IRS treats foreign-regulated separate accounts as segregated under the variable-contract rules

Plain-English summary

The IRS ruled that separate accounts of an electing foreign insurance company could be treated as segregated from its general asset accounts under § 817(d)(1). The company was treated as a domestic corporation under § 953(d), and the accounts were segregated under the law of a foreign country. The IRS interpreted the term “State law or regulation” broadly in this context because a narrower reading would conflict with the statutory scheme for electing § 953(d) companies. The ruling does not address other foreign insurance companies that have not made a § 953(d) election.

Ruling snapshot

• Question: May the company's foreign-law separate accounts satisfy the § 817(d)(1) requirement that an account be segregated pursuant to State law or regulation?
• Outcome: Approved, the foreign-law separate accounts were treated as satisfying § 817(d)(1)
• Key authorities: IRC § 72; IRC § 801; IRC § 807; IRC § 816; IRC § 817; IRC § 953; IRC § 989; IRC § 6110

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201410012 Third Party Communication: None
Release Date: 3/7/2014 Date of Communication: Not Applicable

Index Number: 817.00-00 Person To Contact:
------------------------, ID No. ------------------
---------------------------- ----------------------------------------------------
--------------------------- Telephone Number:
--------------------------------------------------- -------------------------------------------
--------------------- Refer Reply To:
------------------------------------------ CC:FIP:B04
-------------------------------------------- PLR-119900-13
Date:
October 25, 2013

Company = --------------------------------------------------------------
Company A = ------------------------------------------------------
Parent = ------------------------------------------------------------
Foreign Country = --------------
Year 1 = -------

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

This ruling is in response to your authorized representatives’ submission dated April 24,
2013, requesting a ruling on the meaning of the term “State law or regulation” under
§ 817(d)(1) of the Internal Revenue Code.

                                                  FACTS

Company is a life insurance company organized under the laws of Foreign Country.
Company’s principal office is located in Foreign Country. Company does not maintain a
permanent office in the United States. Company is wholly owned by Company A, which,
in turn, is a controlled foreign corporation of Parent, a U.S. corporation.

Company files a U.S. tax return on a calendar year basis pursuant to the election it filed
under § 953(d) to be treated as a domestic corporation for U.S. tax purposes. Company
represents that it is treated as a domestic corporation for U.S. tax purposes pursuant to
§ 953(d).

Company represents that it qualifies as a life insurance company as defined in § 816
and, as such, is subject to tax under § 801.

Company issues annuity contracts and life insurance contracts (“Contracts”) that
provide benefits based on the value of assets Company holds in separate accounts it
PLR-119900-13 2

establishes under Foreign Country laws (the “Separate Accounts”). Company has
issued Contracts since Year 1. Company issues the Contracts exclusively to U.S.
persons, but may issue them to non-U.S. persons in the future.

Company represents that, apart from the issue addressed in this request for a ruling,
each of the Contracts otherwise meets the definition of a “variable contract” in § 817(d).
Thus, the Contracts that are annuity contracts provide for “the payment of annuities”
and “the amounts paid in, or the amount paid out, reflect the investment return and the
market value” of the Separate Accounts. See § 817(d)(2)(A), (3)(A). Likewise, for
Contracts that are life insurance contracts, “the amount of the death benefit (or the
period of coverage) is adjusted on the basis of the investment return and the market
value” of the Separate Accounts. See § 817(d)(2)(B), (3)(B).

Premiums paid for the Contracts, less any applicable charges, are allocated to the
Separate Accounts. Company’s Separate Accounts are established pursuant to a
“Private Act” which modifies Foreign Country law as it applies to Company. Company
represents that the legal effect of the Private Act is that assets credited to a Separate
Account are not available to pay the amounts due to creditors whose claims do not
relate to that Separate Account.

The Contracts are designed to comply with §§ 72, 817(h), 7702, and 7702A, as
applicable. Company represents that generally, for purposes of part I of subchapter L of
chapter 1, subtitle A of the Code, the amount of the life insurance reserves for the
Contracts will be based on their net surrender values as provided in § 807(d)(1)(A),
reflecting the values of the underlying Separate Account assets supporting the
Contracts.

                             RULING REQUESTED

For purposes of § 817(d)(1), the Separate Accounts to which Company allocates all or
part of the amounts received under the Contracts and that, pursuant to Foreign Country
law, are segregated from the general asset accounts of Company, will be treated as
accounts that are segregated from the general asset accounts of Company “pursuant to
State law or regulation.”

