Reinsurance acquisition commission must be amortized under IRC § 197

Plain-English summary

Chief Counsel considered an insurer's purchase of assets from a life reinsurance business together with a retrocession arrangement covering the seller's contracts. The taxpayer treated the arrangement as indemnity reinsurance and immediately deducted the portion of the ceding commission above the amount capitalized under IRC § 848. The advice concluded that the broader transaction was an applicable asset acquisition under IRC § 1060. The regulations treat that acquisition as a deemed assumption reinsurance transaction and the acquired contracts as class VI assets for the residual allocation method, even if indemnity reinsurance was used. The taxpayer therefore had to capitalize the ceding commission under IRC § 848 and amortize the excess over the specified policy acquisition expense amount for 15 years under IRC § 197.

Ruling snapshot

• Question: Could the buyer in an IRC § 1060 acquisition immediately deduct the ceding commission above the amount capitalized under IRC § 848?
• Outcome: Advice given, the excess ceding commission must be amortized over 15 years
• Key authorities: IRC §§ 197, 338, 848, and 1060; Treas. Reg. §§ 1.197-2, 1.338-11, and 1.1060-1

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201501011
       Release Date: 1/2/2015
       CC:FIP:B04:SYHorn                                Third Party Communication: None
       POSTF-128459-13                                  Date of Communication: Not Applicable

UILC: 848.06-06, 848.05-03, 197.00-00, 1060.00-00

date: September 04, 2014

 to:   William R. Davis
       Associate Area Counsel
       (CC:LB&I:CTM:DEN)

from: Sheryl B. Flum
Chief, Branch 4
(CC:FIP)

subject: Life Reinsurance Acquisition

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.


       LEGEND

       TAXPAYER = -------------------------------------------------------

       SELLER = ------------------------------------------------------

       DATE1 = -----------------------

       DATE2 = --------------------------

       DATE3 = --------------------------

       DATE4 = ---------------------

       Tax Year1 = -------

       Tax Year2 = -------

POSTF-128459-13 2

1 = -----

$U = ------------------

$V = ------------------

$W = -----------------

$X = ----------------

$Y = -----------------

TAXPAYER RESPONSE = -------------

ISSUE

In a § 1060 acquisition in which TAXPAYER acquires life reinsurance contracts
pursuant to a purported indemnity retrocession agreement, whether TAXPAYER may
take an immediate deduction for the excess of the ceding commission over the § 848
DAC amount.

CONCLUSION

In a § 1060 acquisition in which the TAXPAYER acquires life reinsurance contracts
pursuant to a purported indemnity retrocession agreement, TAXPAYER does not get an
immediate deduction for the excess of the ceding commission over the § 848 DAC
amount and must amortize it under § 197.

FACTS

TAXPAYER is under audit for Tax Year1 and Tax Year2.

Pursuant to a DATE1 Master Asset Purchase Agreement (AGREEMENT), TAXPAYER
purchased from SELLER certain assets used in SELLER’s life reinsurance business,
including a workforce in place and fixed assets (equipment and furniture, computers,
and phones), and the parties entered a retrocession1 agreement for a specified number
of SELLER’s life reinsurance contracts.

Under the AGREEMENT, SELLER transferred and TAXPAYER assumed “assumed
liabilities”. Assumed liabilities include, among other items, the sum of all reserves and
liabilities required to be maintained with respect to the assumed reinsurance or

1
AGREEMENT is a retrocession contract (reinsurance of reinsurance). However, this memo refers to the arrangement between
TAXPAYER and SELLER as “reinsurance”.
POSTF-128459-13 3

retrocession agreements.2 SELLER also paid TAXPAYER all premiums, payments,
fees or other consideration or amounts due to SELLER under the Life Reinsurance
Agreements.3

Although the AGREEMENT RECITAL4 states that TAXPAYER wishes to assume this
portion of SELLER’s business on a 100% coinsurance indemnity basis, it provides that
SELLER will enter an Assumption Agreement,5 that SELLER will use reasonable efforts
to assign all of its rights and obligations under the reinsurance agreements to ensure
TAXPAYER was entitled to enforce such treaties against the reinsurers in its own
name,6 and that TAXPAYER and SELLER will use commercially reasonable efforts to
ensure that TAXPAYER assumed, on a novation basis, each of the life reinsurance
agreements.7

Finally, an “Entire Agreement” provision states that the AGREEMENT (including the
Ancillary Agreements – e.g., the -----------------------------------and the --------------- ------------
----------------), other agreements contemplated, and the Exhibits [including Exhibit F, -----
--------------------------------------------------------- - and Schedules -------------------------- ---------
--------------------------------------------------------------------------------------------------8
By DATE2, TAXPAYER and SELLER obtained novations for #1 percent of retroceded
contracts. By DATE3, they had novations for all of the contracts.

