Diversification Requirements for Variable Annuity, Endowment, and Life Insurance Contracts, 41651-41654 [E7-14620]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 72, Number 146 (Tuesday, July 31, 2007)]
[Proposed Rules]
[Pages 41651-41654]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E7-14620]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-118719-07]
RIN 1545-BG65


Diversification Requirements for Variable Annuity, Endowment, and 
Life Insurance Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document proposes changes to the regulations concerning 
the diversification requirements of section 817(h) of the Internal 
Revenue Code (Code). The proposed changes would expand the list of 
holders whose beneficial interests in an investment company, 
partnership, or trust do not prevent a segregated asset account from 
looking through to the assets of the investment company, partnership, 
or trust, to satisfy the requirements of section 817(h). The proposed 
regulations also would remove the sentence in Sec.  1.817-5(a)(2) that 
provides that the payment required to remedy an inadvertent 
diversification failure must be based on the tax that would have been 
owed by the policyholders if they were treated as receiving the income 
on the contract. These proposed regulations would affect insurance 
companies that issue variable contracts and would affect policyholders 
who purchase such contracts.

DATES: Written or electronic comments and requests for a public hearing 
must be received by October 29, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-118719-07), room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
118719-07), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at https://www.regulations.gov/ (IRS REG-118719-07).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
James Polfer, at (202) 622-3970 (not a toll-free number). Concerning 
submissions of comments, the hearing, and/or to be placed on the 
building access list to attend the hearing, e-mail Richard A. 
Hurst@irscousel.treas.gov.

SUPPLEMENTARY INFORMATION:

Background

    Section 817(d) defines a variable contract for purposes of part I 
of subchapter L of the Code (sections 801-818). For a contract to be a 
variable contract, it must provide for the allocation of all or a part 
of the amounts received under the contract to an account that, pursuant 
to state law or regulation, is segregated from the general asset 
accounts of the issuing insurance company. In addition, for a life 
insurance contract to be a variable contract, it must qualify as a life 
insurance contract for Federal income tax purposes, and the amount of 
the death benefits (or the period of coverage) must be adjusted on the 
basis of the investment return and the market value of the segregated 
asset account; for an annuity contract to be a variable contract, it 
must provide for the payment of annuities, and the amounts paid in, or 
the amount paid out, must reflect the investment return and the market 
value of the segregated asset account; for a contract that provides 
funding of insurance on retired lives to be a variable contract, the 
amounts paid in, or the amounts paid out, must reflect the investment 
return and the market value of the segregated asset account.
    Section 817(h)(1) provides that a variable contract that is 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 in accordance with regulations prescribed by the 
Secretary. If a

[[Page 41652]]