                                       LAW

Variable Contracts in General

Section 817(d) defines the term “variable contract,” for purposes of part I of subchapter
L, as a contract:

   (1)    that provides for the allocation of all or part of the amounts received under
          the contract to an account which, pursuant to State law or regulation, is
          segregated from the general asset accounts of the company,

PLR-119900-13 3

   (2)    that provides for the payment of annuities, is a life insurance contract, or
          provides for funding of insurance on retired lives as described in section
          807(c)(6), and

   (3)    under which –

          (A)       in the case of an annuity contract, the amounts paid in, or the
                    amount paid out, reflect the investment return and the market value
                    of the segregated asset account,

          (B)       in the case of a life insurance contract, the amount of the death
                    benefit (or the period of coverage) is adjusted on the basis of the
                    investment return and the market value of the segregated asset
                    account, or

          (C)       in the case of funds held under a contract funding insurance on
                    retired lives, the amounts paid in, or the amounts paid out, reflect
                    the investment return and the market value of the segregated asset
                    account.

In addition, § 817(h)(1) of the Code provides that a variable contract (other than a
pension contract) based on a segregated asset account is not treated as an annuity,
endowment, or life insurance contract unless the segregated asset account is
adequately diversified.

Definition of “State”

Section 7701(a) sets forth various definitions for terms and phrases used in the Code
that apply “where not otherwise distinctly expressed or manifestly incompatible with the
intent thereof.” Of particular relevance here, § 7701(a)(9) states that “[t]he term ‘United
States’ when used in a geographical sense includes only the States and the District of
Columbia.” Section 7701(a)(10), in turn, provides that “[t]he term ‘State’ shall be
construed to include the District of Columbia, where such construction is needed to
carry out provisions of this title.”

Life Insurance Companies that Issue Variable Contracts

Section 817(c) provides that, for purposes of part I of subchapter L of the Code, a life
insurance company that issues variable contracts shall separately account for the
various income, exclusion, deduction, asset, reserve, and other liability items
attributable to such contracts.

Section 817(a) provides that, with respect to variable contracts, increases and
decreases in § 807(c) reserves attributable to the appreciation and depreciation in the
value of the assets in the segregated asset account are disregarded for purposes of
PLR-119900-13 4

§ 807(a) and (b). Under § 817(b), the basis of each asset in a segregated asset account
is increased or decreased by the amount of appreciation or depreciation, respectively,
to the extent the reserves or other items referred to in § 817(a) are adjusted.

Foreign Insurance Company Election to be Treated as a Domestic Corporation

In general, § 953(d) permits a foreign insurance company to make an election to be
treated as a domestic corporation for U.S. income tax purposes. Such treatment is
permitted if the following conditions are met:

    (1)     the foreign corporation must be a controlled foreign corporation as defined
            in section 957(a) by substituting “25 percent or more” for “more than 50
            percent” and by using the definition of United States shareholder under
            section 953(c)(1)(A),

    (2)     the foreign corporation would qualify under part I or II of subchapter L of
            the Code for the taxable year if it were a domestic corporation,

    (3)     the foreign corporation must meet such requirements as the Secretary
            shall prescribe to ensure that the taxes imposed on it by chapter 1 of the
            Code are paid, and

    (4)     the foreign corporation must make an election to have section 953(d)(1)
            apply and waive all benefits to such corporation granted by the United
            States under any treaty.1

Section 953(e)(5) provides that, for purposes of §§ 953 and 954, the determination of
whether a contract issued by a controlled foreign corporation or a qualified business unit
(within the meaning of § 989(a)) is a life insurance contract or an annuity contract shall
be made without regard to §§ 72(s), 101(f), 817(h), and 7702 if –

    (1)     such contract is regulated as a life insurance or annuity contract by the
            corporation’s or unit’s home country, and

    (2)     no policyholder, insured, annuitant, or beneficiary with respect to the
            contract is a United States person.

                                           ANALYSIS

1
Section 953(d)(3) provides an exception to the electing corporation’s treatment as a domestic
corporation. It provides that, if any corporation treated as a domestic corporation under § 953(d) is treated
as a member of an affiliated group for purposes of chapter 6 of subtitle A of the Code (relating to
consolidated returns), any loss of such corporation shall be treated as a dual consolidated loss for
purposes of § 1503(d) without regard to paragraph (2)(B) thereof.
PLR-119900-13 5

The ultimate issue in this ruling is whether the Contracts are “variable contracts” within
the meaning of § 817(d). Company has represented that the Contracts meet the
requirements to qualify as variable contracts, other than the requirement that they
provide for the allocation of amounts to an account which, “pursuant to State law or
regulation,” is segregated from the general asset accounts of Company. A question
exists whether the “pursuant to State law or regulation” requirement is met because the
Separate Accounts are established pursuant to Foreign Country law, not the law of a
domestic State.

