Opinion ID: 1501659
Heading Depth: 1
Heading Rank: 1

Heading: So-called Guaranteed Interest Paid as Part of Instalment Settlements.

Text: Instalment settlements were made by the petitioner under both types of policies in 1926 and 1928. The amounts of interest included in such instalment settlements, under the 3 per cent. guaranteed rate, was $211,254.60 for 1926 and $238,640.01 for 1928. The Board found such sums not to be interest and its findings in respect to this are summed up in the following quotation from the majority opinion: There is no agreement in this contract to pay interest, as such, and the fact that the petitioner in writing its contract separates the component parts of the reserve to be set aside for the ultimate payment of such instalments into strict reserve, as determined by the American Experience Table of Mortality, and the amount of interest required to maintain such reserve at a level sufficient to insure payment upon maturity, is merely a matter of computation which, in our opinion, is quite immaterial. The amount so arrived at and paid to the policy holder constitutes a policy obligation and as such is not `interest paid or accrued on indebtedness within the meaning of section 245(a) (8) of the applicable Revenue Acts.' Reserve Loan Life Insurance Company v. Com'r, 18 B.T.A. 359. The questions presented by the so-called guaranteed interest of 3 per cent. compounded annually seem to us to fall into two categories. The first category embraces interest included in instalment settlements made under a contract of insurance originally providing for instalment settlements, that is to say, under the Trust Certificate policy, or, in the case of the Ordinary Life policy, under an option exercised by the insured or by the beneficiary during the life time of the insured. The second category arises under the circumstances of the cause at bar only in the case of Ordinary Life policies where options to receive instalment settlements in lieu of a lump sum payment have been exercised by the beneficiary after the death of the insured. As to the First Category, Contract Made or Option Exercised, Prior to the Death of the Insured for Instalment Settlements. In the argument before us and upon the briefs of the parties much emphasis was laid upon the difference between a policy obligation and an obligation arising out of indebtedness. Examples will serve to illustrate this difference. An individual enters into an ordinary contract of life insurance with an insurance company. We will assume that the policy contains no options. The obligation of the policy is that the insurance company, upon due proof of the individual's death, will pay to the beneficiary the face of the policy. Until the occurrence of the death of the insured the obligation of the insurance company was a policy obligation. Upon the death of the insured the obligation ceased to be a policy obligation and became an obligation of debt. Every legal requirement of an obligation of debt is present. There is a sum certain to be paid and that sum is due and owing. All would agree that such an obligation bears interest if it was not paid at the time stipulated. Interest is commonly defined as a consideration paid for the use of money or for forbearance in demanding it when due. Maryland Casualty Co. v. Omaha Power Co. (C.C.A.) 157 F. 514, 519. Bouvier's Law Dictionary (3d Ed.) p. 1614. A debt is a sum of money due by contract, express or implied. The sum of money may be payable at a fixed time or upon a contingency. When payable upon a contingency, it becomes a debt only when the contingency has happened. Guaranty Trust Company v. Galveston City R. Co. (C.C.A.) 107 F. 311, 317; see also, Walla Walla v. Walla Walla Water Co., 172 U.S. 1, 20, 19 S.Ct. 77, 43 L.Ed. 341. Implicit always in the payment of interest is the concept of a debt which is due or which will become due in a definite amount and at a definite time. For example, money is borrowed from a bank upon a note due in three months. The amount of the note may include the interest, but in such case the sum of the two constitute the debt. If upon the due date the note is not paid, then the sum of the note, which may include the interest charged for the use of the money, in turn bears interest. Let us now apply these well-established legal conceptions to the facts of the case at bar. Under the terms of the Trust Certificate policy the payment of the instalment settlements is provided for in the original contract between the insured and the petitioner. Under the Ordinary Life policy payment of instalment settlements may be contracted for (1) by the exercise of an appropriate option by the insured or by the beneficiary with the permission of the insured, or (2) by the beneficiary alone after the death of the insured. Now dealing with the instalment settlements thus contracted for, under the Trust Certificate policy or under the Ordinary Life policy when the option has been exercised within the lifetime of the insured, we find the obligations thus