Application of Section 338 to Insurance Companies, 17990-18007 [06-3320]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 68 (Monday, April 10, 2006)]
[Rules and Regulations]
[Pages 17990-18007]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-3320]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9257]
RIN 1545-AY49


Application of Section 338 to Insurance Companies

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final regulations that apply to a 
deemed sale or acquisition of an insurance company's assets pursuant to 
an election under section 338 of the Internal Revenue Code, to a sale 
or acquisition of an insurance trade or business subject to section 
1060, and to the acquisition of insurance contracts through assumption 
reinsurance. It also contains final regulations under section 381 
concerning the effect of certain corporate liquidations and 
reorganizations on certain tax attributes of insurance companies. This 
document also contains temporary regulations under section 197 relating 
to the determination of adjusted basis of amortizable section 197 
intangibles with respect to insurance contracts, section 338 relating 
to increases in reserves after a deemed asset sale and sections 338 and 
846 relating to the effect of a section 338 election on a section 
846(e) election. The text of the temporary regulations also serves as 
the text of the proposed regulations set forth in the notice of 
proposed rulemaking on this subject in the Proposed Rules section in 
this issue of the Federal Register. The final and temporary regulations 
apply to insurance companies.

DATES: Effective Date: The final and temporary regulations are 
effective on April 10, 2006.
    Applicability Dates: For dates of applicability of these 
regulations, see Sec. Sec.  1.197-2(g)(5)(iv), 1.338(i)-1(c), and 
1.1060-1(a)(2). The applicability of Sec. Sec.  1.197-2T(g)(5)(ii), 
1.338-11T(d), and 1.338-11T(e) will expire on April 7, 2009.

FOR FURTHER INFORMATION CONTACT: Mark Weiss, (202) 622-7790 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information in these final regulations was not 
proposed in the preceding notice of proposed rulemaking. The collection 
of information has been reviewed in accordance with the Paperwork 
Reduction Act (44 U.S.C. 3507) and, pending receipt and evaluation of 
public comments, approved by the Office of Management and Budget under 
control number 1545-1990.
    The collection of information is in Sec. Sec.  1.338-11T(e)(2), 
1.338(i)-1(c), 1.381(c)(22)-1(c), 1.1060-1(a)(2). This information is 
required by the IRS to allow an insurance company permission to cease 
using its historical loss payment pattern and to allow parties to a 
transaction under section 338, to an applicable asset acquisition under 
section 1060, or to a distribution or reorganization to which section 
381 applies to file a retroactive election to apply these regulations 
to transactions completed before the effective dates of these 
regulations. The likely recordkeepers are business or other for-profit 
institutions.
    The estimated burden is as follows:
    Estimated total annual reporting and/or recordkeeping burden: 12 
hours.
    Estimated average annual burden per respondent: 1 hour.
    Estimated number of respondents: 12.
    Estimated annual frequency of responses: once.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Office of 
Management and Budget, Attn: Desk Officer for the Department of the 
Treasury, Office of Information and Regulatory Affairs, Washington, DC 
20503, with copies to the Internal Revenue Service, Attn: IRS Reports 
Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Any such 
comments should be submitted not later than June 9, 2006.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background and Explanation of Provisions

    On March 8, 2002, the IRS and the Department of Treasury published 
a notice of proposed rulemaking in the Federal Register (REG-118861-00, 
2002-1 C.B. 651 [67 FR 10640]) (the proposed regulations) that sets 
forth

[[Page 17991]]

rules applying to taxable acquisitions and dispositions of insurance 
businesses, including those that are deemed to occur when an election 
under section 338 of the Internal Revenue Code (Code) is made.
    The proposed regulations generally treat the transfer of insurance 
or annuity contracts and the assumption of related reserve liabilities 
that are deemed to occur when an election under section 338 is made 
consistently with the treatment of assumption reinsurance transactions 
entered into in the ordinary course of business under Sec.  1.817-4(d) 
(and other provisions of subchapter L of chapter 1, subtitle A of the 
Code and the regulations promulgated thereunder). The proposed 
regulations provide similar rules for acquisitions of insurance 
businesses governed by section 1060, whether effected through 
assumption or indemnity reinsurance. Thus, in the case of both a deemed 
and an actual transfer of an insurance business, the proposed 
regulations provide that the ceding company (in the case of a section 
338 election, old target) is treated as having income in the amount of 
the reduction in its reserves and having a deduction for the 
consideration paid for the reinsurer's assumption of those liabilities, 
and the reinsurer (in the case of a section 338 election, new target) 
is treated as receiving premium income for its assumption of reserve 
liabilities and having a deduction for its increase in reserves (the 
latter usually offsetting in amount the former). The proposed 
regulations also provide that the consideration allocated to the value 
of the insurance contracts acquired in the assumption reinsurance 
transaction is treated as an amount paid by the reinsurer to purchase 
intangible assets and as ordinary income to the ceding company.
    The proposed regulations depart from the rules governing assumption 
reinsurance transactions effected in the ordinary course of business in 
some circumstances to account for differences that occur because the 
assumption reinsurance transaction occurs as part of a larger 
acquisitive transaction. In an assumption reinsurance transaction 
effected in the ordinary course of business, the total consideration 
paid for the transfer of insurance contracts and assumption of related 
liabilities is known. Furthermore, the rules in Sec.  1.817-4(d) assume 
that the only intangible asset transferred in such an assumption 
reinsurance transaction is the insurance in force which can then be 
valued using the residual method. Thus, if premiums and ceding 
commissions are not separately stated, they can be extrapolated from 
the known elements with a reasonable degree of accuracy. However, when 
the assumption reinsurance transaction occurs as part of a larger 
acquisitive transaction, the total consideration paid by the purchaser 
is not solely for the acquisition of insurance contracts and the 
liabilities assumed are not solely for the risk on the insurance 
contracts. In these circumstances, the extrapolated values would not 
accurately reflect the amount of the items. Accordingly, the proposed 
regulations modify the general rules for assumption reinsurance 
transactions to account for these differences.
    Written comments were received in response to the proposed 
regulations, and a public hearing was held on September 18, 2002. Two 
commentators requested to speak at the hearing. After consideration of 
all the comments, the proposed regulations are adopted as amended by 
this Treasury decision. In general, the final regulations follow the 
approach of the proposed regulations with some revisions. The more 
significant comments and revisions are discussed in the order in which 
they appear in the regulations. In addition to the revisions discussed, 
the final regulations revise the language of the proposed regulations 
in some places to clarify the intent of the IRS and Treasury Department 
or to make the regulations better conform to the terminology and usage 
of the general section 338 regulations.

