[Federal Register Volume 67, Number 46 (Friday, March 8, 2002)]
[Proposed Rules]
[Pages 10640-10652]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-5485]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-118861-00]
RIN 1545-AY49


Application of Section 338 to Insurance Companies

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that apply to a 
deemed sale or acquisition of an insurance company's assets pursuant to 
an election under section 338 of the Internal Revenue Code, to a sale 
or acquisition of an insurance trade or business subject to section 
1060, and to the acquisition of insurance contracts through assumption 
reinsurance. It also contains proposed regulations under section 381 
concerning the effect of certain corporate liquidations and 
reorganizations on certain tax attributes of insurance companies. The 
proposed regulations apply to insurance companies and to corporations 
selling and purchasing stock of insurance companies. This document also 
provides a notice of public hearing on the proposed regulations.

DATES: Written or electronic comments and requests to speak (with 
outlines of oral comments to be discussed) at the public hearing 
scheduled for September 18, 2002, must be received by August 28, 2002.

ADDRESSES: Send submissions to: CC:ITA:RU (REG-118861-00), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to CC:ITA:RU (REG-118861-00), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC 20044. Alternatively, taxpayers may submit comments 
electronically directly to the IRS Internet site at www.irs.gov/regs. 
The public hearing will be held in the auditorium, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Gary Geisler, (202) 622-3970, or Mark Weiss, (202) 622-7790, concerning 
submissions of comments, the hearing, and/or to be placed on the 
building access list to attend the hearing, Guy Traynor, (202) 622-7180 
(not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Overview of the Proposed Regulations

    These proposed regulations apply to taxable asset acquisitions and 
dispositions of insurance businesses and companies, many of which occur 
by virtue of elections under section 338 of the Internal Revenue Code 
(Code). A number of questions have arisen concerning the tax 
consequences of such transactions, and numerous requests for 
clarification were received in response to the proposal of regulations 
under sections 338 and 1060 (REG-107069-97, 1999-2 C.B. 346, 64 FR 
43462) in 1999. The Treasury decision finalizing those regulations in 
February, 2001, announced the intention of the IRS and Treasury to 
provide guidance regarding the treatment of a deemed asset sale by an 
insurance company in a separate project (TD 8940, 2001-15 I.R.B. 1016, 
1017, 66 FR 9925). That additional guidance is proposed in this 
document.
    In taxable asset acquisitions governed by section 338 or 1060 
generally, the total cost of the acquisition is apportioned among 
specific assets under a residual method that extrapolates the price of 
each asset from the overall price of the transaction (including assumed 
liabilities), ranking the assets in classes for priority of allocation, 
with goodwill and going concern value (Class VII assets) ranked last 
and section 197 intangibles (Class VI assets) ranked next to last. See 
Secs. 1.338-6(b)(2) and 1.1060-1(a)(1). Rights under an insurance 
company's outstanding insurance contracts (commonly known as insurance 
in force) that are acquired through assumption reinsurance as part of a 
taxable asset acquisition generally are intangible assets that 
constitute section 197 intangibles within the meaning of section 197(d) 
and, hence, are classified as Class VI assets under Sec. 1.338-
6(b)(2)(vi).

[[Page 10641]]

    The term assumption reinsurance refers to an arrangement whereby 
the reinsurer, or buyer, becomes solely liable to the policyholders on 
contracts transferred by the ceding company, or seller, who ceases to 
have any liability under the transferred contracts. See Sec. 1.809-
5(a)(7)(ii); see also Colonial American Life Ins. Co. v. Commissioner, 
491 U.S. 244, 247 (1989); Beneficial Life Ins. Co. v. Commissioner, 79 
T.C. 627, 636 (1982). It has historically been the IRS's position that, 
where insurance contracts are acquired from an insurance company as 
part of a taxable asset acquisition, the transfer of contract rights 
and assumption of related liabilities is treated as an assumption 
reinsurance transaction if the ceding company ceases to be liable to 
the policyholders. See Southwestern Life Ins. Co. v. Commissioner, 560 
F.2d 627 (5th Cir. 1977), cert. denied, 435 U.S. 995 (1978); see also 
H.R. Rep. No. 103-213, 103d Cong., 1st Sess. 687 n.25 (1993); 
Sec. 1.338-1(a)(2).
    Section 1.817-4(d) prescribes rules for the income tax treatment of 
assumption reinsurance transactions entered into by life insurance 
companies in the ordinary course of business. Under Sec. 1.817-
4(d)(2)(ii) and (iii), the reinsurer is treated as receiving premium 
income from the reinsured in an amount equal to at least the increase 
in the reinsurer's reserves resulting from the transaction, and the 
reinsurer is entitled to deduct the increase in its reserves that is 
attributable to the acquisition of the insurance contracts. If the 
reinsurer receives an amount less than the amount of such reserves, the 
difference is treated as the amount paid by the reinsurer for the 
purchase of the reinsured contracts (i.e., the ceding commission). The 
reinsurer must capitalize the ceding commission as an item of deferred 
expense. Thus, the reinsurer's deduction for its increase in reserves 
resulting from the assumption reinsurance transaction offsets premium 
income, and the reinsurer is treated as purchasing intangible assets 
(i.e., insurance contracts) to the extent that the net consideration 
received by the reinsurer is less than its increase in reserves. If the 
actual amount received by the reinsurer exceeds the increase in the 
reinsurer's reserves resulting from the transaction, the entire amount 
received by the reinsured is treated as premium income, and the 
reinsurer is not treated as having paid any amount for the purchase of 
the reinsured contracts (i.e., the economics of the transaction 
indicate that the insurance contracts have no positive value).
    Under Sec. 1.817-4(d), the ceding company treats the gross amount 
paid to the reinsurer, reduced by any payment received from the 
reinsurer, as an item of deduction for consideration paid for 
reinsurance. See Sec. 1.817-4(d)(2)(i). This deduction fully or 
partially offsets the amount included in the gross income of the ceding 
company that is attributable to the decrease in the ceding company's 
reserves as a result of the reinsurance transaction. Because the amount 
of the deduction is reduced by the amount that the reinsurer actually 
or implicitly pays to purchase the contracts, the net effect is to 
treat any amount received by the ceding company for the sale of the 
reinsured contracts as ordinary income.
    Although Sec. 1.817-4(d) applies only to assumption reinsurance 
transactions involving life insurance companies, the general structure 
of the regulations is not based on any statutory provisions unique to 
life insurance companies. Moreover, because these rules are an 
application of general principles of insurance taxation, many should 
apply not only to assumption reinsurance transactions, but also to 
indemnity reinsurance transactions, where the ceding company is not 
fully relieved of the policy risks.
    The proposed regulations generally treat the transfer of an 
insurance or annuity contract or group of such contracts (hereinafter 
insurance contracts) and the assumption of related reserve liabilities 
that are deemed to occur by reason of an election under section 338 in 
a manner consistent with the treatment of ordinary assumption 
reinsurance transactions under Sec. 1.817-4(d) and other provisions of 
subchapter L of chapter 1, subtitle A of the Code and the regulations 
promulgated thereunder. The proposed regulations provide similar rules 
for acquisitions of insurance businesses governed by section 1060, 
whether effected through assumption or indemnity reinsurance. Thus, in 
the case of both a deemed and an actual transfer of an insurance 
business, the reinsurer (in the case of a section 338 election, new 
target) is treated as receiving premium income for its assumption of 
reserve liabilities and having an offsetting deduction for its increase 
in reserves, and the ceding company (in the case of a section 338 
election, old target) is treated as having income in the amount of the 
reduction in its reserves and having a deduction for the premium it 
pays for the reinsurer's assumption of those liabilities. Moreover, 
consistent with Sec. 1.817-4(d), the consideration allocated to the 
value of the insurance contracts acquired in the assumption reinsurance 
transaction is treated as an amount paid by the reinsurer to purchase 
intangible assets and as ordinary income to the ceding company.
    However, section 1.817-4(d) does not fully describe the income tax 
treatment of insurance contracts that are transferred and the related 
reserve liabilities that are assumed as part of the acquisition of an 
entire company or trade or business. In particular, Sec. 1.817-4(d) 
addresses transactions in which the consideration paid for the transfer 
of insurance contracts and assumption of related liabilities is known 
and not part of a larger acquisitive transaction. Therefore, in order 
to give effect to the principles and rules governing taxable asset 
acquisitions for all trades or businesses generally, these proposed 
regulations depart in certain respects from the rules governing 
assumption reinsurance transactions effected in the ordinary course of 
business. The key elements of the proposed regulations are as follows:
    1. In general, the seller's tax reserves are treated in the same 
manner as fixed liabilities that have been taken into account for 
Federal income tax purposes and, thus, the seller's closing tax 
reserves are treated as a liability in the computation of the seller's 
aggregate deemed sales price (ADSP) and the buyer's adjusted grossed-up 
basis (AGUB).
    2. The residual method that otherwise applies to transactions 
governed by sections 338 and 1060 applies to allocate the ADSP and AGUB 
among classes of transferred assets, including insurance contracts, 
which constitute Class VI assets (regardless of whether they are 
section 197 intangibles). Thus, the amount of consideration allocated 
to insurance contracts under the residual method is treated as the 
amount paid by the buyer for the purchase of insurance contracts in the 
assumption reinsurance transaction (i.e., as a ceding commission to the 
seller).
    3. The gross amount of the reinsurance premium paid by the seller 
to the buyer is deemed to equal the seller's closing tax reserves in 
all cases, thereby eliminating the possibility of immediate net taxable 
income to the buyer.