segregated asset account is not adequately diversified for a calendar 
quarter, then the contracts supported by that segregated asset account 
are not treated as annuity, endowment, or life insurance contracts for 
that period and subsequent periods, even if the segregated asset 
account is adequately diversified in those subsequent periods. Under 
Sec.  1.817-5(a), if a segregated asset account is not adequately 
diversified, income earned by that segregated asset account is treated 
as ordinary income received or accrued by the policyholders. Section 
1.817-5(a)(2) provides conditions an issuer of a variable contract must 
satisfy in order to correct an inadvertent failure to diversify. Rev. 
Proc. 92-25, 1992-1 CB 741, see Sec.  601.601(d)(2) of this chapter, 
sets forth in more detail the procedure by which an issuer may request 
the relief described in Sec.  1.817-5(a)(2).
    Congress enacted the diversification requirements of section 817(h) 
to ``discourage the use of tax-preferred variable annuity and variable 
life insurance primarily as investment vehicles.'' H.R. Conf. Rep. No. 
98-861, at 1055 (1984). In section 817(h)(1), Congress granted the 
Secretary broad regulatory authority to develop rules to carry out this 
intent. Congress directed that these standards be imposed because ``by 
limiting a customer's ability to select specific investments underlying 
a variable contract, [adequate diversification] 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. 98-169, Vol. I at 546 (1984). A primary 
directive from Congress to Treasury in enacting the standards was to 
``deny annuity or life insurance treatment for investments that are 
publicly available to investors.'' H.R. Conf. Rep. No. 98-861, at 1055 
(1984).
    Section 817(h)(4) provides a look-through rule under which 
taxpayers do not treat the interest in a regulated investment company 
(RIC) or trust as a single asset of the segregated asset account but 
rather apply the diversification tests by taking into account the 
assets of the RIC or trust. Section 817(h) further provides that the 
look-through rule applies only if all of the beneficial interests in a 
RIC or trust are held by one or more insurance companies (or affiliated 
companies) in their general account or segregated asset accounts, or by 
fund managers (or affiliated companies) in connection with the creation 
or management of the RIC or trust.
    Under Sec.  1.817-5(f)(1), if look-through treatment is available, 
a beneficial interest in a RIC, real estate investment trust, 
partnership, or trust that is treated under sections 671 through 679 as 
owned by the grantor or another person (``investment company, 
partnership or trust'') is not treated as a single investment of a 
segregated asset account for purposes of testing diversification. 
Instead, a pro rata portion of each asset of the investment company, 
partnership, or trust is treated as an asset of the segregated asset 
account. Section 1.817-5(f)(2)(i) provides that the look-through rule 
applies to any investment company, partnership, or trust if (1) All the 
beneficial interests in the investment company, partnership, or trust 
are held by one or more segregated asset accounts of one or more 
insurance companies; and (2) public access to the investment company, 
partnership, or trust is available exclusively through the purchase of 
a variable contract (except as otherwise permitted in Sec.  1.817-
5(f)(3)).
    Under Sec.  1.817-5(f)(3), look-through treatment is not prevented 
by reason of beneficial interests in an investment company, 
partnership, or trust that are:
    (1) Held by the general account of a life insurance company or a 
corporation related to a life insurance company, but only if the return 
on such interests is computed in the same manner as the return on an 
interest held by a segregated asset account is computed, there is no 
intent to sell such interests to the public, and a segregated asset 
account of such life insurance company also holds or will hold a 
beneficial interest in the investment company, partnership, or trust;
    (2) Held by the manager, or a corporation related to the manager, 
of the investment company, partnership or trust, but only if the 
holding of the interests is in connection with the creation or 
management of the investment company, partnership or trust, the return 
on such interest is computed in the same manner as the return on an 
interest held by a segregated asset account is computed, and there is 
no intent to sell such interests to the public;
    (3) Held by the trustee of a qualified pension or retirement plan; 
or
    (4) Held by the public, or treated as owned by the policyholders 
pursuant to Rev. Rul. 81-225, see Sec.  601.601(d)(2) of this chapter, 
but only if (A) the investment company, partnership or trust was closed 
to the public in accordance with Rev. Rul. 82-55, 1982-1 CB 12, see 
Sec.  601.601(d)(2) of this chapter, or (B) all the assets of the 
segregated asset account are attributable to premium payments made by 
policyholders before September 26, 1981, to premium payments made in 
connection with a qualified pension or retirement plan, or to any 
combination of such premium payments.

Explanation of Provisions

    This document contains proposed amendments to 26 CFR part 1 under 
section 817(h).
    The amendments would remove the sentence from Sec.  1.817-5(a)(2) 
which provides that the amount required to be paid to remedy an 
inadvertent failure to diversify must be based on the tax that would 
have been owed by the policyholders if they were treated as receiving 
the income on the contract for the period or periods of 
nondiversification.
    The amendments also would expand the list of permitted investors in 
Sec.  1.817-5(f)(3) to include (i) Qualified tuition programs as 
defined in section 529, (ii) trustees of foreign pension plans 
established and maintained outside the United States, primarily for the 
benefit of individuals, substantially all of whom are nonresident 
aliens, and (iii) accounts that, pursuant to Puerto Rican law or 
regulation, are segregated from the general asset accounts of the life 
insurance companies that own the accounts, provided the requirements of 
section 817(d) and (h) are satisfied (without regard to the requirement 
the accounts be segregated pursuant to ``State'' law or regulation).