A. Determination of Adjusted Basis of Amortizable Section 197 
Intangibles With Respect to Insurance Contracts Under Section 197(f)(5)

    Section 197(f)(5) provides that, in the case of any amortizable 
section 197 intangible resulting from an assumption reinsurance 
transaction, the amount taken into account as the adjusted basis of 
such intangible is the excess of (A) the amount paid or incurred by the 
acquirer under the assumption reinsurance transaction over (B) the 
amount required to be capitalized under section 848 in connection with 
the transaction. Under section 848, an insurance company is required to 
capitalize an amount of otherwise deductible expenses equal to a 
percentage of the net premiums for the taxable year for certain 
categories of insurance contracts. The capitalized amounts, commonly 
referred to as deferred acquisition costs, or ``DAC,'' are amortized on 
a straight-line basis over 120 months.
    Section 197(f)(5) is designed to ensure that the DAC amounts 
attributable to an assumption reinsurance transaction are amortized 
over the period specified by section 848 rather than the longer period 
under section 197. To achieve this result, the adjusted basis of the 
amortizable section 197 intangible resulting from an assumption 
reinsurance transaction is recognized only to the extent that the 
amount paid or incurred by the acquirer for the relevant contracts 
exceeds the DAC taken into account under section 848 as a result of the 
transaction.
    The proposed regulations provide rules to determine the amounts 
paid or incurred for amortizable section 197 intangibles with respect 
to contracts acquired as a result of assumption reinsurance 
transactions occurring as part of transactions governed by section 1060 
or section 338. The proposed regulations also provide rules for 
purposes of determining the DAC amounts for the transactions. See 
proposed Sec.  1.197-2(g)(5).
    Under the proposed regulations, the amount paid or incurred by the 
acquirer under the assumption reinsurance transaction in a transaction 
governed by section 338 or 1060 is the amount of adjusted grossed up 
basis (AGUB) or consideration allocable to the insurance contracts 
under the residual method. The amount required to be capitalized under 
section 848 in connection with the assumption reinsurance transaction 
is determined by multiplying the acquirer's specified policy 
acquisition expenses for the taxable year by a fraction, the numerator 
of which is the total tentative positive capitalization amount for the 
relevant group of acquired insurance contracts and the denominator of 
which is the total tentative required capitalization amount for the 
taxable year for all specified insurance contracts. The tentative 
positive capitalization amount for the relevant group of acquired 
insurance contracts is the net positive consideration received for the 
contracts in the assumption reinsurance transaction multiplied by the 
percentage factor applicable to the contracts under section 848(c).
    An insurance company's DAC amount may not exceed the company's 
general deductions for the taxable year. See section 848(c). The 
amortization of intangibles under section 197 is a general deduction 
relevant in computing DAC. However, the amount of amortization under 
section 197 cannot be calculated until section 197(f)(5) is applied. To 
avoid complex calculations, for purposes of calculating the basis of 
amortization, the proposed regulations presume that one-half of the 
consideration allocated to the insurance contracts is amortizable under 
section

[[Page 17992]]

197. See proposed Sec.  1.197-2(g)(5)(i)(D)(2). Comments were requested 
regarding alternative approaches to calculating the basis for DAC 
amounts and section 197 amortization.
    A number of comments were received relating to the proposed 
regulations under section 197(f)(5). Commentators requested that the 
final regulations clarify that section 197(f)(5) applies only to 
assumption reinsurance transactions, and not to indemnity reinsurance 
transactions. Commentators asked that the final regulations clarify 
that the full amount of consideration allocable to the reinsured 
contracts is currently deductible under section 848(g) when the 
provisions of section 848 apply to an indemnity reinsurance transaction 
that occurs as part of a section 1060 acquisition of an insurance 
business. Commentators also expressed concern that the proposed 
regulations could cause an acquirer's DAC under section 848 to be 
subject to the general deductions cap in section 848(c) despite the 
existence of a substantial ceding commission. Commentators requested 
that the final regulations clarify that the election under Sec.  1.848-
2(g)(8) is available to allow old target and new target in a deemed 
asset sale governed by section 338(h)(10) to determine the amount of 
DAC attributable to the transaction without regard to the general 
deductions limitation.
    The temporary and proposed regulations generally follow the 
proposed rules under section 197(f)(5), subject to several 
modifications. In particular, the temporary and proposed rules build on 
the method under Sec.  1.848-2(g) of the existing regulations for 
determining the amounts capitalized under section 848 for a reinsurance 
agreement. Under the temporary and proposed rules, the amount of 
expenses capitalized under section 848 as a result of an assumption 
reinsurance transaction equals the lesser of (A) the required 
capitalization amount for the transaction, or (B) the amount of general 
deductions allocable to the transaction. The temporary and proposed 
rules also clarify that in the event that the acquirer purchases more 
than one category of specified insurance contracts, the determination 
of the amount capitalized under section 848 is made as if each category 
were transferred in a separate assumption reinsurance transaction.
    The temporary and proposed regulations also modify the special rule 
in the proposed regulations with respect to the interplay between 
section 197(f)(5) and section 848 as regards the determination of the 
acquirer's general deductions under section 848(c)(2). Under the 
temporary and proposed rules, an acquirer will determine its general 
deductions as if the entire amount paid or incurred for the acquired 
contracts were allocable to an amortizable section 197 intangible.
    If the acquirer has a capitalization shortfall (i.e., the amount of 
general deductions allocable to the assumption reinsurance transaction 
is less than the required capitalization amount for the transaction), 
the temporary and proposed regulations permit the acquirer and the 
ceding company to elect under Sec.  1.848-2(g)(8) to determine the 
amount capitalized under section 848 without regard to the general 
deductions limitation. The additional amounts capitalized by the 
acquirer as a result of the election are treated as first reducing the 
adjusted basis of the amortizable section 197 intangible with regard to 
the insurance contracts acquired in the assumption reinsurance 
transaction, before reducing the acquirer's otherwise deductible 
expenses. The temporary and proposed rules generally allow the acquirer 
to amortize a larger amount over the period specified by section 848 as 
compared to the proposed regulations.
    The temporary and proposed regulations generally apply, on a cut-
off basis, to acquisitions and dispositions on or after April 10, 2006. 
Thus, there is no adjustment under section 481(a). Taxpayers must make 
the change on their income tax return and should not file a Form 3115, 
Application for Change in Accounting Method. Taxpayers are permitted, 
however, to apply the regulations to acquisitions before that date on a 
transaction-by-transaction basis, with an adjustment under section 
481(a). The temporary and proposed regulations provide a procedure for 
taxpayers to obtain automatic consent of the Commissioner to do so.