created are plainly obligations of policy rather than obligations of debt. The face of the policies bears an obligation to pay in instalments and at given dates. There can be no obligation to pay, first, until the policy has matured by the death of the insured, and second, until the arrival of the due dates of the respective instalment payments. Such a policy matures upon the death of the insured. Upon maturity its nature changes from a policy obligation to an obligation of debt, but, before such an obligation of debt can bear interest, it must become due. When the due date arrives it will bear interest and not before. We are not unmindful of the fact that the actual amounts of the instalment settlements are arrived at by a combination of two items; namely, the amounts of the sums paid in by the insured by way of premiums as required according to the American Experience Table of Mortality plus amounts the equivalent of 3 per cent. interest per annum thereon. This computation, however, constitutes merely a bookkeeping or actuarial basis whereby the amount promised to be paid under the instalment settlements is arrived at. The payments in fact are paid by the petitioner from its reserves. These reserves are composed, among other things, of earnings and profits, made by the petitioner. Though each policyholder is entitled by the terms of his policy to share equally with all other policyholders in this reserve, no obligation of debt to the policyholder is created thereby. We deem this ruling to be in accordance with the general principle enunciated by the Supreme Court in Duffy v. Mutual Benefit Life Insurance Company, 272 U.S. 613, 47 S.Ct. 205, 206, 71 L.Ed. 439. In the cited case the life insurance company was a mutual insurance company conducting its business, as does the petitioner, upon the level premium plan and maintaining the reserve as required by law. The question before the Supreme Court was one of alleged deficiency in taxes upon the part of the company under the statute creating the War Excess Profits Tax, chapter 63 of the Revenue Act of October 3, 1917 (40 Stat. 300). The collector contended that the company's reserve maintained as required by law represented a present existing liability to its policyholders, the company having included the amount of its legal reserve in its invested capital. In delivering the opinion of the court, Mr. Justice Sutherland stated: The legal reserve    constitutes assets of a very permanent character. Originally consisting of the contributions of members only, the earnings now make up considerably more than one-half of the whole. The contributions were made for, and have been used to serve, the double purpose of protection and of investment. These assets, thus constituted, have never represented indebtedness any more than the capital of a stock corporation subscribed by its stockholders represents indebtedness. Until the maturity of a policy, the policyholder is simply a member of the corporation, with no present enforceable right against the assets. Upon the maturity of the policy he becomes a creditor with an enforceable right. Then for the first time there is an indebtedness. We hold, therefore, that the portion of the respective sums of $211,254.60 and $238,640.01, which in fact represents the 3 per cent. annual interest included in the instalment settlements paid to beneficiaries by the petitioner under the Trust Certificate policy or under an option of the Ordinary Life policy exercised prior to the death of the insured, is not interest on indebtedness within the terms of the statute and cannot be deducted by the petitioner from its gross income. We sustain the ruling of the Board in so far as it relates to such payments. As to the Second Category, Options for Instalment Settlements of Ordinary Life Policies Exercised by Beneficiaries After Demise of Insured. The record does not disclose what part of the sums referred to were in fact paid out by the petitioner under Options of Ordinary Life policies, such options being exercised by beneficiaries after the demise of the insured. The Board in its majority opinion held that guaranteed interest payments at 3 per cent. paid by the petitioner upon the face amount of the Ordinary Life policy, under an exercise of option D, such option to receive such interest income having been exercised by the beneficiary after the death of the insured, are deductible by the petitioner from its gross income within the terms of the statute. The Commissioner did not petition this court for a review of the decision of the Board in this respect, but we have carefully considered the questions of law involved. By its decision the Board differentiated between interest paid by the petitioner under option D, under the circumstances set out, and interest paid by the petitioner under the other options of section 7 of the Ordinary Life policy. In this connection the Board stated: It will be observed that the arrangement under the provisions of the contract here discussed are supplementary to the