Computation and Allocation of AGUB and ADSP

    In accordance with the principles set forth above, these proposed 
regulations provide rules regarding the computation and allocation of 
AGUB and ADSP where the target is an insurance company. See proposed 
Sec. 1.338-11(a) through (c). A special rule provides that, for 
purposes of allocating AGUB and ADSP under the residual method, the 
fair market value of insurance contracts

[[Page 10642]]

is the amount a willing reinsurer would pay a willing ceding company in 
an arm's length transaction as a ceding commission for the reinsurance 
of the specific insurance contracts if the gross reinsurance premium 
for the insurance contracts were equal to old target's tax reserves for 
the insurance contracts. See proposed Sec. 1.338-11(b)(2).
    Rules comparable to the proposed rules governing the computation 
and allocation of AGUB and ADSP are proposed to apply to applicable 
asset acquisitions under section 1060. See proposed Sec. 1.1060-
1(c)(5). To insure that these rules apply only to acquisitions of 
insurance businesses and not to ordinary reinsurance transactions, the 
proposed regulations describe when an acquisition of insurance 
contracts will be treated as an applicable asset acquisition. The 
proposed regulations provide that the mere reinsurance of insurance 
contracts by an insurance company is not an applicable asset 
acquisition, even if it enables the reinsurer to establish a customer 
relationship with the owners of the reinsured contracts. However, the 
transfer of an insurance business is an applicable asset acquisition if 
the purchaser acquires significant business assets, in addition to 
insurance contracts, to which goodwill and going concern value could 
attach. See proposed Sec. 1.1060-1(b)(9).

Treatment of Liabilities

    For purposes of computing ADSP and AGUB, the proposed regulations 
treat old target's closing tax reserves (before giving effect to the 
deemed sale and assumption reinsurance transaction) as a liability. See 
proposed Sec. 1.338-11(b)(1). The IRS and Treasury recognize that in 
the context of acquisitions of businesses other than insurance 
businesses, courts have held that when contingent liabilities assumed 
in connection with an asset acquisition mature, such liabilities, like 
fixed liabilities, must be capitalized as a cost of the acquired 
assets, even if those matured liabilities would have been currently 
deductible had they been incurred in the acquirer's own historic 
business. See Pacific Transport Co. v. Commissioner, 483 F.2d 209, 214 
(9th Cir. 1973), cert. denied, 415 U.S. 948 (1974); Illinois Tool Works 
Inc. v. Commissioner, 117 T.C. No. 4 (July 31, 2001). As a theoretical 
matter, in the context of acquisitions of insurance businesses, 
capitalization could be required, and deductions could be disallowed, 
for all post-acquisition increases in reserves that are attributable to 
liabilities under acquired insurance contracts that were contingent at 
the time of the acquisition.
    For a number of reasons, however, the IRS and Treasury believe that 
it would be inappropriate to require capitalization of all such post-
acquisition increases in an insurance company's assumed reserve 
liabilities. First, to the extent that reserves are discounted and 
post-acquisition increases are attributable to increases in the present 
value of assumed liabilities reflected in the acquisition date 
reserves, such increases are more properly treated as a currently 
deductible business expense of the reinsurer, analogous to interest on 
a fixed liability, rather than as a capital cost of the acquired 
assets. Second, to the extent that insurance reserves represent 
estimates of contingent liabilities under insurance contracts, the IRS 
and Treasury recognize that adjustments to these estimates are 
customary and that, unlike adjustments in other businesses, such 
adjustments may either increase or decrease an insurance company's 
taxable income. Thus, it would be impractical and inappropriate to 
treat all such adjustments as adjustments to the cost of acquired 
assets. No inference, however, is intended regarding the tax treatment 
of contingent liabilities in situations not covered by these proposed 
regulations.
    Although the IRS and Treasury believe that certain increases in 
reserves that are attributable to acquired insurance contracts should 
be currently deductible, the IRS and Treasury believe that post-
acquisition reserve increases should be capitalized in certain 
situations where it becomes clear that the ceding company's tax 
reserves as of the acquisition date were understated. In such cases, 
increasing the tax reserves attributable to the acquired insurance 
contracts after the acquisition should not produce a more favorable 
result for the reinsurer than had the ceding company increased such 
reserves before the acquisition. Accordingly, proposed Sec. 1.338-11(d) 
provides for the capitalization by the reinsurer of certain reserve 
increases in the four taxable years after the acquisition date.
    Tax reserve increases from three sources with respect to acquired 
contracts could potentially be subject to capitalization under these 
proposed regulations: increases of unpaid loss reserves attributable to 
changes in loss estimates, increases of other reserves through changes 
in methodology or assumptions, and increases of unpaid loss reserves as 
a result of reinsuring acquired contracts at a loss. See proposed 
Sec. 1.338-11(d)(3) and (d)(4). In particular, the proposed regulations 
require capitalization of unpaid loss reserve increases in excess of 
cumulative annual increases of two percent from the acquisition date 
reserves for unpaid losses attributable to acquired insurance contracts 
and for acquired contracts transferred through reinsurance 
transactions. Capitalization is not required, however, to the extent 
increases to reserves for unpaid losses attributable to acquired 
insurance contracts reflect the time value of money. In addition, the 
reinsurer is not required to capitalize any post-acquisition reserve 
increases to the extent such increases occur while it is under state 
receivership or to the extent the deduction for the reserve increase is 
spread over the 10 succeeding taxable years pursuant to section 807(f). 
See proposed Sec. 1.338-11(d)(2).
    To the extent a reinsurer is required to capitalize reserve 
increases, the reinsurer must include such amount in gross income in 
the year of the increase to offset the deduction taken under section 
832(b)(5) for the reserve increases. The reinsurer must include the 
amount to be capitalized in AGUB and treat such amount as additional 
premium received in the deemed asset sale as of the year of the 
adjustment. See proposed Sec. 1.338-11(d)(1). The ceding company does 
not make any adjustments under this provision. See proposed Sec. 1.338-
11(d)(1).

Other Issues

    In addition to providing guidance regarding the treatment of the 
deemed asset sale under section 338 and the assumption reinsurance 
transaction that is deemed to occur in connection therewith, the 
proposed regulations provide guidance on several other issues that 
arise in the context of these transactions. In general, these other 
rules also apply to insurance companies that sell an insurance business 
in a transaction governed by section 1060 if the sale occurs in 
connection with the complete liquidation of the ceding company. See 
proposed Sec. 1.1060-1(c)(5). The rules in the proposed regulations 
under section 197 also apply to reinsurers of insurance businesses in 
transactions governed by section 1060 if effected through assumption 
reinsurance.