B. Recovery of Basis on Dispositions of Acquired Insurance Contracts

    Proposed Sec.  1.197-2(g)(5)(ii)(A)(2) provides that basis recovery 
with respect to a section 197(f)(5) intangible transferred through 
indemnity reinsurance is permitted when sufficient economic rights 
relating to the insurance contracts that gave rise to the section 
197(f)(5) intangible have been transferred. Sufficient economic rights 
are treated as transferred when the ceding company transfers the right 
to future income on the contracts. The proposed regulations also 
provide rules governing the amount of loss recognized on the 
disposition of a section 197(f)(5) intangible. The proposed regulations 
requested comments whether additional guidance should address other 
situations or issues.
    Several commentators requested that the final regulations clarify 
when sufficient economic rights in a section 197(f)(5) intangible are 
transferred through indemnity reinsurance as well as additional 
examples to address situations relating to transfers through indemnity 
reinsurance of less than 100 percent of the insurance contracts that 
gave rise to the section 197(f)(5) intangible. The IRS and Treasury 
Department continue to believe that the rules contained in these 
regulations should refer to general tax principles, and will as needed, 
address these issues in future published guidance.

C. Reserve Increases by New Target After the Deemed Asset Sale

    When a section 338 election is made for an insurance company, Sec.  
1.338-11(d) of the proposed regulations provides that new target must 
capitalize its increases in reserves for any acquired contracts in the 
deemed asset sale. Similar principles apply for an applicable asset 
acquisition of an insurance business under section 1060. The proposed 
regulations generally require capitalization of increases in reserves 
for the acquired contracts in excess of cumulative annual increases of 
two percent per year from the acquisition date reserves. However, the 
proposed regulations do not require capitalization to the extent the 
increases in reserves reflect the time value of money, to the extent 
the increases in reserves occur while new target is under state 
receivership, or to the extent the deduction for the increases in 
reserves is spread over the 10 succeeding taxable years under section 
807(f).
    Many commentators objected to the rule requiring capitalization for 
increases in reserves after the transaction date. They questioned the 
justification for the rule, stating that the rule was inconsistent 
with, and overrode, principles established under subchapter L for 
determining losses incurred. Commentators argued that, under subchapter 
L principles, reserve liabilities are not treated like contingent 
liabilities and that it was inappropriate to treat the reserves as 
contingent liabilities even for the limited purposes of the regulation. 
Commentators also requested that the application of the rule be 
restricted to cases of abuse because the ceding company's reserves 
assumed in the transaction are fair and reasonable estimates under 
Subchapter L as of the transaction date.
    The commentators' objections largely ignore the fact that the 
proposed regulations blend elements of the asset

[[Page 17993]]

purchase model common to most taxpayers that dispose of or acquire 
assets for consideration that includes the discharge of liabilities and 
the services model that generally applies to insurance companies. 
Treating increases in reserves for acquired contracts similarly to 
contingent liabilities under the asset purchase model is just one 
aspect of that amalgam.
    Under the asset purchase model, assumed contingent liabilities are 
an element of the consideration for which a buyer acquires assets. 
Thus, a buyer includes the contingent liability in its cost for the 
acquired assets. However, a buyer may not include the contingent 
liability in its cost until the liability is incurred for Federal 
income tax purposes. The buyer must capitalize the liability in the 
cost of the acquired assets even if the buyer could have currently 
deducted the liability had it arisen in the buyer's historic business. 
Under the asset purchase model, the buyer does not realize any income 
for the assumption of the contingent liability; the buyer merely has 
bought assets. See Commissioner v. Oxford Paper, 194 F.2d 190 (2d Cir. 
1951).
    Under the services model, the seller (or ceding company) is treated 
as paying a premium to the buyer (or reinsurer) to assume the risk on 
its insurance contracts. The reinsurer includes in income the receipt 
of the premium and has a deduction for its increase in reserves for the 
additional risks assumed in the transaction. The amount of the premium 
income is generally equal to the consideration paid by the ceding 
company, that is, the fair market value of the assets that the ceding 
company transfers to the reinsurer in the transaction (though it may 
not be less than the amount of the reinsurer's increase in tax 
reserves, see Sec.  1.817-4(d)(2)(iii)). Thus, when the fair market 
value of the assets that the ceding company transfers exceeds the 
reinsurer's increase in tax reserves for the additional risks assumed 
in the transaction, the reinsurer has net income. See Sec.  1.817-
4(d)(3) Example 4. Under the services model, no liabilities are treated 
as contingent liabilities. The reserve rules effectively treat 
increases to reserves for new risks as fixed liabilities and increases 
to reserves for existing risks as period expenses (similar to 
interest).
    The proposed regulations blend the asset purchase model and the 
services model by--
    (1) Using the residual method of sections 338 and 1060 to determine 
the value of goodwill and going concern value (which assumes that the 
value of all assets other than goodwill and going concern value is 
readily determinable) rather than the residual method of Sec.  1.817-
4(d) to determine the value of insurance in force (which assumes that 
the value of all assets other than insurance in force is readily 
determinable);
    (2) Treating the amount of old target's tax reserves as a fixed 
liability as of the close of the acquisition date that is taken into 
account in determining the seller's aggregate deemed sales price (ADSP) 
under Sec.  1.338-4 and the buyer's AGUB under Sec.  1.338-5;
    (3) Treating certain of new target's increases in reserves for any 
insurance contracts acquired in the deemed asset sale as a contingent 
liability as of the close of the acquisition date that becomes fixed 
when new target increases its reserves;
    (4) Assuming that the amount of reinsurance premium is equal to the 
amount of old target's tax reserves, even though the ceding company 
would have to pay the reinsuring company an amount greater than the tax 
reserves in an arm's length reinsurance transaction. This rule ensures 
that the acquirer of an insurance business will not have immediate net 
taxable income merely as a result of the acquisition; and
    (5) Not requiring capitalization for new target's increases in 
reserves due to the time value of money for any insurance contracts 
acquired in the deemed asset sale.
    The proposed regulations generally treat an insurance company's 
assumption of contingent liabilities related to insurance contracts 
more favorably than a noninsurance company's assumption of a similar 
contingent liability. The proposed regulations also treat an insurance 
company's assumption of contingent liabilities related to insurance 
contracts more favorably than subchapter L does. As discussed 
previously, under subchapter L, a reinsurer may have net income when 
entering into an assumption reinsurance transaction. The amount of the 
income is the amount of the bargain, that is, the excess of fair market 
value of the assets the seller transfers over the amount of the 
consideration the buyer pays at closing (in an assumption reinsurance 
transaction, the latter measured by the reinsurer's increase in tax 
reserves for the risks assumed in the transaction). The proposed 
regulations, unlike subchapter L, require income to be recognized if 
there is an increase in certain reserves for the acquired insurance 
contracts.
    The IRS and Treasury Department believe that a rule requiring 
capitalization of increases to reserves is a necessary corollary to the 
rule in the proposed regulations linking the amount of reinsurance 
deemed paid to the amount of old target's tax reserves at the time of 
the assumption reinsurance transaction (with the concomitant result 
that new target has no income). The logical implication of the 
commentators' arguments would be that the buyer should have premium 
income in a bargain purchase. In addition, without requiring 
capitalization of at least some increases to reserves, there is an 
incentive for sellers to defer increases in reserves. This incentive 
results from the fact that while the seller is generally indifferent to 
an increase in reserves (the immediate deduction to the seller would be 
offset by a corresponding increase in amount realized of ADSP in the 
sale), a buyer would be entitled to an immediate deduction rather than 
increased basis from an increase in the seller's reserves.
    In response to comments, the IRS and Treasury Department have 
decided to issue temporary regulations with these final regulations 
that continue to require capitalization (and concomitant treatment as 
premium) of certain reserve increases, but further limit the 
capitalization rule of the proposed regulations in a manner consistent 
with the application of subchapter L principles. See Sec.  1.338-
11T(d). After the deemed asset sale, the temporary regulations apply 
subchapter L principles to new target. Under the temporary regulations, 
capitalization is required only for increases in reserves that clearly 
reflect a so called ``bargain purchase'' (that is, when the application 
of the residual method clearly indicates the initial understatement of 
the reserve). The amount of the bargain purchase is the amount of 
income the reinsurer would have otherwise recognized under Sec.  1.817-
4(d) if the final regulations (and proposed regulations) had not 
adopted the convention that the reinsurance premium paid by the seller 
to the buyer is deemed to equal the seller's closing tax reserves, and 
were it not necessary to employ a residual method to account for the 
presence of non-insurance intangible assets.
    Under the temporary regulations, new target is required to 
capitalize any increases in reserves for acquired contracts if the AGUB 
allocated to assets in Class I through Class V is less than the fair 
market value of the assets in those classes. Any deductions would 
continue to be capitalized until the basis of the assets in Class I 
through Class V is equal to their fair market value. This mechanism 
avoids the problem of