The term “State” is defined in § 7701(a)(9)2 and (10), which are set forth above. The
implication from these paragraphs of § 7701(a) is that the term “State” means one of the
50 states or the District of Columbia. This implication, however, is subject to the flush
language appearing at the beginning of § 7701(a). Pursuant to that language, the
prescribed definition of “State” applies only “where not otherwise directly expressed or
manifestly incompatible with the intent” of the Code provision in which the term is used.

Section 817(d)(1) does not contain a directly expressed meaning for “State,” other than
one of the 50 states or the District of Columbia. Neither does the legislative history
underlying this Code provision. Thus, it must be determined whether the § 7701(a)(10)
meaning of “State” – one of the 50 states or the District of Columbia – is “manifestly
incompatible with the intent” of § 817(d)(1) in the context of a foreign taxpayer that has
elected to come within the provisions of § 953(d).3

In this case, Company filed an election under § 953(d) to be treated for purposes of the
federal tax law as a domestic corporation. As a domestic corporation, Company also
qualifies for treatment as a life insurance company under subchapter L. If, however, the
Contracts are not treated as variable contracts because “State” is given a restrictive
meaning, then Company and any of its U.S. policyholders will in the following respects
be treated differently from a situation involving a domestic life insurance company.

2
Section 7701(a)(9) is a definition of the term “United States.” Section 7701(a)(9)’s definition of “United
States” helps place section 7701(a)(10)’s definition of “State” in context.
3
See United States v. Bardina, 365 F. Supp. 459 (S.D.N.Y 1973), dealing with the six year statute of
limitations, in which the court found reasons, including legislative history, not to use section 7701(a)(9)’s
definition of “United States,” and instead used a broader definition.
PLR-119900-13 6

Section 817(c) requires that a life insurance company that issues variable contracts
separately account for the “various income, exclusion, deduction, asset, reserve, and
other liability items properly attributable to such variable contracts.” If the Contracts are
not variable contracts, even though they are based on Separate Accounts protected
from Company’s general creditors, Company will not receive separate accounting
treatment. This would be a major difference between the treatment of a domestic life
insurance company issuing a similar product and Company, a § 953(d) electing
company.

The disparity in treatment is readily seen if one focuses on the treatment of the reserves
for Company’s and a domestic company’s separate account products. First, assume
that Company’s reserves for its Separate Accounts do not receive the treatment
mandated by § 817(a)-(c) for variable contracts. The reserves that Company
establishes for the Contracts should qualify as life insurance reserves under § 807.
Company will be allowed a deduction for increases in the reserves under §§ 805(a)(2)
and 807(b) and will be required to include decreases in reserves in gross income under
§§ 803(a)(3) and 807(a). The amount of the reserves will be established under
§ 807(d)(1) as the greater of the net surrender value of the Contract or the reserve
established under § 807(d)(2). Company has represented that, generally, for purposes
of part I of subchapter L of the Code, the amount of the life insurance reserves for the
Contracts will be based on their net surrender values as provided in § 807(d)(1)(A),
reflecting the values of the underlying Separate Account assets supporting the
Contracts.

If the value of assets held in the Separate Accounts increases, the cash surrender value
of the Contracts will increase. Company will be entitled to a deduction against ordinary
income for the increase in the reserve. No adjustment will be made to the basis of the
assets to reflect the increase in market value. When the assets are sold, Company will
recognize a capital gain. Accordingly, absent variable contract treatment under
§ 817(d), Company generally would recognize a current deduction against ordinary
income when the value of the assets increases and a future capital gain when it
disposes of the assets. In contrast, life insurance companies that issue variable
contracts and that are subject to § 817(a)-(c) would not recognize a current deduction
for the increase in the reserve attributable to the increase in value of the separate
account assets and, due to the basis adjustment provisions of § 817(b), would not
recognize any gain on the disposition of the assets.

Conversely, if the value of assets held in the Separate Account decreases, the cash
surrender value of the Contracts will decrease. If § 817(a)-(c) does not apply to
Company, then it, unlike a domestic life insurance company subject to § 817(a)-(c), will
be required to include the decrease in reserves in gross income as ordinary income. No
adjustment will be made to the basis of the assets to reflect the decrease in market
value. When the assets are sold, Company will recognize a capital loss. Accordingly,
Company will recognize current ordinary income when the value of the assets
decreases and a future capital loss when it disposes of the assets.
PLR-119900-13 7

In addition, if the Contracts are not treated as variable contracts, the owners of the
Contracts will receive different treatment from owners of domestic contracts under
§ 817(h) and the regulations thereunder prescribing diversification rules. The
diversification rules under § 817(h) apply only to variable contracts (other than pension
plan contracts). Thus, if the Contracts are not variable contracts, the diversification rules
will not apply to them.