Amortization Under Section 197

    These regulations propose amendments to the regulations under 
section 197 to provide guidance concerning the treatment under section 
197 of insurance contracts acquired through assumption reinsurance 
transactions. For purposes of this

[[Page 10643]]

section, the term insurance contracts includes an annuity contract or 
group of annuity contracts. See proposed Sec. 1.197-2(g)(5).
    Section 197(f)(5) provides that, in the case of any amortizable 
section 197 intangible resulting from an assumption reinsurance 
transaction, the amount taken into account as the adjusted basis of 
such intangible under section 197 is the excess of (A) the amount paid 
or incurred by the acquirer in the assumption reinsurance transaction, 
over (B) the amount required to be capitalized under section 848 in 
connection with the transaction. For policy related intangibles 
acquired in an assumption reinsurance transaction, section 197(f)(5) 
determines the amount that must be capitalized and amortized under 
section 197 and the portion that may be expensed because it is 
reflected in the reinsurer's capitalization of specified policy 
acquisition expenses under section 848.
    The current regulations under section 197 reserve the 
interpretation of section 197(f)(5) in the context of stock 
acquisitions with respect to which an election under section 338 is 
made. See Sec. 1.197-2(g)(5)(ii)(C). For other assumption reinsurance 
transactions, Sec. 1.197-2(g)(5)(ii)(A) interprets the amount paid or 
incurred as the amount determined under Sec. 1.817-4(d)(2) and the 
amount required to be capitalized under section 848 as the amount of 
the specified policy acquisition expenses that are attributable to the 
reinsurer's net positive consideration for the reinsurance agreement 
(as determined under Sec. 1.848-2(f)(3)).
    The proposed regulations clarify that section 197(f)(5) determines 
the basis of an amortizable section 197 intangible asset with respect 
to insurance contracts acquired in an assumption reinsurance 
transaction. See proposed Sec. 1.197-2(g)(5)(i)(A). Under these 
proposed regulations, the amount paid or incurred to acquire the 
relevant insurance contracts is, in a transaction governed by section 
338 or 1060, the amount of the AGUB or consideration allocable to the 
insurance contracts under the residual method. For this purpose, the 
insurance contracts are valued by assuming a gross premium equal to the 
tax reserves. For transactions not governed by section 338 or 1060, the 
amount paid or incurred for insurance contracts is the excess of the 
increase in the reinsurer's tax reserves resulting from the transaction 
(computed in accordance with sections 807, 832(b)(4)(B), and 846) over 
the value of the net assets received from the ceding company in the 
transaction. See proposed Sec. 1.197-2(g)(5)(i)(C).
    Proposed Sec. 1.197-2(g)(5)(i)(D) provides guidance concerning the 
amount required to be capitalized under section 848 in connection with 
an assumption reinsurance transaction. Section 848 requires an 
insurance company to capitalize annually an amount of its ``general 
deductions'' as ``specified policy acquisition expenses'' (DAC). Each 
year, an insurance company capitalizes its general deductions (amounts 
otherwise deductible under sections 161 et seq. and 401 et seq.) up to 
the percentage set forth in section 848(c) of the amount by which 
premiums received on specified insurance contracts in the taxable year 
exceeds return premiums and premiums paid for reinsurance (net 
premiums). The assumption reinsurance transaction itself typically 
generates no general deductions for the reinsurer. Accordingly, the 
amount to be capitalized must be determined by reference to the 
reinsurer's other general expenses and the effect of the transaction on 
the reinsurer's net premiums. The IRS and Treasury believe that, for 
purposes of section 197(f)(5)(B), the amount required to be capitalized 
under section 848 in connection with the transaction should take into 
account the ceding company's actual DAC capitalization amount, based on 
its general deductions for the year and its net premiums for the year, 
including premiums received in the assumption reinsurance transaction.
    Under the proposed regulations, the computation of the amount 
described in section 197(f)(5)(B) is based on the actual capitalization 
amount and is determined at the end of the year by multiplying the DAC 
for the taxable year by a fraction, the numerator of which is the 
tentative positive capitalization amount for the relevant group of 
acquired insurance contracts and the denominator of which is the total 
tentative positive capitalization amount for the taxable year with 
regard to all specified insurance contracts. The tentative positive 
capitalization amount for the acquired insurance contracts is the net 
positive consideration received for the insurance contracts in the 
assumption reinsurance transaction multiplied by the percentage factor 
applicable to the insurance contracts under section 848(c). The total 
tentative positive capitalization amount for the taxable year is the 
sum of each year's net premiums (in each category) multiplied by its 
applicable percentage factor. The total amount required to be 
capitalized under section 197(f)(5)(B) cannot be less than zero or 
greater than the amount of the DAC for the year.
    The amortization of intangibles under section 197 is a general 
deduction relevant in computing DAC. The amount of amortization, 
however, cannot be calculated until section 197(f)(5) is applied to 
compute the year's DAC. To avoid complex calculations, the proposed 
regulations assume that, for purposes of calculating the basis for 
amortization, one-half of the consideration allocated to the insurance 
contracts is amortizable under section 197. Comments are requested 
regarding alternative approaches to calculating the basis for DAC and 
section 197 amortization.

Losses on Dispositions of Acquired Insurance Contracts

    In general, gain or loss is recognized on a disposition, including 
a retirement, of an asset. Section 197(f)(1)(A), however, overrides 
this general rule and bars the recognition of any loss on the 
disposition of an amortizable section 197 intangible acquired in a 
transaction if the taxpayer retains one or more other amortizable 
section 197 intangibles acquired in the same transaction. Where such a 
loss is denied, the adjusted bases of the retained intangibles are 
increased to account for the amount of the unrecognized loss. Section 
1.197-2(g)(2)(B) provides that the abandonment of an amortizable 
section 197 intangible, or any other event rendering an amortizable 
section 197 intangible worthless, is treated as a disposition for 
purposes of the loss disallowance rule of section 197(f)(1)(A).
    The regulations under section 197, however, do not provide any 
special guidance on the ability of a taxpayer to recover basis or the 
proper method for computing loss on the disposition of an amortizable 
section 197 intangible relating to insurance contracts. Such guidance 
is necessary because, in contrast to dispositions of other intangibles, 
subchapter L generally does not compute an ``amount realized'' on the 
disposition of insurance contracts. Accordingly, the proposed 
regulations provide such guidance.
    Under the proposed regulations, a disposition of a section 
197(f)(5) intangible is any event as a result of which, absent section 
197, recovery of basis is otherwise allowed for Federal income tax 
purposes. See proposed Sec. 1.197-2(g)(5)(ii)(A). The proposed 
regulations provide specific guidance regarding when recovery of basis 
is allowed with respect to a section 197(f)(5) intangible in the 
context of an indemnity reinsurance transaction. In particular, they 
provide that basis recovery is permitted when sufficient

[[Page 10644]]

economic rights related to the insurance contracts that gave rise to 
such intangible have been transferred. Sufficient economic rights are 
treated as transferred when the ceding company transfers the right to 
future income on insurance contracts. Sufficient economic rights, 
however, are not treated as transferred if an experience refund 
provision, a recapture option, or another mechanism enables the 
taxpayer to retain a right to a substantial portion of the future 
profits on the reinsured policies. In addition, sufficient economic 
rights are not treated as transferred if the reinsurer assumes only a 
limited portion of the ceding company's risk relating to the underlying 
reinsured contracts (e.g., excess loss reinsurance).
    The proposed regulations also provide rules governing the amount of 
loss recognized on the disposition of a section 197(f)(5) intangible. 
Such loss equals the amount, if any, by which the adjusted basis of the 
section 197(f)(5) intangible immediately prior to the disposition 
exceeds the amount, if any, that the taxpayer receives from another 
person for the right to future income on the insurance contracts to 
which the section 197(f)(5) intangible relates. See proposed 
Sec. 1.197-2(g)(5)(ii)(A)(2). The proposed regulations also provide 
that, in determining the amount of the taxpayer's loss on the 
disposition of a section 197(f)(5) intangible through a reinsurance 
transaction, any effect of the transaction on the amounts capitalized 
by the taxpayer as DAC is disregarded. See proposed Sec. 1.197-
2(g)(5)(ii)(B).
    Other than in the case of certain reinsurance transactions, the 
proposed regulations do not provide specific guidance regarding when a 
disposition of a section 197(f)(5) intangible occurs or the extent to 
which a taxpayer should be permitted to recover the adjusted basis of a 
section 197(f)(5) intangible. Comments are requested regarding whether 
additional guidance should address other situations or issues.