[[Page 17994]]

valuing Class VI and Class VII intangibles. The approach of the 
temporary regulations essentially treats the ceding company as 
transferring no Class VI or Class VII assets to the reinsurer for the 
reinsurer's assumption of the liabilities on the acquired contracts. 
Because the temporary regulations limit the total amount of 
capitalization for increases in reserves for acquired contracts, the 
IRS and Treasury Department believe that it is no longer necessary to 
provide a time limit on when increases in reserves for acquired 
contracts are to be capitalized or to provide a floor below which 
increases in reserves are not capitalized. However the temporary 
regulations retain the other limits on capitalization in the proposed 
regulations.

D. Allocation of ADSP and AGUB to Specific Insurance Contracts

    Proposed Sec.  1.338-11(b)(2) provides a rule that for purposes of 
allocating AGUB and ADSP, the fair market value of a specific insurance 
contract or group of 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 old target's 
tax reserves for the contracts.
    Commentators questioned the reliance of the proposed regulations 
upon tax reserves as a basis for valuing the contracts and asked that 
the value of the contracts be based on GAAP or statutory reserves, or 
an amount upon which the parties agree. The IRS and Treasury Department 
believe that using tax reserves as a basis for valuing the contracts is 
consistent with other areas in which tax reserves, not GAAP or 
statutory reserves, are used to compute taxable income. See, e.g., 
section 807 (prescribing rules for taking life insurance reserves and 
certain other reserves into account for purposes of computing life 
insurance company taxable income); section 846 (prescribing a 
methodology for discounting unpaid loss reserves for purposes of 
computing insurance company taxable income); and Rev. Proc. 90-36, 
(1990-2 C.B. 357) (computing up-front ceding commission paid by a 
reinsurer as the increase in the reinsurer's tax reserve liabilities 
resulting from the reinsurance transaction, minus the value of the net 
assets received, for purposes of capitalizing ceding commissions to 
comply with the Supreme Court decision in Colonial American Life 
Insurance Company v. Commissioner, 491 U.S. 244 (1989), (1989-2 C.B. 
110, Ct. D. 2045). Moreover, in the context of a transaction governed 
by section 338 or 1060, the use of old target's tax reserves as a means 
of valuing the contracts is consistent with both (i) the treatment of 
old target's closing tax reserves as a liability in the computation of 
the seller's ADSP and the buyer's AGUB, and (ii) the general rule of 
Sec.  1.817-4(d)(2)(iii), which treats the assuming company in an 
assumption reinsurance transaction as receiving premium income equal to 
at least the increase in its reserves.

E. Effect of Section 338 Election on Section 846(e) Election by Old 
Target

    The proposed regulations do not provide any special rules under 
section 846 for new target to apply old target's historical loss 
payment pattern as a result of a section 846(e) election made by old 
target because new target is generally treated as a new corporation 
that may adopt its own accounting methods without regard to the methods 
used by old target. See Sec.  1.338-1(b).
    Commentators believed that this result was inconsistent with the 
purpose of allowing a company to make a section 846(e) election. 
Commentators noted that a section 846(e) election is made for all 
eligible lines of business, determined by reference to the accident 
years for the line of business shown on the insurance company's annual 
statement. Additionally, commentators noted that the availability of 
the election should not depend upon the tax identity of new target 
after the section 338 election because the historical loss payment 
pattern is not a tax account, the pattern is determined by reference to 
nontax factors, and new target continues to operate in the same manner 
and legal form as old target.
    In response to these comments, the temporary regulations contain a 
new rule that treats new target and old target as the same corporation 
for purposes of a section 846(e) election to use an insurance company's 
historical loss payment pattern. See Sec.  1.338-1T(b)(2)(vii). 
Therefore, if old target has a section 846(e) election in effect, new 
target will continue to use the historical loss payment pattern of old 
target to discount unpaid losses, unless new target chooses to revoke 
the election. If new target revokes old target's section 846(e) 
election, new target will use the industry-wide factors determined by 
the Secretary to discount unpaid losses incurred in accident years 
beginning on or after the acquisition date. See Sec.  1.338-11T(e)(2).

