[Federal Register Volume 59, Number 242 (Monday, December 19, 1994)] [Unknown Section] [Page 0] From the Federal Register Online via the Government Publishing Office [www.gpo.gov] [FR Doc No: 94-31041] [[Page Unknown]] [Federal Register: December 19, 1994] ----------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION [Rel. No. IC-20764; File No. 812-9116] Federal Kemper Life Assurance Company, et al. December 12, 1994. AGENCY: Securities and Exchange Commission (the ``SEC'' or the ``Commission''). ACTION: Notice of application for exemption under the Investment Company Act of 1940 (the ``1940 Act''). ----------------------------------------------------------------------- APPLICANTS: Federal Kemper Life Assurance Company (``FKLA''), FKLA Variable Separate Account (the ``Separate Account''), any other separate account established in the future (``Future Accounts'') by FKLA or an affiliated life insurance company to support certain scheduled premium, single premium, or flexible premium variable life insurance contracts issued by FKLA or an affiliated life insurance company (the ``Contracts''), and Kemper Financial Services, Inc. (``KFS''). RELEVANT 1940 ACT SECTIONS: Order requested under Section 6(c) of the 1940 Act for exemptions from Section 27(c)(2) of the 1940 Act and Rules 6e-2(c)(4)(v) and 6e-3(T)(c)(4)(v) thereunder. SUMMARY OF APPLICATION: Applications seek an order to permit them to deduct from premiums received under the Contracts an amount that is reasonable in relation to the increased federal income tax burden resulting from the receipt of such premiums in connection with the Contracts. FILING DATE: The application was filed on July 19, 1994. HEARING OR NOTIFICATION OF HEARING: An order granting the application will be issued unless the Commission orders a hearing. Interested persons may request a hearing on this application by writing to the Secretary of the SEC and serving Applicants with a copy of the request, personally or my mail. Hearing requests must be received by the Commission by 5:30 p.m. on January 6, 1995 and should be accompanied by proof of service on Applicants in the form of an affidavit or, for lawyers, a certificate of service. Hearing requests should state the nature of the interest, the reason for the request, and the issues contested. Persons may request notification of a hearing by writing to the Secretary of the SEC. ADDRESSES: Secretary, Securities and Exchange Commission, 450 Fifth Street NW., Washington, D.C. 20549. Applicants, 1 Kemper Drive, Long Grove, Illinois 60049. FOR FURTHER INFORMATION CONTACT: Wendy Finck Friedlander, Senior Attorney, at (202) 942-0670, Office of Insurance Products, Division of Investment Management. SUPPLEMENTARY INFORMATION: Following is a summary of the application. The complete application is available for a fee from the Commission's Public Reference Branch. Applicants' Representations 1. FKLA, a stock life insurance company organized under the laws of Illinois, is the depositor of the Separate Account. FKLA offers life insurance and annuity products and is admitted to do business in the District of Columbia and in all states except New York. 2. The Separate Account was established under Illinois law as a separate account of FKLA. The Separate Account, registered under the 1940 Act as a unit investment trust, will fund the Contracts issued by FKLA. The Contracts will be registered under the Securities Act of 1933. The Kemper Investors Fund (the ``Fund''), a registered open-end management investment company, will serve as the underlying investment medium for the Separate Account. 3. KFS, a registered broker-dealer under the Securities Exchange Act of 1934, is the principal underwriter for the Contracts, and will be the principal underwriter of any other variable life insurance policies funded through the Separate Account or any Future Account (``Future Contracts''). 4. The Contracts are flexible premium individual variable life insurance policies. Applicants represent that the Contracts will be issued in reliance on Rule 6e-3(T)(b)(13)(i)(B) under the 1940 Act. 5. FLKA will deduct a charge of 1.00% of each premium payment under the Contracts to cover a portion of FKLA's estimated cost for higher federal corporate income tax liability resulting from changes made to the Internal Revenue Code of 1986 (``Code'') by the Omnibus Budget Reconciliation Act of 1990 (``OBRA''), affecting the treatment of deferred acquisition costs. The requested order also would permit the deduction of up to 1.25% of each premium payment under Future Contracts. 6. OBRA amended the Code by, among other things, enacting Section 848 thereof. Section 848 changed how a life insurance company must compute its itemized deductions from gross income for federal income tax purposes. Section 848 requires an insurance company to capitalize and amortize, over a period of ten years, part of the company's general expenses for the current year. Under prior law, these general expenses were deductible in full from the current year's gross income. 7. The amount of deductions that must be capitalized and amortized over ten years, rather than deducted in the year incurred, is based on ``net premiums'' received in connection with certain types of insurance contracts. Section 848 of the Code defines ``net premium'' for a type of contract as gross premiums received by the insurance company on the contracts minus return premiums and premiums paid by the insurance company for reinsurance of its obligations under such contracts. Applicants state that the effect of Section 848 is to accelerate the realization of income from insurance contracts covered by that Section, and, accordingly, the payment of taxes on the income generated by those contracts. 