Capitalization Under Section 848

    DAC amounts are intended to serve as a proxy for an insurance 
company's actual cost of acquiring insurance contracts. An insurance 
company's DAC for a particular year will be negative (negative DAC) if 
return premiums and premiums paid for reinsurance for the year exceed 
premiums received in that year. Insurance companies are permitted to 
use any negative DAC to deduct currently the unamortized balance of DAC 
capitalized in prior years. Any remaining negative DAC can be carried 
forward to offset the DAC attributable to premiums received in future 
years.
    Under proposed Sec. 1.338-11(e), the assumption reinsurance 
transaction that results from section 338 generally has the same effect 
under section 848 as other assumption reinsurance transactions. That 
is, the assumption reinsurance transaction first reduces the current 
year's capitalization requirement and then offsets any unamortized DAC 
capitalized in prior years, which results in a current expense 
deduction.
    The IRS and Treasury believe that, generally, once the ceding 
company no longer conducts an insurance business and ceases to exist 
for Federal income tax purposes, any relief from capitalization it 
might have enjoyed going forward is not appropriately transferred to a 
taxpayer other than a successor insurance company under section 381. 
Because regulations under Sec. 1.381(c)(22)-1(b) have not been 
previously amended to reflect the enactment of section 848, the 
proposed regulations provide that remaining balances of DAC or excess 
negative DAC carry over to a successor insurance company in a section 
381 transaction. See proposed Sec. 1.381(c)(22)-1(b)(13). In all other 
cases, these proposed regulations provide that if, after giving effect 
to the reinsurance transaction in the deemed asset sale, the ceding 
company has remaining DAC or excess negative DAC, that remaining DAC is 
expensed or excess negative DAC is eliminated. See proposed Sec. 1.338-
11(e)(2).

Policyholders Surplus Account

    Under section 815, as originally enacted by the Life Insurance 
Company Tax Act of 1959, stock life insurance companies were required 
to maintain a policyholders surplus account (PSA). Amounts contributed 
to a PSA were not included in income subject to tax under section 801. 
This deferral was based on the theory that such amounts may be 
necessary to meet future policyholders' claims.
    The deferral afforded by section 815 generally terminated when 
there was a distribution from the PSA. For this purpose, a distribution 
included a distribution in partial or complete liquidation, a 
distribution in redemption of stock, dividend distributions other than 
distributions made by a corporation of its stock or rights to acquire 
its stock, payments attributable to distributions to shareholders made 
out of other accounts, payments in discharge of indebtedness 
attributable to distributions to shareholders made out of other 
accounts, and the balance of policyholders' surplus accounts on 
termination of life insurance status. See section 815, as originally 
enacted by the Life Insurance Company Tax Act of 1959; Sec. 1.815-2(c); 
see also H.R. Conf. Rep. No. 34, 86th Cong., 1st Sess. 736 (1959), 
Technical Explanation of the Life Insurance Company Income Tax Act of 
1959, at 762-64. However, a distribution did not include a carryover of 
the PSA to an acquiring corporation in a transaction described in 
section 381. Section 1.381(c)(22)-1(b)(7)(i); Rev. Rul. 77-248, 1977-2 
C.B. 228. Therefore, distributions to a parent life insurance company 
of its subsidiary life insurance company's assets in the complete 
liquidation of the subsidiary under section 332 were not treated as 
distributions of the PSA subject to tax under section 801. See Rev. 
Rul. 77-248.
    In 1984, Congress revised section 815 to prohibit further PSA 
contributions and to provide that any direct or indirect distribution 
to shareholders from the PSA would be subject to tax under section 801 
in the year of the distribution. The legislative history indicates that 
the term indirect distribution is to be interpreted broadly to include 
both actual and constructive distributions of amounts in the PSA that 
directly or indirectly are used for the benefit of shareholders. See 
Staff of the Joint Committee on Taxation, 98th Cong., 2d Sess., General 
Explanation of the Revenue Provisions of the Tax Reform Act of 1984, at 
594 (1984).
    When a section 338(h)(10) election is made, old target is deemed to 
sell its assets for the ADSP and to distribute an amount equal to the 
proceeds of the stock sale, if any, to its shareholders in a deemed 
liquidation of old target. Section 332 generally applies to the receipt 
of this amount by the shareholder of an insurance company target. 
Although section 381 and the regulations thereunder provide that the 
PSA carries over to the acquiring corporation, the IRS and Treasury 
believe that where the acquiring corporation acquires less than 50 
percent of old target's insurance business, such a rule is appropriate 
only to the extent that old target's insurance business is distributed 
in the section 381 transaction. To the extent that old target's 
insurance business is not distributed in a section 381 transaction, 
such amount is properly treated as a distribution of old target's PSA 
under section 815. When old target's PSA is separated from old target's 
insurance business, the purposes of the PSA are not served by further 
deferral because the old target's PSA is no longer necessary to meet 
future policyholders' claims. The separation of old target's

[[Page 10645]]

PSA from old target's insurance business effects a distribution of 
those funds, even if the shareholder receiving the distribution has an 
insurance business of its own. See proposed amendments to 
Sec. 1.381(c)(22)-1(b)(7) and Sec. 1.338-11(f); see also Rev. Rul. 95-
19 (1995-1 C.B. 143).
    Recently, some courts have divided over whether the deemed asset 
sale resulting from a section 338(g) election gives rise to a 
distribution by old target of the PSA to its shareholders. Compare 
Bankers Life and Casualty Co. v. United States, 79 AFTR2d (RIA) 1726 
(N.D. Ill. 1996), aff'd on other grounds, 142 F.3d 973 (7th Cir. 1998), 
cert. denied, 525 U.S. 961 (1998), with GE Life and Annuity Co. v. 
United States, 127 F. Supp.2d 794 (E.D. Va. 2000). In a transaction 
with respect to which an election has been made under section 338(g), 
old target's shareholders are treated as having sold their stock of old 
target. In addition, old target is deemed to have sold its assets to 
new target for their fair market value and to terminate its existence. 
Because there has been a separation of the value attributable to the 
PSA and old target's life insurance business for which it was 
maintained, and the shareholders receive that value in a transaction 
other than a section 381 transaction, the proposed regulation 
effectively provides that the deemed asset sale pursuant to a section 
338(g) election effects a distribution of the PSA to old target's 
shareholders to the extent the grossed-up amount realized for the 
recently purchased stock exceeds the shareholders surplus account. See 
proposed Sec. 1.338-11(f).

Section 847  Estimated Tax Payments

    To the extent that old target is deemed to transfer its insurance 
business to new target as a result of the deemed asset sale, old 
target's special loss discount account under section 847(3) must be 
reduced to the extent attributable to such transferred insurance 
business and old target must include the amount of such reduction in 
gross income for the taxable year of the transaction. See proposed 
Sec. 1.338-11(g).
    However, if any of old target's insurance business is distributed 
to its shareholders in a section 381 transaction, the acquiring 
corporation succeeds to the portion of old target's special loss 
discount account that is attributable to the insurance business that is 
transferred to the acquiring corporation. See proposed 
Sec. 1.381(c)(22)-1(b)(14). This rule is intended to apply to both life 
and non-life insurance companies. Old target may apply the balance of 
its special estimated tax account as a credit against any tax resulting 
from the inclusion of this income. Because old target ceases to exist 
for Federal income tax purposes, any special estimated tax payments 
remaining after the credit are voided.

Section 846(e)  Election

    Under section 846(e), an insurance company may elect to compute 
discounted unpaid losses for all eligible lines of business using its 
historical payment pattern as shown on the most recent annual statement 
filed before the accident year instead of the historical payment 
pattern determined by the Commissioner. The election can only be made 
in a determination year, as defined by section 846(d), for the year in 
which the election is made and the four succeeding accident years.
    Because new target is generally treated as a new corporation that 
may adopt its own accounting methods without regard to the methods used 
by old target (Sec. 1.338-1(b)), new target is not permitted to apply 
old target's experience as a result of any section 846(e) election made 
by old target under section 846. Thus, the proposed regulations do not 
provide any special rules under section 846.

Proposed Effective Dates

    In general, these amendments are proposed to be applicable when 
filed as final regulations with the Federal Register.

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 is hereby 
certified that these regulations do not have a significant economic 
impact on a substantial number of small entities. This certification is 
based on the fact that these regulations do not have a substantial 
economic impact because they merely provide guidance about the 
operation of the tax law in the context of acquisitions of insurance 
companies and businesses. Moreover, they are expected to apply 
predominantly to transactions involving larger businesses. Therefore, a 
Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 
U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the 
Code, this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (preferably a 
signed original and eight (8) copies) and comments sent via the 
Internet that are submitted (in the manner described under the 
ADDRESSES portion of this preamble) timely to the IRS. The Department 
of the Treasury and the IRS specifically request comments on the 
clarity of the proposed regulations and how they may be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for September 18, 2002, 
beginning at 10 a.m. in the auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. All visitors must present 
photo identification to enter the building. Because of access 
restrictions, visitors will not be admitted beyond the immediate 
entrance area more than 15 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT portion 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons who wish to present oral comments at the hearing must 
submit written or electronic comments and an outline of the topics to 
be discussed and the time to be devoted to each topic (preferably a 
signed original and eight (8) copies) by August 28, 2002.
    A period of 10 minutes will be allotted to each person for making 
comments. An agenda showing the scheduling of the speakers will be 
prepared after the deadline for receiving outlines has passed. Copies 
of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is Mark J. 
Weiss, Office of Associate Chief Counsel (Corporate), IRS. However, 
other personnel from the Department of the Treasury and the IRS 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

[[Page 10646]]

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805.