F. Treatment of Shareholders Surplus Accounts, Policyholders Surplus 
Accounts (PSA), and Other Accounts in Transactions to Which Section 381 
Applies

    Section 1.381(c)(22)-1(b)(7)(i) of the proposed regulations 
provides that if one corporation distributes or transfers a substantial 
portion (50 percent or more) of an insurance business to another 
corporation in a transaction to which section 381 applies, then the 
acquiring corporation succeeds to the distributor or transferor 
corporation's shareholders surplus account, policyholders surplus 
account, and other accounts. However, under Sec.  1.381(c)(22)-
1(b)(7)(ii) of the proposed regulations, if an acquiring corporation in 
the section 381 transaction acquires less than 50 percent of the 
distributor or transferor corporation's insurance business, then the 
acquiring corporation succeeds only to a ratable portion (determined by 
reference to reserves) of the distributor or transferor corporation's 
shareholders surplus account, policyholders surplus account, and other 
accounts.
    Commentators questioned whether the IRS and Treasury Department 
have the authority to relate the carryover of PSA to the percentage of 
business that was transferred to the acquiring corporation in a section 
381 transaction. The IRS and Treasury Department believe that the rule 
in the proposed regulations is appropriate and that there is sufficient 
authority for the proposed rule. The legislative history to the 1984 
Tax Reform Act indicates that the term indirect distribution is to be 
interpreted broadly to include any use of PSA funds for the indirect 
benefit of shareholders. H.R. Rep. No. 432, pt. 2, 98th Cong., 2d Sess. 
at 1410-11; Staff of the Joint Committee on Taxation, 98th Cong., 2d 
Sess., General Explanation of the Revenue Provisions of the Tax Reform 
Act of 1984, at 594 (1984), as well as Bankers Life and Casualty Co. v. 
United States, 79 AFTR2d (RIA) 1726 (N.D. Ill. 1996), aff'd on other 
grounds, 142 F.3d 973 (7th Cir. 1998), cert denied, 525 U.S. 961 (1998) 
(section 338(g) transaction results in an indirect distribution of old 
target's PSA). Accordingly, the final regulations adopt the rule as 
proposed in Sec. Sec.  1.338-11(f) and 1.381(c)(22)-1(b)(7).

G. Treatment of DAC in Transactions to Which Section 381 Applies

    Section 1.381(c)(22)-1(b)(13) of the proposed regulations provides 
that any remaining balances of DAC or excess negative DAC carry over to 
a successor insurance company in a section 381

[[Page 17995]]

transaction. One commentator questioned whether a nonlife insurance 
company may succeed to DAC attributes under Sec.  1.381(c)(22)-1. 
Another commentator believed positive DAC should not be carried over to 
a successor corporation in a section 381 transaction.
    The IRS and Treasury Department believe that in a section 381 
transaction, positive DAC, like negative DAC, is an attribute that is 
carried over to the acquiring corporation. Thus, the final regulations 
retain the rule in the proposed regulations that the remaining balances 
of DAC or excess negative DAC carry over to a successor insurance 
company in a section 381 transaction. See Sec.  1.381(c)(22)-1(b)(13). 
However, the IRS and Treasury Department believe that a proportionality 
rule similar to the one the final regulations adopt at Sec.  
1.381(c)(22)-1(b)(7) for policyholder surplus accounts is appropriate 
because DAC is a tax accounting convention that relates to a line of 
business. Thus, the final regulations provide that when the acquiring 
corporation acquires 50 percent or more of the distributor or 
transferor corporation's insurance business (measured by its reserves 
for all of its contracts immediately before the earlier of the 
distribution or transfer or the adoption of the plan of liquidation or 
reorganization), the acquiring corporation will succeed to the 
distributor or transferor corporation's entire positive or negative DAC 
amount. To the extent an acquiring corporation in the section 381 
transaction acquires less than 50 percent of the distributor or 
transferor corporation's insurance business, then only that percentage 
of positive or negative DAC remains. In addition, because some 
attributes under section 381(c)(22) and Sec.  1.381(c)(22)-1 are 
equally relevant for life and nonlife insurance companies, the final 
regulations clarify that, except as otherwise provided, the rules in 
Sec.  1.381(c)(22)-1 apply to any insurance company, whether a life or 
a nonlife company.

H. Effective Date of Regulations

    The final and temporary regulations are effective for transactions 
on or after April 10, 2006. Commentators asked for an election to apply 
the final regulations to transactions completed before April 10, 2006. 
The IRS and Treasury Department believe that the elective retroactivity 
of the final regulations is warranted and administrable. Thus, the 
final regulations permit new target and old target an election to apply 
the final regulations, in whole, to qualified stock purchases occurring 
before April 10, 2006 if all taxable years for which the consequences 
of the section 338 election affect the computation of tax are open. In 
the case of a section 338 election for which a section 338(h)(10) 
election is made (or a section 338 election for a foreign target), new 
target's ability to elect to retroactively apply the final regulations 
does not depend upon old target making the election. Similarly, old 
target's ability to elect to retroactively apply the final regulations 
does not depend upon new target making the election. However, in the 
case of a section 338 election for a domestic target for which no 
section 338(h)(10) election is made, the purchasing corporation 
generally controls both the filing of new target's returns and old 
target's final return. Accordingly, when no section 338(h)(10) election 
is made and the target is a domestic corporation, new target and old 
target must both elect to retroactively apply the final regulations. If 
one of new target or old target cannot make the election, the other is 
not permitted to make the election. See Sec.  1.338(i)-1(c).

Special Analyses

    It has been determined that the final regulations issued with 
respect to section 197 and section 338 are not a significant regulatory 
action as defined in Executive Order 12866. Therefore, a regulatory 
assessment is not required. It is hereby certified that the collection 
of information requirement in these regulations will not have a 
significant economic impact on a substantial number of small entities. 
This certification is based on the fact that these regulations do not 
have a substantial economic impact because they merely provide guidance 
about the operation of the tax law in the context of acquisitions of 
insurance companies and businesses. Moreover, they are expected to 
apply predominantly to transactions involving larger businesses. In 
addition, the collection of information requirement merely requires a 
taxpayer to prepare a written representation that contains minimal 
information relating to the making of an election. Therefore, a 
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 
U.S.C. chapter 6) is not required. Under section 7805(f) of the Code, 
the notice of proposed rulemaking preceding this regulation was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business. The Chief 
Counsel for Advocacy did not submit any comments on the regulations.
    It has been determined that the temporary regulations issued with 
respect to sections 197 and 338 are not a significant regulatory action 
as defined in Executive Order 12866. Therefore a regulatory assessment 
is not required. These regulations provide guidance relating to the 
taxable acquisition and disposition of insurance companies. 
Additionally, these regulations provide rules by which a party to the 
transaction may elect to apply these rules to transactions which occur 
prior to April 10, 2006. Based on these considerations, it is 
determined that these temporary regulations will provide taxpayers with 
the necessary guidance and authority to ensure equitable administration 
of the tax laws. Because of the need for immediate guidance, notice and 
public procedure are impracticable and contrary to the public interest 
pursuant to 5 U.S.C. 533(b) and the delayed effective date is not 
required pursuant to 5 U.S.C. 553(d). For applicability of the 
Regulatory Flexibility Act to these temporary regulations, please refer 
to the cross-reference notice of proposed rulemaking published 
elsewhere in this Federal Register. Pursuant to section 7805(f) of the 
Code, these temporary regulations will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on their impact on small business.
    It has been determined that the final regulations issued with 
respect to sections 381, 846 and 1060 are not a significant regulatory 
action as defined in Executive Order 12866. Therefore, a regulatory 
assessment is not required. It has also been determined that section 
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does 
not apply to these regulations, and, because the regulations do not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a 
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 
U.S.C. chapter 6) is not required. Under section 7805(f) of the Code, 
the notice of proposed rulemaking preceding this regulation was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business. The Chief 
Counsel for Advocacy did not submit any comments on the regulations.

Drafting Information

    The principal author of the final regulations is Mark J. Weiss, 
Office of Chief Counsel (Corporate), IRS. However, other personnel from 
the IRS and Treasury Department participated in their development.

[[Page 17996]]

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.197-2 also issued under 26 U.S.C. 197.
    Section 1.197-2T also issued under 26 U.S.C. 197.* * *
    Section 1.338-11 also issued under 26 U.S.C. 338.
    Section 1.338-11T also issued under 26 U.S.C. 338.* * *
    Section 1.846-2(d) is also issued under 26 U.S.C. 846.* * *

0
Par. 2. In Sec.  1.197-0, the entries in the table of contents for 
Sec.  1.197-2, paragraph (g)(5) are revised and Sec.  1.197-2T is added 
to read as follows:


Sec.  1.197-0  Table of contents.

    This section lists the headings that appear in Sec. Sec.  1.197-2 
and 1.197-2T.


Sec.  1.197-2  Amortization of goodwill and certain other intangibles.

* * * * *
    (g) * * *
    (5) Treatment of certain insurance contracts acquired in an 
assumption reinsurance transaction.
    (i) In general.
    (ii) Determination of adjusted basis of amortizable section 197 
intangible resulting from an assumption reinsurance transaction.
    (iii) Application of loss disallowance rule upon a disposition of 
an insurance contract acquired in an assumption reinsurance 
transaction.
    (A) Disposition.
    (1) In general.
    (2) Treatment of indemnity reinsurance transactions.
    (B) Loss.
    (C) Examples.
    (iv) Effective dates.
    (A) In general.
    (B) Application to pre-effective date acquisitions and 
dispositions.
    (C) Change in method of accounting.
    (1) In general.
    (2) Acquisitions and dispositions on or after effective date.
    (3) Acquisitions and dispositions before the effective date.
* * * * *


Sec.  1.197-2T  Amortization of goodwill and certain other intangibles 
(temporary).

    (a) through (g)(5)(i) [Reserved].
    (ii) Determination of adjusted basis of amortizable section 197 
intangible resulting from an assumption reinsurance transaction.
    (A) In general.
    (B) Amount paid or incurred by acquirer (reinsurer) under the 
assumption reinsurance transaction.
    (C) Amount required to be capitalized under section 848 in 
connection with the transaction.
    (1) In general.
    (2) Required capitalization amount.
    (3) General deductions allocable to the assumption reinsurance 
transaction.
    (4) Treatment of a capitalization shortfall allocable to the 
reinsurance agreement.
    (i) In general.
    (ii) Treatment of additional capitalized amounts as the result of 
an election under Sec.  1.848-2(g)(8).
    (5) Cross references and special rules.
    (D) Examples.
    (E) Effective date.
    (g)(5) (iii) through (l) [Reserved].

0
Par. 3. Section 1.197-2 is amended by revising paragraph (g)(5) to read 
as follows:


Sec.  1.197-2  Amortization of goodwill and certain other intangibles.

* * * * *
    (g) * * *
    (5) Treatment of certain insurance contracts acquired in an 
assumption reinsurance transaction--(i) In general. Section 197 
generally applies to insurance and annuity contracts acquired from 
another person through an assumption reinsurance transaction. See Sec.  
1.809-5(a)(7)(ii) for the definition of assumption reinsurance. The 
transfer of insurance or annuity contracts and the assumption of 
related liabilities deemed to occur by reason of a section 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.
    (ii) Determination of adjusted basis of amortizable section 197 
intangible resulting from an assumption reinsurance transaction. For 
further guidance, see Sec.  1.197-2T(g)(5)(ii).
    (iii) Application of loss disallowance rule upon a disposition of 
an insurance contract acquired in an assumption reinsurance 
transaction. The following rules apply for purposes of applying the 
loss disallowance rules of section 197(f)(1)(A) to the disposition of a 
section 197(f)(5) intangible. For this purpose, a section 197(f)(5) 
intangible is an amortizable section 197 intangible the basis of which 
is determined under section 197(f)(5).
    (A) Disposition--(1) In general. A disposition of a section 197 
intangible is any event as a result of which, absent section 197, 
recovery of basis is otherwise allowed for Federal income tax purposes.
    (2) Treatment of indemnity reinsurance transactions. The transfer 
through indemnity reinsurance of the right to the future income from 
the insurance contracts to which a section 197(f)(5) intangible relates 
does not preclude the recovery of basis by the ceding company, provided 
that sufficient economic rights relating to the reinsured contracts are 
transferred to the reinsurer. However, the ceding company is not 
permitted to recover basis in an indemnity reinsurance transaction if 
it has a right to experience refunds reflecting a significant portion 
of the future profits on the reinsured contracts, or if it retains an 
option to reacquire a significant portion of the future profits on the 
reinsured contracts through the exercise of a recapture provision. In 
addition, the ceding company is not permitted to recover basis in an 
indemnity reinsurance transaction if the reinsurer assumes only a 
limited portion of the ceding company's risk relating to the reinsured 
contracts (excess loss reinsurance).
    (B) Loss. The loss, if any, recognized by a taxpayer on the 
disposition of a section 197(f)(5) intangible equals the amount by 
which the taxpayer's adjusted basis in the section 197(f)(5) intangible 
immediately before the disposition exceeds the amount, if any, that the 
taxpayer receives from another person for the future income right from 
the insurance contracts to which the section 197(f)(5) intangible 
relates. In determining the amount of the taxpayer's loss on the 
disposition of a section 197(f)(5) intangible through a reinsurance 
transaction, any effect of the transaction on the amounts capitalized 
by the taxpayer as specified policy acquisition expenses under section 
848 is disregarded.
    (C) Examples. The following examples illustrate the principles of 
this paragraph (g)(5)(iii):


    Example 1. (i) Facts. In a prior taxable year, as a result of a 
section 338 election with respect to T, new T was treated as 
purchasing all of old T's insurance contracts that were