policy obligation. The petitioner agrees that if the beneficiary will forego the right to receive the net proceeds payable to him under the contract immediately upon the death of the insured and if he will permit the petitioner to retain such amount for a stated period of time, it will compensate him by the payment of 3 per cent. interest. A new relationship between new and different parties springs into being  an indebtedness actually arises upon the death of the insured and the immediate satisfaction thereof is postponed by the debtor, on the one hand, and the creditor on the other. There is no life contingency involved in this new transaction. An indebtedness arises under the contract between the petitioner and the beneficiary and the interest is paid upon such indebtedness. Therefore, we are of the opinion that the guaranteed interest payments of 3 per cent. are allowable deductions under the provisions of the applicable sections of the act hereinbefore set forth and discussed.    In view of the fact that this ruling of the Board is not at issue we content ourselves with the statement that the principles of law therein enunciated are correct. In our opinion, however, such principles are equally applicable to the 3 per cent. annual interest paid under the other options of section 7, requiring instalment settlements, when exercised by the beneficiary after the death of the insured. While there is in fact no life contingency specifically referred to in option D, and section 7 in respect to options A, B, and C does specifically refer to manner of payment upon the death of any beneficiary, the amounts to be paid upon the death of the beneficiary are nothing more than the amounts of the instalments yet due commuted under the 3 per cent. per annum rate to the date of the beneficiary's death. Such an obligation is not a policy obligation. The effect of the death of the beneficiary simply serves to accelerate payment precisely as the due date of any debt may be accelerated by the happening of a contingency set forth in the agreement of indebtedness. Prior to the exercise of any option a sum certain, the one-sum value of the policy, is due upon the death of the insured, and any and all other sums provided to be paid by the petitioner after exercise of any of the options of section 7 are nothing more than computations or commutations based upon the original sum due from the petitioner upon the death of the insured, worked out in conjunction with the 3 per cent. annual interest rate. Obviously there is a most plain distinction between the contingency of the death of the insured and the contingency of the death of the beneficiary, an option under section 7 having been exercised by him after the death of the insured. In the first instance the happening of the contingency changed the obligation set out in the insurance contract from a policy obligation to an obligation of debt in a stated amount. The one-sum value of the policy then ceased to be a policy obligation and became an obligation of debt presently due and owing. For example, if option A of section 7 was exercised the obligation was to pay in instalments to the beneficiary throughout the settlement period aliquot portions of the one-sum value plus interest at the rate of 3 per cent. annually as computed. It is true that the fixed sum due immediately upon the death of the insured is enlarged by the exercise of the option by the beneficiary, but that enlargement consists of nothing more than the addition of interest to the fixed sum due. It is in practical effect as if a series of notes had been given by the petitioner to the beneficiary, each note including in its face an amount of interest paid for the use of the money. If the beneficiary dies, the amounts to be paid are simply commuted to the day of the beneficiary's death, again at 3 per cent. The incident of debt is created by the death of the insured, not by the death of the beneficiary. Upon the happening of the second contingency referred to, namely, the death of the beneficiary, the debt has already been created, is due and owing. We therefore hold that the sums computed at the rate of 3 per cent. annually and paid out under the instalment options of section 7 of the Ordinary Life policies, such payments being made under an option exercised by the beneficiary after the death of the insured, are within the terms of the statute and therefore are deductible from the gross income of the petitioner as interest. To this extent we reverse the finding of the Board. The distinction made between interest paid by the petitioner under options exercised before the death of the insured and after the death of the insured may appear to be technical when it is remembered that the sums to be paid, the rate of payment, and the rate of interest are identical whether the option be exercised before or after the death of the insured, but we believe that the distinction is a vital one when it is realized that it is the death of the insured which causes the policy to mature and sets