    Section 1.338-11 is also issued under 26 U.S.C. 338. * * *
    Par. 2. In Sec. 1.197-0, the entries in the table of contents for 
Sec. 1.197-2, paragraph (g)(5) are revised to read as follows:


Sec. 1.197-0  Table of contents.

    This section lists the headings that appear in Sec. 1.197-2.


Sec. 1.197-2  Amortization of goodwill and certain other intangibles.

* * * * *
    (g) * * *
    (5) Treatment of certain insurance contracts.
    (i) Determination of adjusted basis of amortizable section 197 
intangibles with respect to insurance contracts under section 
197(f)(5).
    (A) In general.
    (B) Assumption reinsurance transactions.
    (C) Amount paid or incurred by the reinsurer for the insurance 
contracts.
    (D) Amount required to be capitalized under section 848 in 
connection with the transaction.
    (1) In general.
    (2) Cross references and special rules.
    (E) Example.
    (ii) Application of loss disallowance rule upon a disposition of 
an insurance contract acquired in an assumption reinsurance 
transaction.
    (A) Disposition.
    (1) In general.
    (2) Treatment of indemnity reinsurance transactions.
    (B) Loss.
    (C) Examples.
    (iii) Effective Date.
* * * * *
    Par. 3. Section 1.197-2 is amended by revising paragraph (g)(5) to 
read as follows:


Sec. 1.197-2  Amortization of goodwill and certain other intangibles.

* * * * *
    (g) * * *
    (5) Treatment of certain insurance contracts--(i) Determination of 
adjusted basis of amortizable section 197 intangibles with respect to 
insurance contracts under section 197(f)(5)--(A) In general. Section 
197 generally applies to insurance contracts acquired from another 
person through an assumption reinsurance transaction. Section 197(f)(5) 
determines the basis of an amortizable section 197 intangible with 
respect to insurance contracts acquired in an assumption reinsurance 
transaction. The basis of such an intangible is the excess of the 
amount paid or incurred by the acquirer (reinsurer) for the relevant 
insurance contract or group of insurance contracts (hereinafter 
insurance contracts) over the amount, if any, required to be 
capitalized under section 848 in connection with such transaction. For 
purposes of this paragraph (g)(5), the term insurance contracts 
includes an annuity contract or group of annuity contracts.
    (B) Assumption reinsurance transactions. An assumption reinsurance 
transaction means an arrangement whereby the reinsurer becomes solely 
liable to the policyholders on insurance contracts transferred by the 
ceding company. Thus, the transfer of insurance contracts and 
assumption of related liabilities deemed to occur by reason of a 
section 338 election for a target insurance company is treated as an 
assumption reinsurance transaction.
    (C) Amount paid or incurred by the reinsurer for the insurance 
contracts. The amount paid or incurred to acquire insurance contracts 
is--
    (1) In a deemed asset sale resulting from an election under section 
338, the amount of the AGUB allocable thereto (see Secs. 1.338-6 and 
1.338-11(b)(2));
    (2) In an applicable asset acquisition within the meaning of 
section 1060, the amount of the consideration allocable thereto (see 
Secs. 1.338-6, 1.338-11(b)(2), and 1.1060-1(c)(5)); and
    (3) In any other transaction, the excess of the increase in the 
reinsurer's tax reserves resulting from the transaction (computed in 
accordance with sections 807, 832(b)(4)(B), and 846) over the value of 
the net assets received from the ceding company in the transaction.
    (D) Amount required to be capitalized under section 848 in 
connection with the transaction--(1) In general. With respect to 
specified insurance contracts (as defined in section 848(e)) acquired 
in an assumption reinsurance transaction, the amount required to be 
capitalized under section 848 in connection with the acquisition of the 
relevant contracts is determined by multiplying the reinsurer's 
specified policy acquisition expenses for that taxable year by a 
fraction, the numerator of which is the reinsurer's tentative positive 
capitalization amount for the relevant acquired insurance contracts and 
the denominator of which is the reinsurer's total tentative positive 
capitalization amount for the taxable year with regard to all specified 
insurance contracts. For purposes of this paragraph, the tentative 
positive capitalization amount for the relevant acquired insurance 
contracts is determined by multiplying the net positive consideration 
received by the reinsurer in the assumption reinsurance transaction for 
the insurance contracts by the percentage factor applicable to the 
insurance contracts under section 848(c). The reinsurer's total 
tentative positive capitalization amount for the taxable year is the 
sum of--
    (i) 1.75 percent of the net premiums for the taxable year on 
annuity contracts;
    (ii) 2.05 percent of the net premiums for the taxable year on group 
life insurance contracts; and
    (iii) 7.7 percent of the net premiums for the taxable year on 
specified insurance contracts other than annuity or group life 
insurance contracts.
    (2) Cross references and special rules. In general, for rules 
applicable to the determination of specified policy acquisition 
expenses, net premiums, and net positive consideration, see section 
848(c) and (d), and Sec. 1.848-2(a) and (f). However, the following 
special rules apply solely for purposes of this paragraph 
(g)(5)(i)(D)--
    (i) Specified policy acquisition expenses cannot be less than zero;
    (ii) Net premiums for the taxable year cannot be less than the sum 
of the positive consideration for all contracts acquired by the 
reinsurer in assumption reinsurance transactions during the applicable 
taxable year;
    (iii) In computing general deductions (as defined in section 
848(c)(2)), one-half of the amount paid or incurred by the reinsurer in 
the assumption reinsurance transaction is treated as a section 197 
intangible for which an amortization deduction is allowed under section 
197(a); and
    (iv) Any reduction of specified policy acquisition expenses 
pursuant to an election under Sec. 1.848-2(i)(4) (relating to an 
assumption reinsurance transaction with an insolvent ceding company) is 
disregarded.
    (E) Example. The following example illustrates this paragraph 
(g)(5)(i):

    Example. (i) Facts. On January 15, P purchases all the stock of 
T, an insurance company, in a qualified stock purchase and makes a 
section 338 election for T. T is the issuer of a group life 
insurance contract. Under Secs. 1.338-6 and 1.338-11(b)(2), the 
amount of AGUB allocable to the group contract is $15. P and new T 
are calendar year taxpayers. New T's net premiums for the taxable 
year are $10,000, which includes $500 net consideration with respect 
to the group contract transferred in the transaction. The remaining 
$9,500 of new T's net premiums are on life insurance contracts that 
are not group contracts. New T's specified policy acquisition 
expenses for the taxable year, excluding the amortization of any 
section 197 intangible acquired in this

[[Page 10647]]

transaction, are $199.50. (ii) Analysis. The deemed asset sale 
resulting from the election under section 338 is an assumption 
reinsurance transaction because new T becomes solely liable to 
policyholders on contracts for which old T formerly was liable. New 
T's adjusted basis in the group life insurance contract immediately 
following the assumption reinsurance transaction is determined as 
follows. The amount paid or incurred by new T in the assumption 
reinsurance transaction with respect to the contract is $15. Solely 
for purposes of computing the basis of new T's amortizable section 
197 intangible under section 197(f)(5), new T's specified policy 
acquisition expenses for the year of the transaction equal $200.00 
($199.50 of other specified policy acquisition expenses for the year 
+ $0.50 of assumed amortization expense under section 197, derived 
by treating one-half of the amount paid or incurred for the contract 
as a section 197 intangible for which an amortization deduction is 
allowed ($15.00  x  \1/2\  x  \1/15\)). To determine the amount 
required to be capitalized under section 848 in connection with the 
acquisition of the group contract, new T multiplies the $200 of 
specified policy acquisition expenses for the taxable year by a 
fraction, the numerator of which is $10.25 ($500  x  2.05%) and the 
denominator of which is $741.75 (($500  x  2.05%) + ($9,500  x  
7.7%)). Thus, for purposes of applying section 197(f)(5), new T is 
treated as capitalizing $2.76 ($200  x  $10.25  $741.75) 
under section 848 in connection with the acquisition of the group 
contract. Accordingly, the adjusted basis of the group contract 
under section 197(f)(5) is $12.24, the excess of the amount paid or 
incurred by the reinsurer for the group contract in the assumption 
reinsurance transaction ($15) over the amount treated as capitalized 
under section 848 in connection with the transaction ($2.76). New T 
amortizes the $12.24 adjusted basis of the group contract over 15 
years under section 197. New T deducts the remaining $2.76 of the 
$15 of AGUB allocable to the contract because it is reflected in 
amounts new T capitalizes under section 848. In computing its actual 
capitalization under section 848 for the taxable year, new T takes 
into account its actual amortization under section 197 (i.e., $12.24 
 x  \1/15\ = $0.82) rather than the $0.50 assumed for the purpose of 
determining basis under section 197(f)(5).