TAXPAYER states that the transaction is a § 1060 applicable asset acquisition.9

For statutory accounting purposes, TAXPAYER treated the transaction as indemnity
reinsurance under SSAP 61, assumed $U of net aggregate reserves for life contracts,
and recognized an initial ceding commission of $V. For federal income tax purposes,
TAXPAYER treated $W as ceding commissions – capitalizing $X as § 848 specified
policy acquisition expenses and deducting the remaining $Y in Tax Year 1.

Exam posits that the ceding commission is a § 197 intangible asset requiring
TAXPAYER to amortize $Y over 15 years.

LAW AND ANALYSIS
ASSUMPTION AND INDEMNITY REINSURANCE

“The question of whether the language of an agreement is ambiguous is a question of
law.” Once a finding of ambiguity is made, interpretation of the contract will generally

2

3

4

5
---------------------------------------------------------------------------------------------------------------------.
6
---------------------------------------------------.
7

------------------------------------------------------------------------------------------------------------------.
8
----------------------------------------------------.
9
TAXPAYER RESPONSE - Confirmation of Facts on Seller Acquisition BUYER YEAR ENDED DECEMBER 31, TAX YEAR1.
POSTF-128459-13 4

become a question of fact for the jury. United States v. Donovan, 348 F.3d 509, 512
(6th Cir. 2003).

Insurers may reinsure their obligations to their policyholders by entering an assumption
or indemnity reinsurance contract.10

Section 1.809-5(a)(7)(ii) defines assumption reinsurance as “an arrangement whereby
another person (the reinsurer) becomes solely liable to the policyholders on the
contracts transferred by (the ceding company). Such term does not include indemnity
reinsurance or reinsurance ceded.”

The United States Supreme Court described assumption and indemnity reinsurance
arrangements.

 In the case of assumption reinsurance, the reinsurer steps into the shoes of the
 ceding company with respect to the reinsured policy, assuming all its liabilities and
 its responsibility to maintain required reserves against potential claims. The
 assumption reinsurer thereafter receives all premiums directly and becomes directly
 liable to the holders of the policies it has reinsured.

 In indemnity reinsurance…, it is the ceding company that remains directly liable to its
 policyholders, and that continues to pay claims and collect premiums. The
 indemnity reinsurer assumes no direct liability to policyholders. Instead, it agrees to
 indemnify, or reimburse, the ceding company for a specified percentage of the
 claims and expenses attributable to the risks that have been reinsured, and the
 ceding company turns over to it a like percentage of the premiums generated by the
 reinsurance of those risks.

Colonial Am. Life Ins. Co. v. Commissioner, 491 U.S. 244, 247 (1989).

However, critiquing the Court’s decision in Colonial Am. Life Ins. Co., Holmes'
Appleman on Insurance 2d, states:

 With all due respect to the Supreme Court, true reinsurance, in the eyes of
 insurance lawyers involves… the indemnity taken by an insurance company to
 secure itself against an excessive loss upon a certain risk, not inuring to the benefit
 of the insured. When the risk itself is shifted to a company other than the original
 insurer, and the second company assumes direct liability to the policyholder, it is a
 substitution of risk, rather than true reinsurance.

10
Service position is that a retrocession agreement is treated as reinsurance. See, Rev. Rul. 2008-15, 2008-1 C.B. 633 (premium
paid on a retrocession contract between two foreign reinsurance companies is subject to the one-percent excise tax imposed by §
4371(3)). But see, Validus Reinsurance, Ltd. v. United States 2014-1 U.S. Tax Cas. (CCH) P70, 325 (D.D.C. 2014). (Section 4371
does not impose an excise tax on retrocession insurance transactions; insurer receives a refund of the excise paid).
POSTF-128459-13 5

“In the parlance of the insurance industry a ‘reinsurance and assumption agreement’ is
the contractual vehicle by which a book of primary insurance business is moved from
one primary insurer to another primary insurer. In fact, this transaction is a novation
rather than a reinsurance transaction…. Sometimes insurers make a corporate
decision to exit a line of business and (reinsurance and assumption) is one of the faster
ways of doing so.”11

The Restatement, Second Contracts (RSC)… applies to contracts in general including
reinsurance contracts.12