The Code’s sanction for not meeting the diversification requirements is severe. Section
817(h)(1) provides that, for purposes of subchapter L of the Code, § 72, and § 7702(a),
a variable contract that does not meet the diversification requirements is not treated as
an annuity, endowment, or life insurance contract for any period (and any subsequent
period) for which the investments made by the segregated asset account are not
adequately diversified under regulations prescribed by the Secretary.

The diversification rule of § 817(h) was added to the Code by the Tax Reform Act of
1984. The Senate Finance Committee explained the purpose of new § 817(h) as
follows:

          The bill adopts a provision that grants the Secretary of the
          Treasury regulatory authority to prescribe diversification
          standards for investments of segregated asset accounts
          underlying variable contracts. The diversification requirement
          is provided in order to discourage the use of tax-preferred
          variable annuities and variable life insurance primarily as
          investment vehicles. The committee believes that, by limiting
          a customer’s ability to select specific investments underlying
          a variable contract, the bill will help ensure that a customer’s
          primary motivation in purchasing the contract is more likely
          to be the traditional economic protections provided by
          annuities and life insurance.

S. PRT. NO. 98-169 at 546 (1984). If the Contracts are not treated as variable contracts,
then, as stated above, the diversification rules of § 817(h) and the regulations
thereunder will not apply to them. The result would be that, absent any other defect
(such as a violation of the “investor control” principles of Rev. Rul. 2003-91, 2003-1 C.B.
347, and related rulings), the Contracts would be recognized as life insurance or annuity
contracts without having to meet the diversification rules of the Code and regulations.
Further, the stated purpose of Congress in enacting the diversification requirements,
that is, to discourage the use of tax-preferred variable annuities and variable life
insurance contracts as primarily investment vehicles, would be subverted.

In addition to the reserve anomaly described above, another anomaly will exist if the
Contracts are not treated as variable contracts: a foreign insurance company that
elected to be treated as a domestic insurance company under § 953(d) would be able to
issue separate account products that do not meet the diversification rules, but
PLR-119900-13 8

nevertheless qualify as life insurance, endowment, or annuity contracts. The inside
buildup on the electing foreign company’s nondiversified contracts would not be subject
to current taxation, while the inside buildup on nondiversified contracts issued by
domestic companies would be subject to current taxation. This is a dubious result,
which does not treat the electing § 953(d) company the same as a domestic company.
The electing foreign company is given better treatment against what Congress viewed
as an abusive use of separate account products.

The statutory structure also supports a broad interpretation of “State.” Section 953(d)
was added to the Code in 1988, after §§ 817(d) and (h) were added in 1984. This
suggests that, in 1984, when Congress used the term “State” in § 817(d), it did not
anticipate the potential anomalies, discussed above, that § 953(d) might create with
respect to reserves for separate account products and with respect to the diversification
standards if the term “State” in § 817(d) was given a restrictive meaning.

In light of these anomalies and the statutory scheme of § 953(d), we conclude that
interpreting “State” in § 817(d)(1) as meaning one of the 50 states or the District of
Columbia is “manifestly incompatible with the intent” of § 817(d)(1) in the context of
electing § 953(d) companies like Company involved here. Accordingly, in the context of
electing § 953(d) companies, “State” in § 817(d)(1) should be interpreted broadly
enough to include the jurisdiction exercising statutory or regulatory authority over the
company’s separate accounts. In this case, it is Foreign Country.

                                   CONCLUSION

For purposes of § 817(d)(1), the Separate Accounts to which Company allocates all or
part of the amounts received under Contracts and that, pursuant to Foreign Country
law, are segregated from the general asset accounts of Company, will be treated as
accounts that are segregated from the general asset accounts of Company “pursuant to
State law or regulation.”

                                     CAVEATS

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or reference in
this ruling letter.

No opinion is expressed or implied concerning any foreign insurance company that has
not made an election to be treated as a domestic company under § 953(d)

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.

In accordance with the authorization on file with this office, copies of this letter are being
sent to your authorized representatives.
PLR-119900-13 9

The rulings contained in this letter are based upon information and representations
submitted by the 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.

                                            Sincerely,



                                            SARAH E. LASHLEY
                                            Assistant to the Branch Chief
                                            Branch 4
                                            Office of the Associate Chief Counsel
                                            (Financial Institutions & Products)

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