    (ii) Application of loss disallowance rule upon a disposition of an 
insurance contract acquired in an assumption reinsurance transaction. 
The following rules apply for purposes of applying the loss 
disallowance rules of section 197(f)(1)(A) to the disposition of a 
section 197(f)(5) intangible. For this purpose, a section 197(f)(5) 
intangible is an amortizable section 197 intangible the basis of which 
is determined under section 197(f)(5).
    (A) Disposition--(1) In general. A disposition of a section 197 
intangible is any event as a result of which, absent section 197, 
recovery of basis is otherwise allowed for Federal income tax purposes.
    (2) Treatment of indemnity reinsurance transactions. The transfer 
through indemnity reinsurance of the right to the future income from 
the insurance contracts to which a section 197(f)(5) intangible relates 
does not necessarily preclude the recovery of basis by the ceding 
company, provided that sufficient economic rights relating to the 
reinsured contracts are transferred to the reinsurer. However, the 
ceding company is not permitted to recover basis in an indemnity 
reinsurance transaction if it has a right to experience refunds 
reflecting a significant portion of the future profits on the reinsured 
contracts, or if it retains an option to reacquire a significant 
portion of the future profits on the reinsured contracts through the 
exercise of a recapture provision. In addition, the ceding company is 
not permitted to recover basis in an indemnity reinsurance transaction 
if the reinsurer assumes only a limited portion of the ceding company's 
risk relating to the reinsured contracts (e.g., excess loss 
reinsurance).
    (B) Loss. The loss, if any, recognized by a taxpayer on the 
disposition of a section 197(f)(5) intangible equals the amount by 
which the taxpayer's adjusted basis in the section 197(f)(5) intangible 
immediately prior to the disposition exceeds the amount, if any, that 
the taxpayer receives from another person for the future income right 
from the insurance contracts to which the section 197(f)(5) intangible 
relates. In determining the amount of the taxpayer's loss on the 
disposition of a section 197(f)(5) intangible through a reinsurance 
transaction, any effect of the transaction on the amounts capitalized 
by the taxpayer as specified policy acquisition expenses under section 
848 is disregarded.
    (C) Examples. The following examples illustrate the principles of 
this paragraph (g)(5)(ii):

    Example 1--(i) Facts. In a prior taxable year, as a result of a 
section 338 election with respect to T, new T was treated as 
purchasing all of old T's insurance contracts that were in force on 
the acquisition date in an assumption reinsurance transaction. Under 
Secs. 1.338-6 and 1.338-11(b)(2), the amount of AGUB allocable to 
the future income right from the purchased insurance contracts was 
$15, net of the amounts required to be capitalized under section 848 
as a result of the assumption reinsurance transaction. At the 
beginning of the current taxable year, as a result of amortization 
deductions allowed by section 197(a), new T's adjusted basis in the 
section 197(f)(5) intangible resulting from the assumption 
reinsurance transaction is $12. During the current taxable year, new 
T enters into an indemnity reinsurance agreement with R, another 
insurance company, in which R assumes 100 percent of the risk 
relating to the insurance contracts to which the section 197(f)(5) 
intangible relates. In the indemnity reinsurance transaction, R 
agrees to pay new T a ceding commission of $10 in exchange for the 
future profits on the underlying reinsured policies. Under the 
indemnity reinsurance agreement, new T continues to administer the 
reinsured policies, but transfers investment assets equal to the 
required reserves for the reinsured policies together with all 
future premiums to R. The indemnity reinsurance agreement does not 
contain an experience refund provision or a provision allowing new T 
to terminate the reinsurance agreement at its sole option. New T 
retains the insurance licenses and other amortizable section 197 
intangibles acquired in the deemed asset sale and continues to 
underwrite and issue new insurance contracts.
    (ii) Analysis. The indemnity reinsurance agreement constitutes a 
disposition of the section 197(f)(5) intangible because it involves 
the transfer of sufficient economic rights attributable to the 
insurance contracts to which the section 197(f)(5) intangible 
relates such that recovery of basis is allowed. For purposes of 
applying the loss disallowance rules of section 197(f)(1) and 
paragraph (g) of this section, new T's loss is $2 (new T's adjusted 
basis in the section197(f)(5) intangible immediately prior to the 
disposition ($12) less the ceding commission ($10)). Therefore, new 
T applies $10 of the adjusted basis in the section 197(f)(5) 
intangible against the amount received from R for the future income 
right on the reinsured policies and increases its basis in the 
amortizable section 197 intangibles that it acquired and retained 
from the deemed asset sale by $2, the amount of the disallowed loss. 
The amount of new T's disallowed loss under section 197(f)(1)(A) is 
determined without regard to the effect of the indemnity reinsurance 
transaction on the amounts capitalized by new T as specified policy 
acquisition expenses under section 848.
    Example 2--(i) Facts. Assume the same facts as in Example 1, 
except that under the indemnity reinsurance agreement R agrees to 
pay new T a ceding commission of $5 with respect to the underlying 
reinsured contracts. In addition, under the indemnity reinsurance 
agreement, new T is entitled to an experience refund equal to any 
future profits on the reinsured contracts in excess of the ceding 
commission plus an annual risk charge. New T also has a right to 
recapture the business at any time after R has recovered an amount 
equal to the ceding commission.
    (ii) Analysis. The indemnity reinsurance agreement between new T 
and R does not represent a disposition because it does not involve 
the transfer of sufficient economic rights with respect to the 
future income on the reinsured contracts. Therefore, new T may not 
recover its basis in the section 197(f)(5) intangible to which the 
contracts relate and must continue to amortize ratably the adjusted 
basis of the section 197(f)(5) intangible over the remainder of the 
15-year recovery period and cannot apply any portion of this 
adjusted basis to offset the

[[Page 10648]]

ceding commission received from R in the indemnity reinsurance 
transaction.

    (iii) Effective date. This paragraph (g)(5) is applicable to 
acquisitions and dispositions on or after the date it is filed as a 
final regulation with the Federal Register. For rules applicable to 
acquisitions and dispositions on or before that date, see Sec. 1.197-2 
in effect prior to that date (see 26 CFR part 1, revised April 1, 
2001).
* * * * *
    Par. 4. Section 1.338-0 is amended by adding entries to the outline 
of topics for Sec. 1.338-11 to read as follows:


Sec. 1.338-0  Outline of topics.

* * * * *


Sec. 1.338-11  Effect of section 338 election with respect to insurance 
company target.

    (a) In general.
    (b) Computation of ADSP and AGUB.
    (1) Reserves as an assumed liability.
    (2) Allocation of AGUB and ADSP to specific insurance contracts.
    (c) Application of assumption reinsurance principles.
    (1) In general.
    (2) Reinsurance premium amount.
    (3) Ceding commission.
    (4) Examples.
    (d) Reserve increases by new target after the deemed asset sale.
    (1) In general.
    (2) Exceptions.
    (3) Increases in unpaid loss reserves.
    (4) Increases in other reserves.
    (5) DAC characteristics of the premium resulting from an 
adjustment.
    (6) Subsequent dispositions of amortizable section 197 intangibles 
with respect to insurance contracts.
    (7) Examples.
    (e) Effect of section 338 election on old target's capitalization 
amounts under section 848.
    (1) Determination of net consideration for specified insurance 
contracts.
    (2) Determination of capitalization amount.
    (3) Section 381 transactions.
    (f) Effect of section 338 election on policyholders surplus 
account.
    (g) Effect of section 338 election on section 847 special estimated 
tax payments.
    (h) Effective date.
    Par. 5. Section 1.338-1 is amended by revising the last two 
sentences of paragraph (a)(2) and adding a sentence before the last 
sentence of paragraph (a)(3), to read as follows:


Sec. 1.338-1  General principles; status of old target and new target.