In certain circumstances, the RSC precludes an obligor from delegating the
performance of his duty to another and, unless the obligee agrees otherwise, neither
delegation of performance nor the contract between the obligor and the person to whom
delegated relieves the obligor of its duty or liability.13 However, if the original contract
provides for potential novation, then the original obligor can discharge its liability
(emphasis added).14

         MERE REINSURANCE - REINSURER’S TAX TREATMENT OF CEDING COMMISSION
         (SERVICES MODEL)

The mere reinsurance of insurance contracts by an insurance company is not a § 1060
acquisition, even if it enables the reinsurer to establish a customer relationship with the
owners of the reinsured contracts.15

Described by the Service as the “services model” (i.e., the seller/ceding company is
treated as paying a premium to the buyer/reinsurer to assume the risk on its insurance
contracts),16 mere reinsurance is subject to the reinsurance rules of Treas. Reg.
§ 1.817-4(d) because the total consideration paid for the transfer of insurance contracts
and assumption of related liabilities is known and it is not part of a larger acquisitive
transaction.17 The reinsurer’s ceding commission for the reinsured contracts equals the
liabilities assumed by the reinsurer as a result of the reinsurance transaction minus the
net value of the tangible and intangible assets acquired (other than any value of the
reinsured policies). (Treas. Reg. § 1.817-4(d)(2).)

How the reinsurer treats the ceding commission for federal income tax purposes
depends on whether (1) the parties entered an assumption or indemnity reinsurance

11
Robert M. Hall, REINSURANCE AND ASSUMPTION AGREEMENTS: HOW DOES THE NOVATION TAKE PLACE?, Piper
Marbury Rudnick & Wolfe (2001) at http://www.robertmhall.com/articles/Reins_AssumpArt.htm.
12
Ibid; See also, Larry P. Schiffer, Adventures in Contract Wording: The Effect of Ambiguous Reinsurance Contract Language,
Squire Patton Boggs (US) LLP (September 2000) at http://www.irmi.com/expert/articles/2000/schiffer09.aspx. (“The law of contracts
applies to reinsurance contracts with equal force.”)
13
Restat 2d of Contracts, § 318(1) – (3).
14
Ibid.
15
Treas. Reg. § 1.1060-1(b)(9).
16
Preamble, T.D. 9257, 2006-1 C.B. 821 (April 10, 2006).
17
Preamble, Prop. Treas. Reg. § 1.1060-1, 67 Fed. Reg. 10640 (March 8, 2002).
POSTF-128459-13 6

agreement and (2) the underlying contracts are specified insurance contracts under
§ 848.

Assumption reinsurance contracts are § 197 intangibles. (§ 197(d)(2).) In general,
indemnity reinsurance contracts are not.18 However, the legislative history provides
that, for purposes of § 197, an assumption reinsurance transaction includes any
acquisition of an insurance contract that is treated as occurring by reasons of an
election under § 338 thus expressing Congressional intent that an indemnity
reinsurance acquired in a § 338 asset acquisition could be a § 197 intangible.19

Consistent with this legislative history, the § 197 regulations provide that the transfer of
insurance or annuity contracts and the assumption of related liabilities deemed to occur
by reason of a § 338 election for a target insurance company is treated as an
assumption reinsurance transaction. The transfer of a reinsurance contract by a
reinsurer (transferor) to another reinsurer (acquirer) is treated as an assumption
reinsurance transaction if the transferor's obligations are extinguished as a result of the
transaction.20

The reinsurer in an assumption reinsurance arrangement amortizes the ceding
commission over 15 years.21 The reinsurer in an indemnity reinsurance contract
deducts the ceding commission.22

Insurers issuing specified insurance contracts capitalize specified policy acquisition
expenses (DAC). (§ 848(a)).

The DAC amount (net premium multiplied by the capitalization rate for that type not in
excess insurance company’s general deduction) serves as a proxy for the actual cost,
including the ceding commission, the reinsurer incurred to acquire the insurance
contract. (§ 848(c).)

A specified insurance contract (DAC contract) is any life insurance, annuity, or
noncancellable accident and health insurance contract (or any combination thereof).
(§ 848(e)(1).)

A reinsurance contract is treated in the same manner as the reinsured contract without
distinguishing between an assumption and an indemnity reinsurance arrangement.
(§ 848(e)(5).)