[[Page 17997]]

in force on the acquisition date in an assumption reinsurance 
transaction. Under Sec. Sec.  1.338-6 and 1.338-11(b)(2), the amount 
of AGUB allocable to the future income right from the purchased 
insurance contracts was $15, net of the amounts required to be 
capitalized under section 848 as a result of the assumption 
reinsurance transaction. At the beginning of the current taxable 
year, as a result of amortization deductions allowed by section 
197(a), new T's adjusted basis in the section 197(f)(5) intangible 
resulting from the assumption reinsurance transaction is $12. During 
the current taxable year, new T enters into an indemnity reinsurance 
agreement with R, another insurance company, in which R assumes 100 
percent of the risk relating to the insurance contracts to which the 
section 197(f)(5) intangible relates. In the indemnity reinsurance 
transaction, R agrees to pay new T a ceding commission of $10 in 
exchange for the future profits on the underlying reinsured 
policies. Under the indemnity reinsurance agreement, new T continues 
to administer the reinsured policies, but transfers investment 
assets equal to the required reserves for the reinsured policies 
together with all future premiums to R. The indemnity reinsurance 
agreement does not contain an experience refund provision or a 
provision allowing new T to terminate the reinsurance agreement at 
its sole option. New T retains the insurance licenses and other 
amortizable section 197 intangibles acquired in the deemed asset 
sale and continues to underwrite and issue new insurance contracts.
    (ii) Analysis. The indemnity reinsurance agreement constitutes a 
disposition of the section 197(f)(5) intangible because it involves 
the transfer of sufficient economic rights attributable to the 
insurance contracts to which the section 197(f)(5) intangible 
relates such that recovery of basis is allowed. For purposes of 
applying the loss disallowance rules of section 197(f)(1) and 
paragraph (g) of this section, new T's loss is $2 (new T's adjusted 
basis in the section 197(f)(5) intangible immediately before the 
disposition ($12) less the ceding commission ($10)). Therefore, new 
T applies $10 of the adjusted basis in the section 197(f)(5) 
intangible against the amount received from R for the future income 
right on the reinsured policies and increases its basis in the 
amortizable section 197 intangibles that it acquired and retained 
from the deemed asset sale by $2, the amount of the disallowed loss. 
The amount of new T's disallowed loss under section 197(f)(1)(A) is 
determined without regard to the effect of the indemnity reinsurance 
transaction on the amounts capitalized by new T as specified policy 
acquisition expenses under section 848.
    Example 2. (i) Facts. Assume the same facts as in Example 1, 
except that under the indemnity reinsurance agreement R agrees to 
pay new T a ceding commission of $5 with respect to the underlying 
reinsured contracts. In addition, under the indemnity reinsurance 
agreement, new T is entitled to an experience refund equal to any 
future profits on the reinsured contracts in excess of the ceding 
commission plus an annual risk charge. New T also has a right to 
recapture the business at any time after R has recovered an amount 
equal to the ceding commission.
    (ii) Analysis. The indemnity reinsurance agreement between new T 
and R does not represent a disposition because it does not involve 
the transfer of sufficient economic rights with respect to the 
future income on the reinsured contracts. Therefore, new T may not 
recover its basis in the section 197(f)(5) intangible to which the 
contracts relate and must continue to amortize ratably the adjusted 
basis of the section 197(f)(5) intangible over the remainder of the 
15-year recovery period and cannot apply any portion of this 
adjusted basis to offset the ceding commission received from R in 
the indemnity reinsurance transaction.

    (iv) Effective dates--(A) In general--This paragraph (g)(5) applies 
to acquisitions and dispositions on or after April 10, 2006. For rules 
applicable to acquisitions and dispositions before that date, see Sec.  
1.197-2 in effect before that date (see 26 CFR part 1, revised April 1, 
2001).
    (B) Application to pre-effective date acquisitions and 
dispositions. A taxpayer may choose, on a transaction-by-transaction 
basis, to apply the provisions of this paragraph (g)(5) to property 
acquired and disposed of before April 10, 2006.
    (C) Change in method of accounting--(1) In general--A change in a 
taxpayer's treatment of all property acquired and disposed under 
paragraph (g)(5) is a change in method of accounting to which the 
provisions of sections 446 and 481 and the regulations thereunder 
apply.
    (2) Acquisitions and dispositions on or after effective date. A 
Taxpayer is granted the consent of the Commissioner under section 
446(e) to change its method of accounting to comply with this paragraph 
(g)(5) for acquisitions and dispositions on or after April 10, 2006. 
The change must be made on a cut-off basis with no section 481(a) 
adjustment. Notwithstanding Sec.  1.446-1(e)(3), a taxpayer should not 
file a Form 3115, ``Application for Change in Accounting Method,'' to 
obtain the consent of the Commissioner to change its method of 
accounting under this paragraph (g)(5)(iv)(C)(2). Instead, a taxpayer 
must make the change by using the new method on its federal income tax 
returns.
    (3) Acquisitions and dispositions before the effective date. For 
the first taxable year ending after April 10, 2006, a taxpayer is 
granted consent of the Commissioner to change its method of accounting 
for all property acquired in transactions described in paragraph 
(g)(5)(iv)(B) to comply with this paragraph (g)(5) unless the proper 
treatment of any such property is an issue under consideration in an 
examination, before an Appeals office, or before a Federal Court. (For 
the definition of when an issue is under consideration, see, Rev. Proc. 
97-27 (1997-1 C.B. 680); and, Sec.  601.601(d)(2) of this chapter). A 
taxpayer changing its method of accounting in accordance with this 
paragraph (g)(5)(iv)(C)(3) must follow the applicable administrative 
procedures for obtaining the Commissioner's automatic consent to a 
change in method of accounting (for further guidance, see, for example, 
Rev. Proc. 2002-9 (2002-1 C.B. 327) as modified and clarified by 
Announcement 2002-17 (2002-1 C.B. 561), modified and amplified by Rev. 
Proc. 2002-19 (2002-1 C.B. 696), and amplified, clarified and modified 
by Rev. Proc. 2002-54 (2002-2 C.B. 432); and, Sec.  601.601(d)(2) of 
this chapter), except, for purposes of this paragraph (g)(5)(iv)(C)(3), 
any limitations in such administrative procedures for obtaining the 
automatic consent of the Commissioner shall not apply. However, if the 
taxpayer is under examination, before an appeals office, or before a 
Federal court, the taxpayer must provide a copy of the application to 
the examining agent(s), appeals officer, or counsel for the government, 
as appropriate, at the same time that it files the copy of the 
application with the National Office. The application must contain the 
name(s) and telephone number(s) of the examining agent(s), appeals 
officer, or counsel for the government, as appropriate. For purposes of 
From 3115, ``Application for Change in Accounting Method,'' the 
designated number for the automatic accounting method change authorized 
by this paragraph (g)(5)(iv)(C)(3) is ``98.'' A change in method of 
accounting in accordance with this paragraph (g)(5)(iv)(C)(3) requires 
an adjustment under section 481(a).
* * * * *

0
Par. 4. Section 1.197-2T is added to read as follows:


Sec.  1.197-2T  Amortization of goodwill and certain other intangibles 
(temporary).

