\[4830‑01‑p\]

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

\[REG‑163974-02\]

RIN 1545‑BB77

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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document proposes removing provisions of the Income Tax
Regulations that apply a look-through rule to assets of a nonregistered
partnership for purposes of satisfying the diversification requirements
of section 817(h) of the Internal Revenue Code. The Treasury Department
and the IRS believe that removal of these provisions will eliminate any
possible confusion regarding the prohibition on ownership of interests
by the public in a nonregistered partnership funding a variable
contract.

DATES: Written or electronic comments and requests for a public hearing
must be received by **\[[INSERT DATE 90 DAYS AFTER PUBLICATION OF THIS
DOCUMENT IN THE FEDERAL REGISTER]{.underline}\]**.

ADDRESSES: Send submissions to: CC:PA:RU (REG-163974-02), room 5226,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC
20044. Comments may be hand delivered Monday through Friday between the
hours of 8 a.m. and 4 p.m. to CC:PA:RU (REG-163974-02), Courier=s Desk,
Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC.
Alternatively, taxpayers may submit electronic comments directly to the
IRS internet site at www.irs.gov/regs.

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

SUPPLEMENTARY INFORMATION:

**Background**

Section 817(d) defines a variable contract as an annuity contract, a
life insurance contract, or a contract that provides funding of
insurance on retired lives as described in section 807(c)(6). A variable
contract must provide for the allocation of all or part of the amounts
received under the contract to an account that is segregated from the
general asset accounts (a segregated asset account) of the company under
State law. In the case of an annuity 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(d)(3)(A). In the case
of a life insurance contract, the amount of the death benefit (or the
period of coverage) must be adjusted on the basis of the investment
return and the market value of the account. Section 817(d)(3)(B). In the
case of a contract for funding of insurance on retired lives, the
amounts paid in, or the amounts paid out, must reflect the investment
return and the market value of the account. Section 817(d)(3)(C).

Section 817(h)(1) provides that a variable contract based on a
segregated asset account shall not be 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. Under section 817(h)(1), if a segregated asset account fails
to be adequately diversified for a period, then the contracts supported
by that segregated asset account shall not be 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. Section 1.817-5(c)(1) defines period as a
calendar quarter. 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.[^1]

Section 817(h) was enacted by Congress in the Deficit Reduction Act of
1984 (Public Law No. 98-369). Congress enacted the diversification
requirements of section 817(h) to Adiscourage 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. Pursuant to this authority,
\'1.817-5 sets forth the standards a segregated asset account must meet
to be treated as adequately diversified within the meaning of section
817(h).

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 general or segregated asset accounts of insurance
companies (or affiliated companies), or by fund managers (or affiliated
companies) in connection with the creation or management of the RIC or
trust. AIn authorizing Treasury to prescribe diversification standards,
the conferees intend that the standards be designed to deny annuity or
life insurance treatment for investments that are publicly available to
investors . . . A H.R. Conf. Rep.at 1055.

Section 1.817-5(f)(1) of the regulations implements the Congressional
directive to prescribe diversification standards by providing that 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) will not be 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 will be treated as an asset of
the segregated asset account.

Section 1.817-5(f)(2) provides more detailed rules for determining
whether look-through treatment is available. Under \'1.817-5(f)(2)(i),
the look-through rule applies to any investment company, partnership, or
trust if: (A) 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 (B) public access to such
investment company, partnership, or trust is available exclusively
through the purchase of a variable contract. Section 1.817-5(f)(iii)
provides exceptions to the general ownership limitations of
\'1.817-5(f)(2)(i), specifically permitting life insurance company
general accounts, managers of the investment company, partnership or
trust, pension or retirement plan trustees, and certain individuals
whose investment falls into one of two limited classes.

Under \'1.817-5(f)(2)(ii), the look-through rule applies to a
partnership interest that is not registered under a Federal or State law
regulating the offering or sale of securities. Unlike
\'1.817-5(f)(2)(i), satisfaction of the non-registered partnership
look-through rule of \'1.817-5(f)(2)(ii) is not explicitly conditioned
on limiting the ownership of interests in the partnership to certain
specified holders.

Under \'1.817-5(f)(2)(iii), the look-through rule applies to a trust
that is treated under sections 671 through 679 as owned by the grantor
or another person if substantially all of the assets of the trust are
represented by Treasury securities.

Section 1.817-5(g) provides examples of the application of the
look-through rules of \'1.817-5(f). Example (3) of \'1.817-5(g) provides
an example of the application of the

\'1.817-5(f)(2)(ii) non-registered partnership look-through rule.

**Explanation of Provisions**

This document contains proposed amendments to 26 CFR part 1 under
section

817(h). These proposed amendments would remove \'1.817-5(f)(2)(ii),
which requires taxpayers to look through an interest in a nonregistered
partnership, as defined in \'1.817-5(f)(2)(ii), to determine whether a
segregated asset account supporting a variable contract

is adequately diversified within the meaning of section 817(h) and
\'1.817-5. In addition, the proposed regulations would conform the other
provisions of \'1.817-5 to the removal of \'1.817-5(f)(2)(ii), and would
remove Example (3) of \'1.817-5(g).

> The application of \'1.817-5(f)(2)(i) to interests in nonregistered
> partnerships will be

unchanged by the removal of \'1.817-5(f)(2)(ii). Thus, look through
treatment will be available for interests in a nonregistered partnership
if: (A) all the beneficial interests in the nonregistered partnership
(other than those described in \'1.817- 5(f)(3)) are held by one or more
segregated asset accounts of one or more insurance companies; and (B)
public access to such nonregistered partnership is available exclusively
(except as otherwise permitted in \'1.817-5(f)(3)) through the purchase
of a variable contract.

[Reasons for Change]{.underline}

The Treasury Department and the IRS are concerned that
\'1.817-5(f)(2)(ii) is not consistent with Congressional intent because
it is not explicitly subject to the public availability limitation of
section 817(h). The Treasury Department and the IRS believe that removal
of \'1.817-5(f)(2)(ii) will eliminate any possible confusion regarding
the prohibition on ownership of interests by the public in a
non-registered partnership funding a variable contract.

In addition, the Treasury Department and the IRS understand that certain
taxpayers are purchasing contracts invested in partnerships that rely on
the nonregistered partnership rule of \'1.817-5(f)(2)(ii) to satisfy the
diversification requirements of section 817(h). The Treasury Department
and the IRS are concerned that these contracts are funded by interests
in partnerships that are also available to certain limited classes of
investors, specifically individuals that are Aqualified purchasers@
within the meaning of 15 U.S.C. \' 80a-2(a)(51) or Aaccredited
investors@ as defined in Regulation D of the Securities Act of 1933.[^2]
The Treasury Department and the IRS believe that Congress intended to
treat qualified purchasers and accredited investors as part of the
general public when determining whether an investment is available for
the purchase by the general public. Elimination of \'1.817-5(f)(2)(ii)
will limit access to interests in non-registered partnerships to the
same holders that are permitted under \'1.817-5(f)(2)(i), which does not
include either qualified investors or accredited investors.

**Proposed Effective Date**

The Treasury Department and the IRS intend revocation of
\'1.817-5(f)(2)(ii) and Example (3) of \'1.817-5(g) to be effective on
the date the final regulations are published in the Federal Register.
The revocation will be effective for all investments in nonregistered
partnerships, including investments made prior to the effective date of
the revocation that relied on the look-through rule of
\'1.817-5(f)(2)(ii) to satisfy the diversification requirements of
section 817(h) and the regulations and do not meet the requirements of
\'1.817-5(f)(2)(i). However, arrangements in existence on the effective
date of the revocation of \'1.817-5(f)(2)(ii) will be considered to be
adequately diversified if: (i) those arrangements were adequately
diversified within the meaning of section 817(h) prior to the revocation
of \'1.817-5(f)(2)(ii) and (ii) by the end of the last day of the second
calendar quarter ending after the effective date of the regulation, the
arrangements are brought into compliance with the final regulations.

**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 Request for a Public Hearing**

Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) or electronic comments that are timely submitted
to the IRS. The Treasury Department and the IRS specifically request
comments on the clarity of the proposed rule and how it may be made
easier to understand. All comments will be available for public
inspection and copying. A public hearing may be scheduled if requested
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**.

The Treasury Department and the IRS specifically request comments on:
(1) whether revocation of \'1.817-5(f)(2)(ii) necessitates other changes
to the look-through rules of \'1.817-5(f), in particular whether the
list of holders permitted by \'1.817-5(f)(3) should be amended or
expanded, and whether a non-pro-rata distribution of the investment
returns of a segregated asset account should be permitted to take
account of certain bonus payments to investment managers commonly
referred to as incentive payments, (2) whether \'1.817-5 should be
updated to take account of changes to variable contracts since the final
regulations were published in 1986, and (3) whether regulations are
needed to address when a holder of a variable contract will be treated
as the owner of assets held in a segregated asset account and,
therefore, required to include earnings on those assets in income.[^3]

**Drafting Information**

The principal author of these proposed regulations is James Polfer,
Office of the Associate Chief Counsel (Financial Institutions and
Products), Office of Chief Counsel, 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 Amendment 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 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\. Paragraphs (f)(2)(ii) and (g) [Example 3]{.underline} are removed.

2\. Paragraph (f)(2)(iii) is redesignated as paragraph (f)(2)(ii).

3\. Paragraph (g) [Example 4]{.underline} is redesignated as paragraph
(g) [Example 3]{.underline}.

> Deputy Commissioner (Services and Enforcement)

[^1]: Section 1.817-5(a)(2) provides a mechanism for insurance companies
    to avoid this result if certain enumerated correction procedures are
    satisfied.

[^2]: The Treasury Department and the IRS understand that many of the
    partnership interests that are available under these arrangements
    are interests in partnerships that operate as hedge funds, often
    established and operated in foreign jurisdictions. In many cases,
    interests in these partnerships are available for purchase directly
    by the general public as well as through the purchase of a variable
    contract. Taxpayers that purchase a variable annuity or life
    insurance contract are indirectly investing in partnership interests
    that are available for direct investment by the general public. By
    indirectly investing in these partnership interests through the
    purchase of a variable contract taxpayers defer tax on partnership
    earnings that might otherwise be currently taxable. The Treasury
    Department and the IRS believe that these arrangements (often
    marketed as Ainsurance wrappers@) are the type of overly investment
    oriented insurance and annuity arrangements that Congress sought to
    prevent when it enacted the diversification rules of section 817(h).

[^3]: The Treasury Department and the IRS have issued a number of
    revenue rulings that provide guidance for determining whether the
    holder of a variable contract will be treated as the owner of assets
    held by a segregated asset account by virtue of the control the
    contract holder has over those assets. [See]{.underline} Rev. Rul.
    2003-92, 2003-33 I.R.B. \_\_ (August 18, 2003); Rev. Rul. 2003-91,
    2003-33 I.R.B. \_\_ (August 18, 2003); Rev. Rul. 82-54, 1982-1 C.B.
    11; Rev. Rul. 81-225, 1981-2 C.B. 12; Rev. Rul. 80-274, 1980-2 C.B.
    27; Rev. Rul. 77-85, 1977-1 C.B. 12. [See also]{.underline}
    [Christoffersen v. U.S.]{.underline}, 749 F.2d 513 (8^th^ Cir.
    1984), [rev=g]{.underline} 578 F. Supp. 398 (N.D. Iowa 1984). These
    rulings apply general concepts of ownership that have developed in
    case law to conclude that a contract holder was the owner of assets
    held in the account that supported the contract holder=s annuity
    contract, and was therefore subject to current taxation on the
    earnings on those assets.