    (a) * * *
    (2) * * * For example, if the target is an insurance company for 
which a section 338 election is made, the deemed asset sale results in 
an assumption reinsurance transaction with respect to the insurance 
contracts deemed transferred from old target to new target. See, 
generally, Sec. 1.817-4(d), and for specific rules regarding 
transactions to which section 338 applies, Sec. 1.338-11.
    (3) * * * Section 1.338-11 provides special rules for insurance 
company targets. * * *
* * * * *
    Par. 6. Section 1.338-11 is added to read as follows:


Sec. 1.338-11  Effect of section 338 election with respect to insurance 
company target.

    (a) In general. This section provides rules that apply where an 
election under section 338 is made with respect to a target that is an 
insurance company. The rules in this section apply in addition to those 
generally applicable upon the making of an election under section 338. 
In the case of a conflict between the provisions of this section and 
other provisions of the Internal Revenue Code or regulations, the rules 
set forth in this section determine the Federal income tax treatment of 
the parties and the transaction where a section 338 election is made 
with respect to an insurance company target.
    (b) Computation of ADSP and AGUB--(1) Reserves as an assumed 
liability. For purposes of computing ADSP and AGUB under Secs. 1.338-4 
and 1.338-5, old target's reserves for Federal income tax purposes with 
respect to any insurance, annuity, and reinsurance contracts deemed 
sold by old target to new target in the deemed asset sale will be 
treated as liabilities of old target assumed by new target. Such 
reserves are those properly taken into account by old target with 
respect to such contracts at the close of the taxable year ending on 
the acquisition date (before giving effect to the deemed asset sale and 
assumption reinsurance transaction). Such reserves are hereinafter 
referred to as old target's tax reserves.
    (2) Allocation of AGUB and ADSP to specific insurance contracts. 
For purposes of allocating AGUB and ADSP pursuant to Secs. 1.338-6 and 
1.338-7, the fair market value of a specific insurance, reinsurance or 
annuity contract or group of insurance, reinsurance or annuity 
contracts (hereinafter insurance contracts) is the amount of the ceding 
commission a willing reinsurer would pay a willing ceding company in an 
arm's length transaction for the reinsurance of the contracts if the 
gross reinsurance premium for the contracts were equal to old target's 
tax reserves for the contracts. See Sec. 1.197-2(g)(5) for rules 
concerning the treatment of the amount allocable to insurance contracts 
acquired in the deemed asset sale.
    (c) Application of assumption reinsurance principles--(1) In 
general. If a target is an insurance company, the deemed sale of 
insurance contracts is treated for Federal income tax purposes as an 
assumption reinsurance transaction between old target, as the reinsured 
or ceding company, and new target, as the reinsurer or acquiring 
company, at the close of the acquisition date. The Federal income tax 
treatment of the assumption reinsurance transaction is determined under 
the applicable provisions of subchapter L, chapter 1, subtitle A of the 
Internal Revenue Code, as modified by the rules set forth in this 
section.
    (2) Reinsurance premium amount. In general, the gross amount of the 
premium paid by old target in the assumption reinsurance transaction is 
equal to the amount of old target's tax reserves with respect to the 
contracts deemed transferred from old target to new target, as computed 
in paragraph (b)(1) of this section. Thus, old target is entitled to a 
deduction for this amount, and includes in income the ceding 
commission, if any, deemed received from new target. New target is 
deemed to receive a reinsurance premium from old target in the amount 
of the reserves for the contracts and to pay old target the amount of 
any ceding commission, as computed in paragraph (c)(3) of this section.
    (3) Ceding commission. Old target is deemed to receive a ceding 
commission in an amount equal to the amount of ADSP allocated to the 
insurance contracts transferred in the assumption reinsurance 
transaction, as determined under Secs. 1.338-6 and 1.338-7 and 
paragraph (b) of this section. New target is deemed to pay a ceding 
commission in an amount equal to the amount of AGUB allocated to the 
insurance contracts acquired in the assumption reinsurance transaction, 
as determined under Secs. 1.338-6 and 1.338-7 and paragraph (b) of this 
section.
    (4) Examples. The following examples illustrate this paragraph (c):

    Example 1--(i) Facts. On January 1, 2003, T, an insurance 
company, has the following assets with the following fair market 
values: $10 cash, $30 of securities, $10 of equipment, a life 
insurance contract having a value, under paragraph (b)(2) of this 
section, of $17, and goodwill and going concern value. T has tax 
reserves of $50 and no other liabilities. On January 1, 2003, P 
purchases all of the stock of T for $16 and makes a section 338 
election for T. For purposes of the capitalization requirements of 
section 848, assume new T has $20 of general deductions in its first 
taxable year ending on December

[[Page 10649]]

31, 2003, and earns no other premiums during the year.
    (ii) Analysis. (A) For Federal income tax purposes, the section 
338 election results in a deemed sale of the assets of old T to new 
T. Old T's ADSP is $66 ($16 amount realized for the T stock plus $50 
liabilities). New T's AGUB also is $66 ($16 basis for the T stock 
plus $50 liabilities). See paragraph (b)(1) of this section. Each of 
the AGUB and ADSP is allocated under the residual method of 
Sec. 1.338-6 to determine the purchase or sale price of each asset 
transferred. Each of the AGUB and ADSP is allocated as follows: $10 
to cash (Class I), $30 to the securities (Class II), $10 to 
equipment (Class V), $16 to the life insurance contract (Class VI), 
and $0 to goodwill and going concern value (Class VII).
    (B) Under section 1001, old T's amount realized with respect to 
the securities is $30 and with respect to the equipment is $10. As a 
result of the deemed asset sale, there is an assumption reinsurance 
transaction between old T (as ceding company) and new T (as 
reinsurer) at the close of the acquisition date with respect to the 
life insurance contract issued by old T. See paragraph (c)(1) of 
this section. Although the assumption reinsurance transaction 
results in a $50 decrease in old T's reserves, which is taxable 
income to old T, the reinsurance premium paid by old T is deductible 
by old T. Under paragraph (c)(2) of this section, old T is deemed to 
pay a reinsurance premium equal to the reserve for the life 
insurance contract immediately before the deemed asset sale ($50) 
and is deemed to receive a ceding commission from new T. Under 
paragraph (c)(3) of this section, the portion of the ADSP allocated 
to the life insurance contract is $16; thus, the ceding commission 
is $16. Old T, therefore, is deemed to pay new T a reinsurance 
premium of $34 ($50-$16 = $34). Old T also has $34 of net negative 
consideration for purposes of section 848. See paragraph (e) of this 
section for rules relating to the effect of a section 338 election 
on the capitalization of amounts under section 848.
    (C) New T obtains an initial basis of $30 in the securities and 
$10 in the equipment. New T is deemed to receive a reinsurance 
premium from old T in an amount equal to the $50 of reserves for the 
life insurance contract and to pay old T a $16 ceding commission for 
the contract. See paragraphs (c)(2) and (3) of this section. 
Accordingly, new T includes $50 of premium in income and deducts $50 
for its increase in reserves. For purposes of section 848, new T has 
$34 of net positive consideration with regard to the deemed 
assumption reinsurance transaction. Because the only contract 
involved in the deemed assumption reinsurance transaction is a life 
insurance contract, new T must capitalize $2.62 ($34  x  7.7% = 
$2.62) under section 848. New T will amortize the $2.62 as provided 
under section 848. New T's adjusted basis in the life insurance 
contract, which is an amortizable section 197 intangible, is $13.38, 
the excess of the $16 ceding commission over the $2.62 capitalized 
under section 848. See section 197 and Sec. 1.197-2(g)(5). New T 
deducts the $2.62 of the ceding commission that is not amortizable 
under section 197 because it is reflected in the amount capitalized 
under section 848 and also deducts the remaining $17.38 of its 
general deductions.
    Example 2--(i) Facts. Assume the same facts as in Example 1, 
except the life insurance contract has a value of $0. Thus, to 
reinsure the contract in an arm's length transaction, T would have 
to pay the reinsurer a reinsurance premium in excess of T's $50 of 
tax reserves for the contract.
    (ii) Analysis. (A) For Federal income tax purposes, the section 
338 election results in a deemed sale of the assets of old T to new 
T. Old T's ADSP is $66 ($16 amount realized for the T stock plus $50 
liabilities). New T's AGUB also is $66 ($16 basis for the T stock 
plus $50 liabilities). See paragraph (b)(1) of this section. Each of 
the AGUB and ADSP is allocated under the residual method of 
Sec. 1.338-6 to determine the purchase or sale price of each asset 
transferred. Each of the AGUB and ADSP is allocated as follows: $10 
to cash (Class I), $30 to the securities (Class II), $10 to the 
equipment (Class V), $0 to the life insurance contract (Class VI), 
and $16 to goodwill and going concern value (Class VII).
    (B) Under section 1001, old T's amount realized with respect to 
the securities is $30 and with respect to the equipment is $10. As a 
result of the deemed asset sale, there is an assumption reinsurance 
transaction between old T (as ceding company) and new T (as 
reinsurer) at the close of the acquisition date with respect to the 
life insurance contract issued by old T. See paragraph (c)(1) of 
this section. Although the assumption reinsurance transaction 
results in a $50 decrease in old T's reserves, which is taxable 
income to old T, the reinsurance premium deemed paid by old T to new 
T is deductible by old T. Under paragraph (c)(2) of this section, 
old T is deemed to pay a reinsurance premium equal to the reserve 
for the life insurance contract immediately before the deemed asset 
sale ($50), and is deemed to receive from new T a ceding commission 
equal to the amount of AGUB allocated to the life insurance contract 
($0), as provided in paragraph (c)(3) of this section. Old T also 
has $50 of net negative consideration for purposes of section 848. 
See paragraph (e) of section for rules relating to the effect of a 
section 338 election on capitalization amounts under section 848.
    (C) New T obtains an initial basis of $30 in the securities and 
$10 in the equipment. New T is deemed to receive a reinsurance 
premium from old T in an amount equal to the $50 of reserves for the 
life insurance contract. Accordingly, new T includes $50 of premium 
in income and deducts $50 for its increase in reserves. For purposes 
of section 848, new T has $50 of net positive consideration with 
respect to the deemed assumption reinsurance transaction. Because 
the only contract involved in the assumption reinsurance transaction 
is a life insurance contract, new T must capitalize $3.85 ($50  x  
7.7%) under section 848 from the transaction and deducts the 
remaining $16.15 of its general deductions. Because new T allocates 
$0 of the AGUB to the insurance contract, no amount is amortizable 
under section 197 with respect to the insurance contract. See 
paragraph (d) of this section for rules on adjustments required if, 
before the end of 2006, new T increases its reserves for, or 
reinsures at a loss, the acquired life insurance contract.

