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2007-37 September 10, 2007
Notice of Proposed RulemakingDiversification Requirements for Variable Annuity, Endowment, and Life Insurance Contracts
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 §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.
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 http://www.regulations.gov/ (IRS REG-118719-07).
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.
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 §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 C.B. 741, see §601.601(d)(2) of this chapter, sets forth in more detail the procedure by which an issuer may request the relief described in §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).
Under §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 §1.817-5(f)(3)).
Under §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
(4) Held by the public, or treated as owned by the policyholders pursuant to Rev. Rul. 81-225, 1981-2 C.B. 12, see §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 C.B. 12, see §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.
The amendments would remove the sentence from §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 §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).
1. Proposed amendment to §1.817-5(a)(2) (remedy for inadvertent nondiversification. The proposed regulations would remove the sentence in §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 §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 §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 time in the case of failures due to investments in U.S. Treasury securities). See §601.601(d)(2) of this chapter.
Even with the proposed modification of §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 §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 §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 C.B. 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 C.B. 749) 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 C.B. 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 C.B. 350).
These proposed regulations would expand the list of permitted investors in §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.
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 C.B. 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 §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 §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 §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 §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).
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.
§1.817-5 Diversification requirements for variable annuity, endowment, and life insurance contracts. * * * * *
Note (Filed by the Office of the Federal Register on July 30, 2007, 8:45 a.m., and published in the issue of the Federal Register for July 31, 2007, 72 F.R. 41651)
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