligations to
all investors in the Affiliated Investment Vehicles under federal securities law, General
Partner is obligated to act in the best interests of all of the investors. All investors in the
Affiliated Investment Vehicles are subject to the same redemption restrictions.
Taxpayer represents that the decision to suspend redemptions from the Affiliated
Investment Vehicles was based entirely on non-tax considerations and was not
intended to facilitate any particular tax result for the Funds. The Funds own, directly
and indirectly, between approximately ----% and ----% of the interests of any particular
Affiliated Investment Vehicle and the remaining interests in each such Affiliated
Investment Vehicle are owned by investors other than the Funds. The Funds’
ownership interests in the Affiliated Investment Vehicles are de minimis relative to the
ownership interests of the other investors.
PLR-132158-12 4

      General Partner does not expect to acquire any assets for the Affiliated

Investment Vehicles. There may be circumstances, however in which General Partner
in its role as manager of the Affiliated Investment Vehicles finds it necessary to acquire
new assets for an Affiliated Investment Vehicle’s portfolio in order to protect the best
interests of all of the investors in that Affiliated Investment Vehicle. Any such
acquisition activity will be limited to situations in which General Partner determines that
it is in the best economic interests of all investors in the Affiliated Investment Vehicles to
acquire an asset in order to protect or preserve the value of existing investments or to
prevent or limit losses on existing investments. Any such activity will occur in the
normal course of General Partner managing the assets of an Affiliated Investment
Vehicle, consistent with General Partner’s objective of liquidating and redeeming all
interests therein as soon as reasonably practicable.

    As of Date 2, Fund 1 had received redemption requests totaling approximately

X% of its net asset value. As of Date 3, Fund 2 had received redemption requests
totaling approximately Y% of its net asset value. As a result of suspensions and other
redemption restrictions imposed by the managers of the Investment Vehicles described
above, for reasons beyond the control of either the Funds or General Partner, the Funds
are no longer able to satisfy immediately Cash Value Requests.

   In Year 3, General Partner suspended its obligation to fulfill Cash Value

Requests. General Partner will redeem all of the contractholders’ interests in each
Fund, regardless of whether General Partner has received a Cash Value Request from
every contractholder. As a result of the Proposed Transaction described below, each
Fund will redeem all of the limited partners’ interests in each Fund. Pursuant to the
Proposed Transaction, described below, General Partner will redeem all of the limited
partners’ interests in the Funds on a pro rata basis by distributing cash generated from
the disposition of the Investment Vehicles and other Underlying Assets.

II. PROPOSED TRANSACTION

   To facilitate the pro rata redemption of the limited partners’ interests in the

Funds, as described above, Taxpayer proposes to engage in the following transaction
with respect to each Fund (the “Proposed Transaction”):
1. Each Fund will distribute some or all of the cash it may currently hold to its
limited partners.
2. As each Fund receives additional amounts of cash, it will distribute that
cash on a pro rata basis to its limited partners. The additional amounts of
cash may result from either a payment generated by an Underlying Asset
or through the disposition of an Underlying Asset.
3. Shortly after receiving the cash with respect to its Underlying Assets, each
Fund will distribute the cash it receives to its respective limited partners
pro rata based on each limited partner’s capital account.
PLR-132158-12 5

      4. The Funds will not use the cash to purchase other assets or increase the
         Funds’ investment in any of the existing Underlying Assets. Neither Fund
         will exchange any of its assets for any other non-cash assets.
      5. Taxpayer, which holds its limited partnership interest in each Fund through
         a Separate Account, will transfer any cash it receives as part of the
         Proposed Transaction in accordance with contractholders’ instructions
         pursuant to Cash Value Requests. While a contractholder may reallocate
         cash received under a Contract to another investment option under the
         Contract, a contractholder may not reallocate any cash received in the
         Proposed Transaction to either Fund 1 or Fund 2.
      6. With respect to each Fund, the Proposed Transaction will last until each
         Fund has redeemed all of its limited partners’ interests. The Proposed
         Transaction is expected to last multiple calendar quarters. Taxpayer has
         represented that the Proposed Transaction will be completed as soon as
         reasonably practicable.

   As a result of engaging in the Proposed Transaction, Taxpayer expects that

during the Proposed Transaction a discrepancy may arise between each Fund’s
holdings and the diversification requirements of § 817(h). Taxpayer expects that any
such discrepancy between the asset composition of either Fund and the diversification
requirements of § 817(h) would continue for multiple calendar quarters.