8. The amount of general deductions that must be capitalized depends upon the type of contract to which the premiums received relate and varies according to a schedule set forth in Section 848. Applicants represent that the Contracts are ``specified insurance contracts'' that fall into the category of life insurance contracts, and, under Section 848, 7.7% of the year's net premiums received must be capitalized and amortized. 9. Applicants represent that the increased tax burden resulting from Section 848 may be quantified as follows. For each $10,000 of net premiums received under the Contracts in a given year, Section 848 requires FKLA to capitalize $770 (7.7% of $10,000) and $38.50 of this $770 may be deducted in the current year. This leaves $731.50 ($770 minus $38.50) subject to taxation at the corporate tax rate of 35% which results in FKLA owing $256.03 (.35 x $731.50) more in taxes for the current year than would have been owed prior to OBRA. This current increase in federal income tax will be partially offset by deductions that will be allowed during the next ten years as a result of amortizing the remainder of the $770 ($77 in each of the following nine years and $38.50 in the tenth year). 10. In FKLA's business judgment, a discount rate of 8% is appropriate for use in calculating the present value of the increased future tax deductions resulting from the amortization described above. Applicants state that FKLA seeks an after tax rate of return on the investment of its capital in excess of 15%. To the extent that capital must be used by FKLA to meets its increased federal tax burden under Section 848 resulting from the receipt of premiums, such capital is not available to FKLA for investment. Thus, Applicants argue, the cost of capital used to satisfy FKLA's increased federal income tax burden under Section 848 is, in essence, FKLA's after tax rate of return on capital; and, accordingly, the rate of return on capital is appropriate for use in this present value calculation. To the extent that the 8% discount rate is lower than FKLA's actual targeted rate of return, Applicants submit that a measure of comfort is provided that the calculation of FKLA's increased tax burden attributable to the receipt of premiums will continue to be reasonable over time, even if the corporate tax rate applicable to FKLA is reduced, or its targeted rate of return is lowered. 11. In determining the after tax rate of return used in arriving at this discount rate, Applicants state that a number of factors were considered, including: market interest rates; FKLA's anticipated long term growth rate; the risk level for this type of business; inflation; and available information about the rates of return obtained by other life insurance companies. FKLA represents that such factors are appropriate factors to consider in determining FKLA's cost of capital. Applicants state that FKLA first projects its future growth rate based on the anticipated sales, the current interest rates, the inflation rate, acceptable risk levels, the amount of capital that FKLA can provide to support such growth, and industry practice. FKLA then uses the anticipated growth rate and the other factors enumerated above to set a rate of return on capital that equals or exceeds this rate of growth. Of these other factors, market interest rates, the acceptable risk levels and the inflation rate receive significantly more weight than information about the rates of return obtained by other companies. 12. Applicants state that FKLA seeks to maintain a ratio of capital to assets that is established based on its judgment of the risks represented by various components of its assets and liabilities. Applicants state that maintaining the ratio of capital to assets is critical to offering competitively priced products and, as to FKLA, to maintaining a competitive rating from various rating agencies. Consequently, Applicants state that FKLA's capital should grow at least at the same rate as do its assets. 13. Using a corporate federal income tax rate of 35% and assuming a discount rate of 8%, the present value of the federal income tax effect of the increased deductions allowable in the following 10 years, which partially offsets the increased federal income tax burden, comes to $174.60. The effect of Section 848 on the Contracts is, therefore, an increased federal income tax burden with a present value of $81.43 for each $10,000 of net premiums, i.e., $256.03 minus $174.60. 14. State premium taxes are deductible in computing federal income taxes. Thus, FKLA does not incur incremental federal income tax when it passes on state premium taxes to owners of the Contracts. Conversely, federal income taxes are not deductible in computing FKLA's federal income taxes. To compensate FKLA fully for the impact of Section 848, therefore, it would be necessary to allow FKLA to impose an additional charge that would make it whole not only for the $81.43 additional federal income tax burden attributable to Section 848 but also for the federal income tax on the additional $81.43 itself. This federal income tax can be determined by dividing $81.43 by the complement of the 35% federal corporate income tax rate, i.e., 65%, resulting in an additional charge of $125.28 for each $10,000 of net premiums, or 1.25%. However, FKLA currently intends to deduct 1.00% of each premium payment under the Contracts, which is less than its increased federal corporate income tax burden. FKLA reserves the rights to increase the charge and to deduct up to 1.25% of each premium payment of Future Contracts. 15. Based on prior experience, FKLA expects that all of its current and future deductions will be fully taken. Applicants represent that the maximum 1.25% charge, and the current 1.00% charge, to be deducted pursuant to the relief requested, are reasonably related to their increased federal income tax burden under Section 848, taking into account the capitalization and amortization permitted by Section 848, and the use by FKLA of a discount rate of 8% in computing the future deductions resulting from such capitalization and amortization, such rate being lower than, but assumed for these purposes to be the equivalent of, FKLA's cost of capital. 16. While the application states that FKLA believes that a charge of 1.00% of premium payments would reimburse it for the impact of Section 848 (as currently written) on FKLA's federal income tax liabilities, the application also states, however, that FKLA believes that it will have to increase this charge if any future change in, or interpretation of Section 848, or any successor provision, results in an increased federal income tax burden due to the receipt of premiums. Such an increase could result from a change in the corporate federal income tax rate, a change in the 7.7% figure, a change in the categorization of specified insurance contracts, or a change in the amortization period. Applicants' Legal Analysis 1. Applicants request an order to the Commission pursuant to Section 6(c) exempting them from the provisions of Section 27(c)(2) of the 1940 Act, and Rules 6e-2(c)(4)(v) and 6e-3(T)(c)(4)(v) thereunder, to the extent necessary to permit deductions to be made from premium payments received in connection with the Contracts. The deductions would be in an amount that is reasonable in relation to the increased federal income tax burden related to the receipt of such premiums. Applicants further request an exemption from Rules 6e-2(c)(4) and 6e- 3(T)(c)(4) under the 1940 Act to premit the proposed deductions to be treated as other than ``sales load'' for the purposes of Section 27 of the 1940 and the exemptions from various provisions of that Section found in Rules 6e-2 and 6e-3(T). 2. Section 6(c) of the 1940 Act provides, in pertinent part, that the Commission may by order upon application, conditionally or unconditionally exempt any person, security or transaction from any provision of the 1940 Act if and to the extent that such exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and the provisions of the 1940 Act. 3. Section 27(c)(2) of the 1940 Act prohibits the sale of periodic payment plan certificates unless the proceeds of all payments (except such amounts as are deducted for sales load) are held under an indenture or agreement containing in substance the provisions required by Sections 26(a)(2) and 26(a)(3) of the 1940 Act. Certain provisions of Rules 6e-2 and 6e-3(T) provide a range of exemptive relief for the offering of variable life insurance policies such as the Contracts. 4. Rule 6e-2(c)(4)(v) defines ``sales load'' charged on any payment as the excess of the payment over certain specified charges and adjustments, including ``a deduction approximately equal to state premium taxes''. Rule 6e-3(T)(c)(4)(v) defines ``sales load'' charged during a contract period as the excess of any payments made during the period over the sum of certain specified charges and adjustments, including ``a deduction for and approximately equal to state premium taxes.'' 5. Applicants submit that the deduction for federal income tax charges, proposed to be deducted in connection with the Contracts, should be treated as other than sales load, as is a state premium tax charge, for purposes of the 1940 Act. 6. Applicants argue that the requested exemptions from Rules 6e- 2(c)(4) and 6e-3(c)(4) are necessary in connection with Applicant's reliance on certain provisions of Rules 6e-2(b)(13) and 6e-3(T)(b)(13), which provide exemptions from Sections 27(a)(1) and 27(h)(1) of the 1940 Act. Issuers and their affiliates may only rely on Rules 6e- 2(b)(13)(i) or 6e-3(T)(b)(13)(i) if they meet the respective Rule's alternative limitations on sales load as defined in Rule 6e-2(c)(4) or Rule 6e-3(T)(c)(4). Applicants state that, depending upon the load structure of a particular Contract, these alternative limitations may not be met if the deduction for the increase in an issuer's federal tax burden is included in sales load. Although a deduction for an insurance company's increased federal tax burden does not fall squarely within any of the specified charges or adjustments which are excluded from the definition of ``sales load'' in Rules 6e-2(c)(4) and 6e-3(T)(c)(4), Applicants state that they have found no public policy reason for including them in ``sales load.'' 7. The public policy that underlies Rules 6e-2(b)(13)(i) and 6e- 3(T)(b)(13)(i), like that which underlies Sections 27(a)(1) and 27(h)(1) of the 1940 Act, is to prevent excessive sales loads from being charged in connection with the sale of periodic payment plan certificates. Applicants submit that the treatment of a federal income tax charge attributable to premium payments as sales load would not in any way further this legislative purpose because such a deduction has no relation to the payment of sales commissions or other distribution expenses. Applicants state that the Commission has concurred with this conclusion by excluding deductions for state premium taxes from the definition of ``sales load'' in Rules 6e-2(c)(4) and 6e-3(T)(c)(4). 8. Applicants assert that the source for the definition of ``sales load'' found in the Rules supports this analysis. Applicants state that the Commission's intent in adopting such provisions was to tailor the general terms of Section 2(a)(35) of the 1940 Act to variable life insurance contracts. Just as the percentage limits of Sections 27(a)(1) and 27(h)(1) depend on the definition of ``sales load'' in Section 2(a)(35) for their efficacy, the percentage limits in Rules 6e- 2(b)(13)(i) and 6e-3(T)(b)(13)(i) depend on Rules 6e-2(c)(4) and 6e- 3(T)(c)(4), respectively, which do not depart, in principle, from Section 2(a)(35). 9. Section 2(a)(35) excludes deductions from premiums for ``issue taxes'' from the definition of ``sales load'' under the 1940 Act. Applicants submit that this suggests that it is consistent with the policies of the 1940 Act to exclude from the definition of ``sales load'' in Rules 6e-2 and 6e-3(T) deductions made to pay an insurance company's costs attributable to its tax obligations. Section 2(a)(35) also excludes administrative expenses or fees that are ``not properly chargeable to sales or promotional activities.'' Applicants argue that this suggests that the only deductions intended to fall within the definition of ``sales load'' are those that are properly chargeable to such activities. Because the proposed deductions will be used to compensate FKLA for its increased federal income tax burden attributable to the receipt of premiums, and are not properly chargeable to sales or promotional activities, this language in Section 2(a)(35) is another indication that not treating such deductions as ``sales load'' is consistent with the policies of the 1940 Act. 10. Applicants assert that the terms of the relief requested with respect to Contracts to be issued through the Separate Account or through Future Accounts are consistent with the standards enumerated in Section 6(c) of the 1940 Act. Without the requested relief, Applicants would have to request and obtain exemptive relief for each Future Contract. Applicants state that such additional requests for exemptive relief would present no issues under the 1940 Act not already addressed in this request for exemptive relief. 11. Applicants assert that the requested relief is appropriate in the public interest because it would promote competitiveness in the variable life insurance market by eliminating the need for Applicants to file redundant exemptive applications, thereby reducing administrative expenses and maximizing efficient use of resources. The delay and expense involved in having to seek repeated exemptive relief would impair the ability of Applicants to take advantage fully of business opportunities as those opportunities arise. Additionally, Applicants state that the requested relief is consistent with the purposes of the 1940 Act and the protection of investors for the same reasons. If Applicants were required to seek exemptive relief repeatedly with respect to the same issues addressed in this application, investors would not receive any benefit or additional protection thereby and might be disadvantaged as a result of increased overhead expenses for Applicants. Conditions for Relief 1. Applicants represent that FKLA will monitor the reasonableness of the charge to be deducted pursuant to the requested exemptive relief. 2. Applicants represent that the registration statement for each Contract under which the charge referenced in paragraph one of this section is deducted will : (i) Disclose the charge; (ii) explain the purpose of the charge; and (iii) state that the charge is reasonable in relation to the increased federal income tax burden under Section 848 of the Code resulting from the receipt of premiums. 3. Applicants represent that the registration statement for each Contract under which the charge referenced in paragraph one of this section is deducted will contain as an exhibit an actuarial opinion as to: (i) The reasonableness of the charge in relation to the increased federal income tax burden under Section 848 resulting from the receipt of premiums; (ii) the reasonableness of the after tax rate of return that is used in calculating such charge; and (iii) the appropriateness of the factors taken into account in determining the after tax rate of return. Conclusion Applicants submit that, for the reasons and upon the facts set forth above, the requested exemptions from Section 27(c)(2) of the 1940 Act, and Rules 6e-2(c)(4)(v) and 6e-3(T)(c)(4)(v) thereunder, to permit the deduction of up to 1.25% of premium payments under the Contracts meet the standards in Section 6(c) of the 1940 Act. In this regard, Applicants assert that granting the relief requested in the application would be appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of the 1940 Act. For the Commission, by the Division of Investment Management, pursuant to delegated authority. Margaret H. McFarland, Deputy Secretary. [FR Doc. 94-31041 Filed 12-16-94; 8:45 am] BILLING CODE 8010-01-M