Section 848(g) provides:
18
See H.R. Conf. Rep. No. 213, 103rd. Cong. 1st Sess. 687-688. Although the legislative history does not state why Congress
excluded indemnity reinsurance from the provisions of § 197, one commentator suggests that it is because goodwill does not attach
to indemnity reinsurance contracts. M Douglass, Tangible Results for Intangible Assets: An Analysis of Section 197, The Tax
Lawyer (vol. 47 No. 3 Spring 1994) at 733 nt.126.
19
S. Rep. No. 213, 103d Cong. 1st Sess. 675, 687 (1993).
20
§ 1.197-2(g)(5)(i).
21
§ 197(f)(5) and Treas. Reg. § 1.197-2(f)(1).
22
See, Colonial Am. Life Ins. Co. and § 848(g).
POSTF-128459-13 7

  Nothing in any provision of law (other than this section or section 197) shall require
  the capitalization of any ceding commission incurred on or after September 30,
  1990, under any contract which reinsures a specified insurance contract.

An assumption reinsurer of a DAC contract capitalizes, straight-line over a 120-month
period, the ceding commission it paid for assumption reinsurance of DAC contracts. It
then amortizes, over fifteen years, the excess of the ceding commission over the DAC
amount.23

An indemnity reinsurer of a DAC contract capitalizes the ceding commission over the
120-month period then deducts the excess of the ceding commission over the DAC
amount. (§§ 848(a) and (g).)

 § 1060 APPLICABLE ASSET ACQUISTION THAT INCLUDES INSURANCE CONTRACTS –
 REINSURER’S TAX TREATMENT OF CEDING COMMISSION (ASSET PURCHASE
 MODEL)

In contrast to mere reinsurance, a transfer of an insurance business is a § 1060
acquisition if the TAXPAYER acquires significant business assets, in addition to
insurance contracts, to which goodwill and going concern value could attach.24

To reflect what the Service described as an “asset purchase model” (i.e., buyer acquires
assets for a stated consideration),25 a § 1060 acquisition of a trade or business is
subject to the regulations applicable to certain § 338 deemed asset sales.26 Therefore,
like § 338 transaction, § 1060 acquisitions are hypothetical assumption reinsurance
transactions.27 As assumption reinsurance transactions, they are subject to the
reinsurance rules of Treas. Reg. § 1.817-4. However, these reinsurers use the residual
method, not the reserve method of Treas. Reg. § 1.817-4(d)(2), to determine their basis
in the assets (including the ceding commission).28

The residual method allocates the total purchase price among all the assets acquired
(including the ceding commission and assumed liabilities) based on asset class. Both
indemnity and assumption reinsurance contracts are treated as Class VI assets29 even
if the acquisition is effected in whole or in part through indemnity reinsurance rather
than assumption reinsurance, and, for the insurer or reinsurer, an insurance contract

23
§§ 848(a) and 197(f)(5) and Treas. Reg. § 1.197-2(g)(5)(i).
24
Treas. Reg. § 1.1060-1(b)(9).
25
See Supra, note 16.
26
Treas. Reg. §§ 1.338-6, 1.338-7, and 1.338-11(a) – (d). See, Treas. Reg. § 1.197-2(e)(5). A qualified stock purchase that is
treated as a purchase of assets under § 338 is treated as a transaction involving the acquisition of assets constituting a trade or
business only if the direct acquisition of the assets of the corporation would have been treated as the acquisition of assets
constituting a trade or business or a substantial portion thereof.
27
Treas. Reg. § 1.338-11(c).
28
Treas. Reg. §§ 1.338-11(c) and 1.1060-1(a) and (c)(5).
29
A Class VI asset is “all § 197 intangibles, except goodwill and going concern value.” Treas. Reg. § 1.338-6(b)(2)(vi)
POSTF-128459-13 8

(including an annuity or reinsurance contract) is a Class VI asset regardless of whether
it is a section 197 intangible.30

For purposes of allocating the total purchase price, the fair market value of a specific
insurance, reinsurance or annuity contract or group of insurance, reinsurance or annuity
contracts (insurance contracts) is the amount of the ceding commission a willing
reinsurer would pay a willing ceding company in an arm's length transaction for the
reinsurance of the contracts if the gross reinsurance premium for the contracts were
equal to (seller’s) reserves for the contracts.31

Treas. Reg. § 1.338-11(a) provides:

   In the case of a conflict between the provisions of this and other provisions of the
   Internal Revenue Code or regulations, the rules set forth in this section determine
   the Federal income tax treatment of the parties and the transaction when a section
   338 election is made for an acquired insurance company.

ANALYSIS

TAXPAYER determined that the AGREEMENT was an indemnity retrocession contract
in Tax Year1 because it did not create any legal relationship between TAXPAYER and
any person other than SELLER. SELLER remained liable to the parties to the
underlying reinsurance contracts because none of the novations were complete before
DATE4.

The AGREEMENT RECITAL supports TAXPAYER’s position that the retrocession is on
a 100 percent indemnity co-insurance basis. However, the contract as a whole includes
the language of an assumption reinsurance arrangement and there are sufficient facts
to conclude that AGREEMENT is an assumption retrocession contract. They include:

       The “Entire Agreement” provision incorporates, among other ancillary
        agreements, Assumption and Novation Agreements;
       Under the RCS, the potential novation can discharge SELLERS liability;
       AGREEMENT transfers the sum of all reserves and liabilities required to be
        maintained with respect to the assumed reinsurance or retrocession agreements
        and the SELLER agreed to pay TAXPAYER all premiums, payments, fees or
        other consideration or amounts due to SELLER under the Life Reinsurance
        Agreements; and
       Entering a § 1060 applicable asset acquisition of a trade or business, shows
        SELLER’s intent to sell and exit, and TAXPAYERS intent to acquire, the life
        reinsurance business.

30
Treas. Reg. §§ 1.1060-1(a)(1) and 1.1060-1(c)(5).
31
Treas. Reg. §§ 1.338-11(b)(2) and (c)(3).
POSTF-128459-13 9

To explain its tax treatment of the ceding commission, TAXPAYER stated that the
indemnity retroceded life insurance contracts are § 848 specified insurance contracts so
it amortized the ceding commission up to the DAC amount. With respect to the
remainder, because the indemnity retrocession contract with SELLER is not a § 197
intangible, § 848(g) allows an immediate deduction for the ceding commission in excess
of the DAC amount. However, TAXPAYER’s analysis is incomplete.

TAXPAYER does not address why the regulations under §§ 1060, 338, and 197 do not
apply to this transaction. If they do, whether TAXPAYER entered an assumption or
indemnity arrangement with SELLER does not determine how it treats the ceding
commission for federal income tax purposes (and precludes consideration of whether
ARRANGEMENT is an assumption or indemnity retrocession contract).

The rules describing the residual method are clear that an indemnity reinsurance
contract is a Class VI, § 197 intangible. They are also clear that they treat § 338 and
§ 1060 acquisitions as deemed assumption reinsurance arrangements. In general, the
ceding commission on assumption reinsurance contracts are capitalized over ten years
under § 848 then amortized over fifteen under § 197.

After it issued the proposed regulations, the Service received comments asking that the
final § 338 regulations clarify that § 197 amortization does not apply to deemed
assumption reinsurance arrangements allowing an indemnity reinsurer an immediate
deduction of the ceding commission under § 848(g). The final regulations do not
provide this immediate deduction and allowing it would be inconsistent with
Congressional intent.32

The § 338 regulations treat the deemed sale of insurance contracts as assumption
reinsurance transactions for federal income tax purposes. These regulations apply to
§ 1060 acquisitions of insurance companies. Accordingly, a § 1060 acquisition is
likewise treated as an assumption reinsurance transaction. Under Treas. Reg. § 1.338-
11(a)(1), these provisions take precedence over all others in the Code and regulations.
In order for § 1.338-11(a)(1) to be consistent with § 848(g) (that no provision of law
other than §§ 848 and 197 shall require the capitalization of any ceding commission on
any reinsured specified insurance contract), the hypothetical assumption reinsurance
contract would also have to be treated as a § 197 intangible. As a § 197 intangible,
any excess ceding commission over the DAC amount is amortized over fifteen years.33

TAXPAYER must capitalize, under § 848, the ceding commission it paid SELLER to acquire its life reinsurance
34
business in a § 1060 acquisition and amortize, under § 197, the excess above the DAC amount.

32
Supra, note 16.
33
§ 197 and Treas. Reg. §§ 1.197-2(g)(5) and 1.338-11(c)(4) EXAMPLE 1.
34
But see, FSA 200144028 (November 2, 2001). In a transaction in which TAXPAYER acquired, through indemnity reinsurance,
substantially all of the tangible and intangible assets associated with the SELLER’s insurance business, the Service concluded that,
under the proposed and temporary §§ 338 and 1060 regulations, TAXPAYER applies the § 338 residual allocation method, not the
reserve method of Treas. Reg. § 1.817-4(d)(2), to determine its basis in the reinsurance ceding commission paid. However,
although § 338 regulations treated asset acquisitions (and stock purchases treated as asset acquisitions) involving insurance
POSTF-128459-13 10
companies as assumption reinsurance transactions, the FSA does not address the application of this provision to the indemnity
reinsurance contracts described. Also, it appears that the Service, without further analysis, accepted as fact that § 848(g) applied to
allow the TAXPAYER an immediate deduction for the ceding commission paid.

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