    (a) through (g)(5)(i) [Reserved]. For further guidance, see Sec.  
1.197-2(a) through (g)(5)(i).
    (g)(5)(ii) Determination of adjusted basis of amortizable section 
197 intangible resulting from an assumption reinsurance transaction--
(A) In general. Section 197(f)(5) determines the basis of an 
amortizable section 197 intangible for insurance or annuity contracts 
acquired in an assumption reinsurance transaction. The basis of such 
intangible is the excess, if any, of--
    (1) The amount paid or incurred by the acquirer (reinsurer) under 
the assumption reinsurance transaction; over

[[Page 17998]]

    (2) The amount, if any, required to be capitalized under section 
848 in connection with such transaction.
    (B) Amount paid or incurred by acquirer (reinsurer) under the 
assumption reinsurance transaction. The amount paid or incurred by the 
acquirer (reinsurer) under the assumption reinsurance transaction is--
    (1) In a deemed asset sale resulting from an election under section 
338, the amount of the AGUB allocable thereto (see Sec. Sec.  1.338-6 
and 1.338-11(b)(2));
    (2) In an applicable asset acquisition within the meaning of 
section 1060, the amount of the consideration allocable thereto (see 
Sec. Sec.  1.338-6, 1.338-11(b)(2), and 1.1060-1(c)(5)); and
    (3) In any other transaction, the excess of the increase in the 
reinsurer's tax reserves resulting from the transaction (computed in 
accordance with sections 807, 832(b)(4)(B), and 846) over the value of 
the net assets received from the ceding company in the transaction.
    (C) Amount required to be capitalized under section 848 in 
connection with the transaction--(1) In general. The amount required to 
be capitalized under section 848 for specified insurance contracts (as 
defined in section 848(e)) acquired in an assumption reinsurance 
transaction is the lesser of--
    (i) The reinsurer's required capitalization amount for the 
assumption reinsurance transaction; or
    (ii) The reinsurer's general deductions (as defined in section 
848(c)(2)) allocable to the transaction.
    (2) Required capitalization amount. The reinsurer determines the 
required capitalization amount for an assumption reinsurance 
transaction by multiplying the net positive or net negative 
consideration for the transaction by the applicable percentage set 
forth in section 848(c)(1) for the category of specified insurance 
contracts acquired in the transaction. See Sec.  1.848-2(g)(5). If more 
than one category of specified insurance contracts is acquired in an 
assumption reinsurance transaction, the required capitalization amount 
for each category is determined as if the transfer of the contracts in 
that category were made under a separate assumption reinsurance 
transaction. See Sec.  1.848-2(f)(7).
    (3) General deductions allocable to the assumption reinsurance 
transaction. The reinsurer determines the general deductions allocable 
to the assumption reinsurance transaction in accordance with the 
procedure set forth in Sec.  1.848-2(g)(6). Accordingly, the reinsurer 
must allocate its general deductions to the amount required under 
section 848(c)(1) on specified insurance contracts that the reinsurer 
has issued directly before determining the general deductions allocable 
to the assumption reinsurance transaction. For purposes of allocating 
its general deductions under Sec.  1.848-2(g)(6), the reinsurer 
includes premiums received on the acquired specified insurance 
contracts after the assumption reinsurance transaction in determining 
the amount required under section 848(c)(1) on specified insurance 
contracts that the reinsurer has issued directly. If the reinsurer has 
entered into multiple reinsurance agreements during the taxable year, 
the reinsurer determines the general deductions allocable to each 
reinsurance agreement (including the assumption reinsurance 
transaction) by allocating the general deductions allocable to 
reinsurance agreements under Sec.  1.848-2(g)(6) to each reinsurance 
agreement with a positive required capitalization amount.
    (4) Treatment of a capitalization shortfall allocable to the 
reinsurance agreement--(i) In general. The reinsurer determines any 
capitalization shortfall allocable to the assumption reinsurance 
transaction in the manner provided in Sec. Sec.  1.848-2(g)(4) and 
1.848-2(g)(7). If the reinsurer has a capitalization shortfall 
allocable to the assumption reinsurance transaction, the ceding company 
must reduce the net negative consideration (as determined under Sec.  
1.848-2(f)(2)) for the transaction by the amount described in Sec.  
1.848-2(g)(3) unless the parties make the election provided in Sec.  
1.848-2(g)(8) to determine the amounts capitalized under section 848 in 
connection with the transaction without regard to the general 
deductions limitation of section 848(c)(2).
    (ii) Treatment of additional capitalized amounts as the result of 
an election under Sec.  1.848-2(g)(8). The additional amounts 
capitalized by the reinsurer as the result of the election under Sec.  
1.848-2(g)(8) reduce the adjusted basis of any amortizable section 197 
intangible with respect to specified insurance contracts acquired in 
the assumption reinsurance transaction. If the additional capitalized 
amounts exceed the adjusted basis of the amortizable section 197 
intangible, the reinsurer must reduce its deductions under section 805 
or section 832 by the amount of such excess. The additional capitalized 
amounts are treated as specified policy acquisition expenses 
attributable to the premiums and other consideration on the assumption 
reinsurance transaction and are deducted ratably over a 120-month 
period as provided under section 848(a)(2).
    (5) Cross references and special rules. In general, for rules 
applicable to the determination of specified policy acquisition 
expenses, net premiums, and net consideration, see section 848(c) and 
(d), and Sec.  1.848-2(a) and (f). However, the following special rules 
apply for purposes of this paragraph (g)(5)(ii)(C)--
    (i) The amount required to be capitalized under section 848 in 
connection with the assumption reinsurance transaction cannot be less 
than zero;
    (ii) For purposes of determining the company's general deductions 
under section 848(c)(2) for the taxable year of the assumption 
reinsurance transaction, the reinsurer takes into account a tentative 
amortization deduction under section 197(a) as if the entire amount 
paid or incurred by the reinsurer for the specified insurance contracts 
were allocated to an amortizable section 197 intangible with respect to 
insurance contracts acquired in an assumption reinsurance transaction; 
and
    (iii) Any reduction of specified policy acquisition expenses 
pursuant to an election under Sec.  1.848-2(i)(4) (relating to an 
assumption reinsurance transaction with an insolvent insurance company) 
is disregarded.
    (D) Examples. The following examples illustrate the principles of 
this paragraph (g)(5)(ii):

    Example 1. (i) Facts. On January 15, 2006, P acquires all of the 
stock of T, an insurance company, in a qualified stock purchase and 
makes a section 338 election for T. T issues individual life 
insurance contracts which are specified insurance contracts as 
defined in section 848(e)(1). P and new T are calendar year 
taxpayers. Under Sec. Sec.  1.338-6 and 1.338-11(b)(2