III. ADDITIONAL REPRESENTATIONS

  In addition to the facts and representations presented above, Taxpayer has also

made the following representations:
1. With respect to the Unaffiliated Investment Vehicles, General Partner will
not directly or indirectly attempt to influence the investment manager of
any Unaffiliated Investment Vehicle to engage in any activity involving the
acquisition of assets. The independent investment managers of the
Unaffiliated Investment Vehicles may decide on their own to engage in
such activity, and General Partner would have no control over such
decisions.
2. Neither Fund will increase or otherwise modify its non-cash holdings as
part of the Proposed Transaction.
3. Each Fund will be adequately diversified within the meaning of § 817(h) at
the end of the calendar quarter immediately preceding the calendar
quarter in which the Proposed Transaction first occurs and each Separate
Account has satisfied the diversification requirements of § 817(h) since its
inception.
4. The Contracts are variable contracts within the meaning of § 817(d).
5. The Contracts qualify as life insurance contracts for federal income tax
purposes.
PLR-132158-12 6

      6. Other than any discrepancy that may arise in connection with the
         Proposed Transaction, each Fund has satisfied and will satisfy the
         diversification requirements under § 817(h).

IV. REQUESTED RULING

   Under Treas. Reg. § 1.817-5(d) any discrepancy that may arise as a result of the

Proposed Transaction would not cause either Fund 1 or Fund 2 to fail the diversification
requirements of § 817(h) in the calendar quarter in which such discrepancy arises or
any subsequent calendar quarter.

V. LAW AND ANALYSIS

    Section 817(d) defines the term “variable contract” for purposes of Part I of

Subchapter L of the Code. A life insurance contract is one type of variable contract
recognized under § 817(d). For a life insurance contract to be a variable contract, all or
part of the amounts received by the insurance company pursuant to the contract must
be allocated to a segregated asset account which, pursuant to State law or regulation, is
separate from the general assets of the insurance company. In addition, the amount of
the contractholder’s death benefit (or the period of coverage) must be adjusted on the
basis of the investment return and the market value of the segregated asset account.
§ 817(d).

   Section 817 was enacted as part of the Deficit Reduction Act of 1984, Pub. L.

No. 98-369. The Conference Report to the Deficit Reduction Act of 1984, H.R. Conf.
Rep. No. 98-861, at 1055 (1984), indicates that “[i]n authorizing Treasury to prescribe
diversification standards, the conferees intend that the standards be designed to deny
annuity or life insurance treatment for investments that are publicly available to
investors and investments which are made, in effect, at the direction of the investor.” In
addition to the diversification requirements under § 817, the investor control doctrine
applies to determine whether a variable contract based on a given segregated asset
account qualifies for treatment as a life insurance contract. See e.g., Rev. Rul. 77-85,
1977-1 C.B. 12; see also T.D. 8101, 1986-2 C.B. 97 (providing that the diversification
rules do not override the investor control doctrine). Taxpayer has represented that the
Contracts qualify as life insurance contracts for federal income tax purposes.

    Section 817(h)(1) generally provides that a variable contract that otherwise

meets the requirements of § 817 shall not be treated as a life insurance contract for any
period (and for any subsequent period) for which the investments made by the
underlying segregated asset account are not adequately diversified in accordance with
Treasury regulations. Section 1.817-5(b) of the regulations states the diversification
requirements for variable contracts based on segregated asset accounts, including
variable life insurance contracts. Generally, the investments of a segregated asset
account are considered to be adequately diversified for purposes of § 817(h) if there are
PLR-132158-12 7

at least five investments and no more than 55 percent of the total asset value of the
segregated asset 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. The diversification of segregated
asset accounts is tested quarterly. Treas. Reg. § 1.817-5(c).

   For purposes of applying the diversification requirements of § 817(h), a look-

through rule in Treas. Reg. § 1.817-5(f) applies to a segregated asset account’s assets
held through a partnership. The look-through rule only applies to a partnership if all
beneficial interests in the partnership are held by one or more segregated asset
accounts of one or more insurance companies, or as otherwise described in Treas.
Reg. § 1.817-5(f)(3). Treas. Reg. § 1.817-5(f)(2)(A). Interests in the partnership must
also be available exclusively through the purchase of a variable contract. Treas. Reg.
§ 1.817-5(f)(2)(B). If the look-through rule applies, the partnership interest of the
segregated asset account is not treated as a single investment of the segregated asset
account. Instead, the regulations look through the partnership to the partnership’s
assets. A pro rata portion of each partnership asset is treated as an asset of the
segregated asset account. Each partner’s ratable interest in a partnership asset is
determined in accordance with the partner’s capital interest in the partnership. Treas.
Reg. § 1.817-5(f)(1).