Reasons for Change

1. Proposed Amendment to Sec.  1.817-5(a)(2) (Remedy for Inadvertent 
Nondiversification
    The proposed regulations would remove the sentence in Sec.  1.817-
5(a)(2) that provides that the payment required to remedy an 
inadvertent diversification failure must be based on the tax that would 
have been owed by the policyholders if they were treated as receiving 
the income on the contract. In Notice 2007-15, 2007-7 I.R.B. 503 
(February 12, 2007), the IRS requested comments on how various 
correction procedures, including those described in Sec.  1.817-5(a)(2) 
and Rev. Proc. 92-25, may be improved. Section 5.03(e) and (f) of the 
Notice specifically requested comments on the computation of the 
amounts required to be paid under these correction procedures. 
Moreover, in the past, the provision in Sec.  1.817-5(a)(2) of the 
amount required to be paid has caused confusion about the scope of the 
IRS's authority to provide for amounts that depart from the plain 
language of the regulation. See, for example, Notice 2000-9, 2000-1 
C.B. 449 (reduced amount applied for a limited period of

[[Page 41653]]

time in the case of failures due to investments in U.S. Treasury 
securities). See Sec.  601.601(d)(2) of this chapter.
    Even with the proposed modification of Sec.  1.817-5(a)(2), the 
amount required to be paid to remedy an inadvertent failure to 
diversify remains the amount set forth in Rev. Proc. 92-25, section 
4.02. The modification of Sec.  1.817-5(a)(2) will preserve 
flexibility, however, should the IRS choose to modify this amount by 
publication in the Internal Revenue Bulletin in response to comments on 
Notice 2007-15.
2. Expansion of List of Permitted Investors Under Sec.  1.817-5(f)(3)
    On July 30, 2003, the Treasury Department and the IRS published a 
notice of proposed rulemaking (REG-163974-02, 2003-2 CB 595) under 
section 817 in the Federal Register (68 FR 44689), proposing to remove 
a specific rule that applied to nonregistered partnerships for purposes 
of testing diversification. Written comments were received both on the 
proposed regulations and on the need for further guidance under section 
817 more generally. Comments on the proposed regulations were taken 
into account in final regulations (T.D. 9185, 2005-1 CB 752) that were 
published March 1, 2005 in the Federal Register (70 FR 9869). Comments 
on section 817 more generally covered a broad range of issues. Two of 
those issues have since been addressed by revenue ruling. See Rev. Rul. 
2005-7, 2005-1 CB 464 (concerning application of the look-through rule 
in the case of tiered regulated investment companies); Rev. Rul. 2007-
7, 2007-7 I.R.B. 468 (February 12, 2007) (concluding that an interest 
held by a permitted investor is not treated as an interest held by the 
general public for purposes of Rev. Rul. 2003-92, 2003-2 CB 350).
    These proposed regulations would expand the list of permitted 
investors in Sec.  1.817-5(f)(3) to include two categories of holders 
that were the subject of comments in 2003: (i) Qualified tuition 
programs as defined in section 529, and (ii) trustees of pension or 
retirement plans established and maintained outside of the United 
States primarily for the benefit of individuals substantially all of 
whom are nonresident aliens.
    Section 529 provides for the exemption from Federal income tax of 
qualified tuition programs. The term ``qualified tuition program'' 
means a program established and maintained by a state or agency or 
instrumentality thereof or by one or more eligible educational 
institutions (A) Under which a person (i) May purchase tuition credits 
or certificates on behalf of a designated beneficiary which entitle the 
beneficiary to the waiver or payment of qualified higher education 
expenses of the beneficiary, or (ii) in the case of a program 
established and maintained by a State or agency or instrumentality 
thereof, may make contributions to an account which is established for 
the purpose of meeting the qualified higher education expenses of the 
designated beneficiary of the account, and (B) which meets the other 
requirements of section 529(b).
    The Treasury Department and the IRS agree with the 2003 
commentators that permitting qualified tuition programs and certain 
trustees of foreign pension plans to own a beneficial interest in an 
investment company, partnership, or trust that is also owned by one or 
more segregated asset accounts would be consistent with the purpose and 
operation of section 817(h). In addition, neither qualified tuition 
programs nor the foreign pension plans that are described in the 
proposed regulations present the possibility of investment by the 
general public, as that term is used in Rev. Rul. 81-225, 1981-2 CB 12, 
and Rev. Rul. 2003-92. See also Rev. Rul. 2007-7. The inclusion of 
qualified tuition programs in the list of permitted investors in Sec.  
1.817-5(f)(3) does not relieve those programs of the need to satisfy 
all requirements of section 529 and the regulations under that section. 
In particular, the inclusion of such programs does not imply that an 
investment in a single investment company, partnership, or trust 
satisfying the minimum diversification requirements of Sec.  1.817-5(b) 
would necessarily be treated as a permitted investment under section 
529, whether as a ``broad-based investment strategy'' within the 
meaning of Notice 2001-55, 2001-2 C.B. 299 or otherwise. The Treasury 
Department and the IRS will continue to evaluate other comments 
received in this area for future guidance by publication in the 
Internal Revenue Bulletin.
    Finally, the proposed regulations would expand the list of 
permitted investors in Sec.  1.817-5(f)(3) to include investment by an 
account which, pursuant to Puerto Rican law or regulation, is 
segregated from the general asset accounts of the life insurance 
company that owns the account, provided the requirements of section 
817(d) and (h) are satisfied (without regard to the requirement that 
the account be segregated pursuant to ``State'' law or regulation). The 
Treasury Department and the IRS have received a number of requests for 
guidance interpreting the term ``variable contract'' to include a 
contract issued by a Puerto Rican company, based on accounts that are 
segregated under Puerto Rican law or regulation. One reason for these 
requests is to ensure that a beneficial interest held by a Puerto Rican 
company in an investment company, partnership, or trust does not 
prevent look-through treatment for the other holders of an interest in 
the same investment, company, partnership, or trust under Sec.  1.817-
5(f)(2). The Treasury Department and the IRS believe that expanding the 
list of permitted investors as proposed would address this issue 
without implicating the interpretive question of what constitutes a 
``State'' within the meaning of sections 817(d) and 7701(a)(10).