the time at which the debt obligation of the petitioner must begin. At that time a definite sum is owing from the petitioner. The element of contingency is gone from the contract of insurance and that element is the essence of a policy obligation. As to the Additional Interest Awarded to the Policies by the Board of Trustees and Paid Out During the Years 1926 and 1928. The amount of so-called excess interest, generally 1.85 per cent., paid on matured policies payable in instalments was $105,418.55 for 1926, and $187,912.18 for 1928. The provisions of the policies in respect to such additions to the guaranteed rate of 3 per cent. have been set out before in this opinion and need not be repeated here. It is the contention of the appellant that such additions of 1.85 per cent. are interest and therefore may be deducted from its gross income. The appellant's contention in this regard is based upon the right of a beneficiary to receive such addition under the terms of the policy. The petitioner cites the statutes of Pennsylvania, [2] requiring that its policies contain provisions that each shall participate ratably in the company's surplus. It also cites decisions of the courts of Pennsylvania, among others, Reed v. Philadelphia Life Insurance Company, 50 Pa.Super. 384, and Kaufman v. New York Life Insurance Company, 111 Pa.Super. 273, 169 A. 447, affirmed in 315 Pa. 34, 172 A. 306, in support of its view. The petitioner refers also to the anti-discrimination and antirebate statutes of Pennsylvania now in force. [3] None of these authorities, however, bears directly upon the point here at issue. In view of our holding that the guaranteed rate of 3 per cent. per annum does not constitute interest when paid as part of instalment settlements under the Trust Certificate policies or under an option of the Ordinary Life policy, such option being exercised prior to the death of the insured, we also hold that the addition paid upon such instalments does not constitute interest on indebtedness within the terms of the statute. Must such payments be treated as interest when paid as part of instalment settlements made pursuant to an option of the Ordinary Life policy exercised after the death of an insured and after the maturing of a policy? This question must turn upon the nature of the action of the board of trustees of the petitioner taken pursuant to the provisions of section 1 of the policies. Section 1 of each policy is entitled Participation-Dividends of Surplus. The addition of 1.85 per cent. is awarded by the trustees from surplus and only under circumstances which, in the opinion of the board of trustees, justify the addition. Whether appropriate action to award the additional percentage be taken is a matter which rests within the discretion of the board, and, so long as the members thereof exercise reasonable business judgment and act in good faith, their action in withholding the addition or granting it may not be questioned. Under such circumstances, the making of the award is in substance the declaration of a dividend. The nature of a dividend has been defined by the Supreme Court in Mobile & O. R. Co. v. Tennessee, 153 U.S. 486, 14 S.Ct. 968, 38 L. Ed. 793, as that portion of profits and surplus funds of the corporation which has been actually set apart by a valid resolution of the board of directors, or by the shareholders at a corporate meeting, for distribution among the shareholders according to their respective interests, in such a sense as to become segregated from the property of the corporation and to become the property of the shareholders distributively. The policyholders of the petitioner in the case at bar stand in the position of the stockholders in the cited case. In our opinion the award of the additional percentage by the board of the petitioner was in the nature of a declaration of a dividend and therefore cannot be brought within the terms of the statute as interest upon indebtedness. We sustain the ruling of the Board of Tax Appeals in regard to the sums in question. As to the additional interest awarded upon the net proceeds of policies held under the interest option, amounting to $31,-182.10 for 1926 and $66,764.00 for 1928, in view of our holding set out above, it is unnecessary to discuss the question presented further. We therefore sustain the ruling of the Board disallowing the sums referred to as interest on indebtedness deductible from the gross income of the petitioner within the terms of the Statute. As to So-Called Interest Paid on Accrued Dividends Under the Accumulated Surplus Policy. An additional type of insurance policy issued by the petitioner must now be considered. It is designated by the petitioner as an Ordinary Life Policy. Accumulated Surplus Plan. We will designate it as an Accumulated Surplus Policy. This kind of policy, no longer issued by the petitioner, bears a face value of $100,000, this being the sum insured. The pertinent provisions of the policy in so far as they relate to the questions before us are as follows: