Source: https://www.law.cornell.edu/supremecourt/text/381/233
Timestamp: 2019-08-22 00:29:00
Document Index: 669133451

Matched Legal Cases: ['§ 804', '§ 804', '§ 809', '§ 804', '§ 804', '§ 214']

UNITED STATES, Petitioner, v. ATLAS LIFE INSURANCE COMPANY. | US Law | LII / Legal Information Institute
381 U.S. 233 (85 S.Ct. 1379, 14 L.Ed.2d 358)
Syllabus from pages 233-234 intentionally omitted
The Life Insurance Company Income Tax Act of 1959, 1 which represents a comprehensive overhaul of the laws relating to the taxation of life insurance companies, places a tax upon taxable investment income and upon one-half the amount by which total gain from operations exceeds taxable investment income. 2 In arriving at taxable investment income and gain from operations, the 1959 Act, consistent with prior law in this regard, recognizes that life insurance companies are required by law to maintain policyholder reserves to meet future claims, that they normally add to these reserves a large portion of their investment income and that these annual reserve increments should not be subjected to tax. The question in this case is whether the method by which Congress chose to deal with these annual reserve increments and to arrive at taxable investment income places an impermissible tax on the interest earned by life insurance companies from municipal bonds, within the meaning of the Act itself and the relevant cases in this Court.
The 1959 Act defines life insurance company reserves, 3 provides a rather intricate method for establishing the amount which for tax purposes is deemed to be added each year to these reserves 4 and in § 804 prescribes a division of the investment income of an insurance company into two parts, the policyholders' share and the company's share. 5 More specifically, the total amount to be added to the reserve—the policy and other contract liability requirements—is divided by the total investment yield 6 and the resulting percentage is used to allocate each item of investment income, including tax-exempt interest, partly to the policyholders and partly to the company. In this case, approximately 85% of each item of income was assigned to the policyholders and was, as the Act provides, excluded from the company's taxable income. The remainder of each item is considered to be the company's share of investment income. From the total amount allocated to the company the Act allows a deduction of the company's share of tax-exempt interest (and of other nontaxed items) to arrive at taxable investment income. 7 The taxable investment income for the purposes of arriving at the portion of gain from operations which is to be subjected to tax is arrived at by much the same process as above described.
This view of the section is fully supported by its legislative history. As H.R. 4245 came to the Senate after passage by the House, it provided for deducting the annual addition to reserves, but to prevent a 'double deduction' reduced the deduction by a portion of tax-exempt interest. 8 This treatment of tax-exempt interest was one of many subjects of comment in the extensive hearings which followed before the Senate Committee on Finance. It was repeatedly and strongly argued by many that life insurance companies were entitled to deduct in full both the annual addition to reserves and the entire amount of tax-exempt interest, that the provisions of H.R. 4245 with regard to tax-exempt interest discriminated against the insurance companies, that the section was constitutionally invalid under the National Life and Gehner cases and that the formula would have adverse consequences on the municipal bond market. 9 Other witnesses, however, including those representing the Treasury Department, supported the bill and considered it to accord proper and constitutionally permissible treatment to municipal bond interest. 10 It is very doubtful that there remained at the conclusion of the hearings any unexplored facts or legal arguments concerning this aspect of the bill.
The Senate Committee, with the hearings behind it, reported out a bill with amendments which, among other things, took a decidedly different approach to the ascertainment of the annual addition to reserves and to the handling of tax-exempt interest. This approach was essentially that which is contained in the statute as described above. 11
As time and again stated in the Committee Report and by those who presented the bill on the floor of the Senate, the purpose of the formula provided by the Senate was to avoid taxing exempt interest. 12 Senator Byrd, the Committee chairman, stated that '(i)n providing the formula I have described to the Senate it was the intention of the committee not to impose any tax or tax-exempt interest.' 105 Cong.Rec. 8401. It is extremely difficult to read the hearings, the reports, and the debates without concluding that in the opinion of Congress the formula it provided, without adjustment under § 804(a)(6) or § 809(b)(4), did not impose a tax on exempt interest in either the statutory or constitutional sense.
None of the materials called to our attention, however, explain why or for what purpose §§ 804(a)(6) and 809(b)(4) were added to the Act, save for mere recitations in the reports and the debates that an adjustment would be required in any case where tax-exempt interest was shown to be subjected to tax. 13 It may be that Congress thought that peculiar facts and circumstances in particular cases would require different treatment than the general formula would provide. If this was the case, no examples or illustrations of these aberrational situations were referred to or explained. And if this was to be the sole function of §§ 804(a)(6) and 809(b)(4) the Commissioner is surely entitled to a judgment, for there is nothing in this record indicating that this case is anything but the typical one to which Congress intended to apply the general formula.
It is obvious that this is not the case under the 1959 Act. Here, a company receiving income from both exempt and nonexempt securities pays not the same, but less, tax than the company with an identical amount of gross income derived from only taxable sources. As the taxpayer displaces taxable income with exempt income, the size of the tax base, and the tax, are reduced. The tax burden per taxable dollar of taxable gross income does not increase, but remains the same. 14
But Atlas urges that the rule of National Life, when read in conjunction with State of Missouri ex rel. Missouri Ins. Co. v. Gehner, 281 U.S. 313, 50 S.Ct. 326, means that a tax is imposed on tax-exempt interest whenever the liability of the taxpayer receiving such interest is greater than it would have been if the tax-exempt interest had not been received. In the Gehner case a state ad valorem property tax was imposed on the net personal property of an insurance company. Exempt government bonds were excluded from the tax base but only 84%—the ratio of taxable assets to total assets—of the legally required reserves was allowed as a deduction. The Court considered National Life to hold that 'a state may not subject one to a greater burden upon his taxable property merely because he owns tax-exempt government securities.' 281 U.S., at 321, 50 S.Ct., at 328. This paraphrase of the National Life holding was correct and states the principle for which both of these cases have been cited. 15 But it is obvious that the tax in Gehner did not infringe this rule. Reducing the reserve deduction by the ration of taxable assets to total assets did not result in an increased tax burden on taxable property. The Court, nevertheless, invalidated the tax because 'the ownership of United States bonds is made the basis of denying the full exemption which is accorded to those who own no such bonds.' 281 U.S., at 321—322, 50 S.Ct., at 328. The company was apparently to have the full benefit of both the exclusion of the government bonds and the deduction for the full amount of policyholder reserves. Otherwise, the law would not disregard the ownership of the bonds in exacting the tax. The Gehner case does, therefore, condemn more than an increase in the tax rate on taxable dollars for those owning exempt securities.
This extension of National Life was soon repudiated. 16 In Denman v. Slayton, 282 U.S. 514, 51 S.Ct. 269, 75 L.Ed. 500, decided but one Term after Gehner, the Court unanimously upheld § 214(a)(2) of the Revenue Act of 1921, which permitted the deduction of interest generally except interest on indebtedness incurred or continued to purchase or carry tax-exempt securities, as applied to a dealer in securities whose disallowed interest incurred to carry exempt bonds exceeded the return from the bonds. Although the parties argued both Gehner and National Life, the Court did not mention Gehner and said National Life was radically different, since the dealer 'was not in effect required to pay more upon his taxable receipts than was demanded of others who enjoyed like incomes solely because he was the recipient of interest from tax-free securities.' 282 U.S., at 519, 51 S.Ct., at 270. But he was, like the taxpayer in Gehner, required to pay a greater tax than would be the case if the exempt securities were ignored entirely; absent ownership of the exempt bonds, the disallowed interest would have been deductible from taxable income. Ownership of exempt bonds was indeed the 'basis of denying the full exemption which is accorded to those who own no such bonds.' Gehner, 281 U.S., at 321—322, 50 S.Ct., at 328. Thus the Court not only refused to follow the implications of Gehner in the context of the federal income tax, but also sustained the propriety of disallowing an expense attributable to the production of nontaxable income. Such disallowance was not to impose an impermissible burden on the exempt receipts. 'While guaranteed exemptions must be strictly observed, this obligation is not inconsistent with reasonable classification designed to subject all to the payment of their just share of a burden fairly imposed.' 282 U.S., at 519, 51 S.Ct., at 270.
An insurance company obtains most of its funds from premiums paid to it by policyholders in exchange for the company's promise to pay future death claims and other benefits. The company is also obligated to maintain reserves, which, if they are to be adequate to pay future claims, must grow at a sufficient rate each year. The receipt of premiums necessarily entails the creation of reserves and additions to reserves from investment income. Thus the insurance company is not only permitted to invest, but it must invest; and it must return to the reserve a large portion of its investment income. As no insurance company would deny, there is sufficient economic and legal substance to the company's obligation to return a large portion of investment income to policyholder reserves to warrant or require the exclusion of investment income so employed from the taxable income of the company. And we think the policyholders' claim against investment income is sufficiently direct and immediate to justify the Congress in treating a major part of investment income not as income to the company but as income to the policyholders. Whether viewed as income to the policyholders, or, as Atlas would have it, as the principal cost of carrying on the business which produces the company's net investment income, 17 a large portion of total investment income is credited to the reserve and eliminated from taxable investment income.
Under the 1959 Act this portion is arrived at by subjecting each dollar of investment income, whatever its source, to a pro rata share of the obligation owed by the company to the policyholders, from whom the invested funds are chiefly obtained. In our view, there is nothing inherently arbitrary or irrational in such a formula for setting aside that share of investment income which must be committed to the reserves. Undoubtedly policyholders have not contracted to have assigned to them either taxable or exempt dollars. Their claim can be fully satisfied with either, but it runs against all investment income, whatever its source. We see no sound reason, legal or economic, for distinguishing between the taxable and nontaxable dollar or for saying that the reserve must be satisfied by resort to taxable income alone. Interest on municipal bonds may be exempt from tax, but this does not carry with it exemption from the company's obligation to add a large portion of investment income to policyholder reserve. 18
COMMISSIONER OF INTERNAL REVENUE, Petitioner, v. STANDARD LIFE & ACCIDENT INSURANCE COMPANY.