Proposed Effective Date

    The Treasury Department and the IRS intend these regulations to be 
effective on the date the final regulations are published in the 
Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
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. Pursuant to section 7805(f) of the Internal Revenue Code, the 
notice of proposed rulemaking will be submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on their 
impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are timely submitted to the 
IRS. In addition to comments on the proposed regulations more 
generally, the Treasury Department and the IRS specifically request 
comments on (i) the clarity of the proposed regulations and how they 
can be made easier to understand; and (ii) whether rules similar to 
those proposed to apply to accounts that are segregated pursuant to 
Puerto Rican law or regulation should apply to accounts that are 
segregated pursuant to the laws or regulations of other territories.
    All comments will be available for public inspection and copying. A 
public hearing may be scheduled if requested

[[Page 41654]]

in writing by any person that timely submits written or electronic 
comments. If a public hearing is scheduled, notice of the date, time, 
and place for the hearing will be published in the Federal Register.

Drafting Information

    The principal author of these proposed regulations is James Polfer, 
Office of the Associate Chief Counsel (Financial Institutions and 
Products), Internal Revenue Service. However, personnel from other 
offices of the Treasury Department and the IRS participated in their 
development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAX

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

    Authority: 26 U.S.C. 7805 * * *
    Section 1.817-5 also issued under 26 U.S.C. 817(h). * * *

    Par. 2. Section 1.817-5 is amended as follows:
    1. The last sentence of paragraph (a)(2)(iii) is removed.
    2. Paragraph (f)(3)(iii) is revised.
    3. Paragraph (f)(3)(iv) is redesignated as paragraph (f)(3)(vii).
    4. New paragraphs (f)(3)(iv) through (vi) are added.
    The revisions and additions read as follows:


Sec.  1.817-5  Diversification requirements for variable annuity, 
endowment, and life insurance contracts.

* * * * *
    (f) * * *
    (3) * * *
    (iii) Held by the trustee of a qualified pension or retirement 
plan;
    (iv) Held by a qualified tuition program as defined in section 529;
    (v) Held by the trustee of a pension plan established and 
maintained outside of the United States, as defined in section 
7701(a)(9), primarily for the benefit of individuals substantially all 
of whom are nonresident aliens, as defined in section 7701(b)(1)(B);
    (vi) Held by an account which, pursuant to Puerto Rican law or 
regulation, is segregated from the general asset accounts of the life 
insurance company that owns the account, provided the requirements of 
section 817(d) and (h) are satisfied. Solely for purposes of this 
paragraph (f)(3)(vi), the requirement under section 817(d)(1) that the 
account be segregated pursuant to State law or regulation shall be 
disregarded; or
* * * * *

Kevin M. Brown,
Deputy Commissioner for Services and Enforcement.
 [FR Doc. E7-14620 Filed 7-30-07; 8:45 am]
BILLING CODE 4830-01-P