Diversification Requirements for Variable Annuity, Endowment, and Life Insurance Contracts, 12263-12265 [E8-4577]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 73, Number 46 (Friday, March 7, 2008)]
[Rules and Regulations]
[Pages 12263-12265]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-4577]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9385]
RIN 1545-BG65


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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations concerning the 
diversification requirements of section 817(h) of the Internal Revenue 
Code (Code). The regulations 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 regulations also 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. The regulations affect 
insurance companies that issue variable contracts and affect 
policyholders who purchase such contracts.

DATES: Effective/applicability date: These regulations are effective as 
of March 7, 2008.

FOR FURTHER INFORMATION CONTACT: James Polfer, (202) 622-3970 (not a 
toll-free number).

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 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

[[Page 12264]]

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.
    On July 31, 2007, the Treasury Department and the IRS published a 
notice of proposed rulemaking (REG-118719-07) under section 817 in the 
Federal Register (72 FR 41651). The proposed regulations 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. One written comment was received in 
response to the notice of proposed rulemaking, and no public hearing 
was requested or held. After consideration of the comment, the proposed 
regulations are adopted as final regulations with the change discussed 
below.

Summary of Comment and Explanation of Revisions

Comment on the Proposed Regulation

A. Amendment to Sec.  1.817-5(a)(2) (Remedy for Inadvertent 
Nondiversification)
    The regulations 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.
    The commentator supports the removal of the sentence. The 
commentator also suggested that the correction procedures under section 
817(h) should be modified to (1) provide flexibility to more 
appropriately address various fact patterns, (2) encourage taxpayers to 
establish compliance practices and procedures, (3) promote compliance 
by providing limited fees for voluntary corrections, (4) provide for 
fees and sanctions in graduated steps to ensure that there is always an 
incentive for prompt correction, and (5) provide for sanctions that are 
reasonable in light of the nature, extent, and severity of the 
violation. The Treasury Department and the IRS will consider these 
comments in the course of evaluating what steps, if any, to take in 
response to submissions received concerning correction procedures more 
generally under Notice 2007-15, 2007-7 I.R.B. 503 (February 12, 2007).
B. Expansion of List of Permitted Investors Under Sec.  1.817-5(f)(3)
    The regulations 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 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, and 
(iii) 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.
    The commentator supports such an expansion of the list of permitted 
investors and urged that the list be further expanded to include 
segregated asset accounts of any foreign insurer that makes an election 
under section 953(d) to be treated as a domestic corporation for U.S. 
tax purposes. A general rule to this effect would be beyond the scope 
of the proposed regulations and may require a more

[[Page 12265]]

specific examination of the manner in which such accounts are 
segregated under the applicable foreign law. Accordingly, such an 
expansion is not provided in these regulations, but the Treasury 
Department and IRS will consider the issue for possible future 
published guidance.
    The commentator also urged that guidance is needed concerning (1) 
what steps must be taken to verify that an entity is a permitted 
investor, and (2) what happens if, despite verification efforts, the 
entity in question was never a permitted investor or subsequently loses 
its status as such. The Treasury Department and IRS are aware of this 
issue, but have concluded it is beyond the scope of the proposed 
regulations and at this time might better be addressed by Internal 
Revenue Bulletin guidance or by letter ruling. Accordingly, the issue 
is not addressed in these final regulations, but the Treasury 
Department and IRS will consider the issue for possible future 
published guidance.
    Finally, the commentator suggested that the language of the 
amendment that expands the list of permitted investors to include 
certain Puerto Rican accounts should be clarified to eliminate 
confusion. Specifically, in the notice of proposed rulemaking, the 
proviso clause of the amendment stated that such an account will be a 
permitted investor ``provided the requirements of section 817(d) and 
(h) are satisfied.'' The commentator expressed concern that the 
language of the amendment as written in the notice of proposed 
rulemaking could be read to present an issue of circularity (that is, 
to be a permitted investor, the account must satisfy section 817(h), 
but to satisfy section 817(h), the account must be a permitted 
investor.) To eliminate this potential confusion, the final regulations 
state that, solely for purposes of Sec.  1.817-5(f)(3)(vi), the 
requirement under section 817(d)(1) that the account be segregated 
pursuant to State law or regulation shall be disregarded and Sec.  
1.817-5(f)(1) shall be applied without regard to the Puerto Rican 
segregated asset account.

Special Analyses

    It has been determined that this Treasury decision 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 preceding this regulation was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on its impact on small business.

Drafting Information

    The principal author of these final 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.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAX

0
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).

0
Par. 2. Section 1.817-5 is amended as follows:
0
1. The last sentence of paragraph (a)(2)(iii) is removed.
0
2. Paragraph (f)(3)(iii) is revised.
0
3. Paragraph (f)(3)(iv) is redesignated as paragraph (f)(3)(vii).
0
4. New paragraphs (f)(3)(iv) through (vi) are added.
0
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 and Sec.  1.817-5(f)(1) shall be applied without regard to 
the Puerto Rican segregated asset account; or
* * * * *

Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
    Approved: February 29, 2008.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E8-4577 Filed 3-6-08; 8:45 am]
BILLING CODE 4830-01-P