    Treas. Reg. § 1.817-5(d) provides that a segregated asset account that satisfies

the diversification requirements stated in Treas. Reg. § 1.817-5(b) at the end of any
calendar quarter (or within 30 days after the end of such calendar quarter) shall not be
considered nondiversified in a subsequent quarter because of a discrepancy between
the value of its assets and the diversification requirements unless such discrepancy
exists immediately after the acquisition of any asset and such discrepancy is wholly or
partly the result of such acquisition. Treas. Reg. § 1.817-5(d) does not provide an
exception to the diversification requirements of § 817(h). In the interests of sound tax
administration, the regulation clarifies that neither holding assets in nor disposing assets
from a segregated asset account, which otherwise satisfied the diversification
requirements at the end of the preceding calendar quarter (or within 30 days thereafter),
does not give rise to a failure to meet the diversification requirements in a subsequent
quarter. The regulation provides that there is no failure to meet the diversification
requirements in such situations unless the discrepancy exists immediately after the
acquisition of any asset and such discrepancy is wholly or partly the result of such
acquisition (and the discrepancy is not remedied within 30 days after the end of the
calendar quarter in which such post-acquisition discrepancy arises).

   Taxpayer has represented that each Contract is a variable contract within the

meaning of § 817(d) and qualifies as a life insurance contract. Taxpayer has
represented that each of Separate Account 1 and Separate Account 2 is a segregated
asset account. For a Contract to be treated as a variable contract, the segregated asset
account underlying each Contract must be diversified. Taxpayer has represented that
PLR-132158-12 8

the diversification requirements must be applied at the Fund level according to the look-
through rule in Treas. Reg. § 1.817-5(f).

     Taxpayer has represented that each Fund will be adequately diversified within

the meaning of § 817(h) at the end of the calendar quarter immediately preceding the
calendar quarter in which the Proposed Transaction first occurs. Neither Fund will
increase or otherwise modify its non-cash holdings as part of the Proposed Transaction.
Although neither Fund will increase or otherwise modify its non-cash holdings as part of
the Proposed Transaction, each cash distribution a Fund makes will reduce its overall
holdings such that the relative value of the Fund’s remaining assets, expressed as a
percentage of each Fund’s reduced overall holdings, will increase. Taxpayer expects
that the Proposed Transaction may generate discrepancies between the diversification
requirements and the holdings of each Fund. Any potential discrepancy between the
relative value of each Fund’s remaining assets and the diversification requirements
imposed by § 817(h) will result from the disposition of Underlying Assets by each of the
Funds, and the related distributions to the contractholders, in the Proposed Transaction.
No potential discrepancy will exist immediately after the acquisition of any asset. No
potential discrepancy will arise either wholly or partly as the result of the acquisition of
any asset. Accordingly, under Treas. Reg. § 1.817-5(d) neither Fund will be considered
to fail the diversification requirements imposed by § 817(h) in the calendar quarter in
which any discrepancy arises pursuant to the Proposed Transaction or in any
subsequent calendar quarter.

VI. HOLDING

   Based on the information submitted and Taxpayer’s representations, under

Treas. Reg. § 1.817-5(d) any discrepancy that may arise as a result of the Proposed
Transaction would not cause either Fund 1 or Fund 2 to fail the diversification
requirements of § 817(h) in the calendar quarter in which such discrepancy arises or
any subsequent calendar quarter.

    Except as expressly provided herein, no opinion is expressed concerning the tax

consequences of any aspect of any transaction or item discussed or referenced in this
letter. The rulings contained in this letter are based upon information and
representations submitted by Taxpayer 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 taxpayer who requested it. Section
6110(k)(3) provides that it may not be used or cited as precedent.
PLR-132158-12 9

     In accordance with the Power of Attorney on file with this office, a copy of this

letter is being sent to your authorized representatives.

                                               Sincerely,



                                               SHERYL B. FLUM
                                               Branch Chief, Branch 4
                                               Office of Associate Chief Counsel
                                               (Financial Institutions & Products)