    (d) Reserve increases by new target after the deemed asset sale--
(1) In general. If, during any of its first four taxable years, new 
target increases its reserves for any insurance contracts acquired in 
the deemed asset sale (acquired contracts), new target shall be treated 
as receiving in that year the sum of the positive amounts, if any, 
described in paragraphs (d)(3) and (4) of this section as an additional 
premium for the acquired insurance contracts in the assumption 
reinsurance transaction (described in paragraph (c)(1) of this section) 
that occurred in connection with the deemed asset sale and will include 
such amount in income, and such amount will increase AGUB. See 
Secs. 1.338-5(b)(2)(ii) and 1.338-7. Old target makes no adjustments to 
ADSP under this paragraph (d).
    (2) Exceptions. New target is not required to take into account 
reserve increases under this paragraph (d)--
    (i) To the extent such increases occur while it is under state 
receivership; or
    (ii) To the extent its deduction for the reserve increase is spread 
under section 807(f) over the 10 succeeding taxable years.
    (3) Increases in unpaid loss reserves. The amount of reserve 
increases, if any, taken into account under this paragraph (d) with 
respect to unpaid losses on acquired contracts is computed using the 
formula A/B  x  (C-[D + E]) where--
    (i) A equals old target's discounted unpaid losses (determined 
under section 846) used to compute the tax reserves included in AGUB 
under paragraph (b)(1) of this section;
    (ii) B equals old target's undiscounted unpaid losses (as defined 
by section 846(b)(1)) used to compute the tax reserves included in AGUB 
under paragraph (b)(1) of this section;
    (iii) C equals new target's undiscounted unpaid losses (as defined 
by section 846(b)(1)) at the end of the taxable year that are 
attributable to losses incurred by old target on or before the 
acquisition date;
    (iv) D (which may be a negative number) equals the amount 
determined by--
    (A) Multiplying old target's undiscounted unpaid losses (as defined 
by section 846(b)(1)) by 1.02 for new target's first taxable year, 1.04 
for new target's second taxable year, 1.06 for new target's third 
taxable year, or 1.08 for new target's fourth taxable year; and
    (B) Subtracting the cumulative amount of losses, loss adjustment 
expenses, and reinsurance premiums paid by new target through the end 
of

[[Page 10650]]

the taxable year with regard to losses incurred by old target on or 
before the acquisition date; and
    (v) E equals the cumulative amount of the undiscounted unpaid 
losses taken into account in prior taxable years by new target as 
adjustments to reserves with regard to losses incurred by old target on 
or before the acquisition date.
    (4) Increases in other reserves. The amount of the increases in 
reserves other than unpaid loss reserves is taken into account under 
this paragraph (d) to the extent of any net increase (in the aggregate) 
in reserves for acquired contracts due to changes in methodology or 
assumptions used to compute the reserves for those contracts (including 
the adoption by new target of a methodology or assumptions different 
from those used by old target).
    (5) DAC characteristics of the premium resulting from an 
adjustment. For purposes of applying section 848, the additional 
premium arising from the adjustment under this paragraph (d) is 
allocated among each category of specified insurance contracts under 
section 848(c)(1) (and contracts that are not specified insurance 
contracts) as follows--
    (i) For each category of specified insurance contracts (and 
contracts that are not specified insurance contracts), by taking the 
sum of that category's contribution to the amounts in paragraphs (d)(3) 
and (4) of this section; and
    (ii) Dividing the additional premium described in paragraph (d)(1) 
of this section in proportion to the positive sums for each category 
from paragraph (d)(5)(i) of this section.
    (6) Subsequent dispositions of amortizable section 197 intangibles 
with respect to insurance contracts. For rules regarding subsequent 
dispositions of contracts acquired in the deemed asset sale, see also 
Sec. 1.197-2(g)(5)(ii).
    (7) Examples. The following examples illustrate this paragraph (d):

    Example 1--(i) Facts. On January 1, 2003, P purchases all of the 
stock of T, a non-life insurance company, for $120 and makes a 
section 338 election for T. On the acquisition date, old T has total 
reserve liabilities under state law of $725, consisting of 
undiscounted unpaid losses of $625 and unearned premiums of $100. 
Old T's tax reserves on the acquisition date are $580, which consist 
of discounted unpaid losses (as defined in section 846) of $500 and 
unearned premiums (as computed under section 832(b)(4)(B)) of $80. 
Old T has assets in Classes I through V with a fair market value of 
$700. As of the beginning of January 1, 2003, old T also has Class 
VI assets with a value of $75, consisting of the future profit 
stream on certain insurance contracts. During 2003, new T makes loss 
adjustment expense payments of $200 with respect to the unpaid 
losses incurred by old T prior to the acquisition date. As of 
December 31, 2003, new T reports undiscounted unpaid losses of $435 
attributable to losses incurred prior to the acquisition date. The 
related amount of discounted losses (as defined in section 846) for 
those losses is $360.
    (ii) Computation and allocation of AGUB. Pursuant to Sec. 1.338-
5 and paragraph (b)(1) of this section, as of the acquisition date, 
AGUB is $700, reflecting the sum of the amount paid for old T's 
stock ($120) and the tax reserves assumed by new T in the 
transaction ($580). Under Sec. 1.338-6, new T allocates the AGUB to 
each of the assets in Class I through V up to their fair market 
value. No AGUB is available for the assets in Class VI, even though 
the future profit stream on old T's insurance contracts has a fair 
market value of $75 on the acquisition date.
    (iii) Adjustments for increases in reserves with respect to 
unpaid losses. Pursuant to paragraph (d) of this section, new T must 
determine whether any amounts by which it increased its unpaid loss 
reserves will be treated as an additional premium. New T applies the 
formula of paragraph (d)(3) of this section, where A equals $500, B 
equals $625, C equals $435, D equals $437.50 [($625  x  1.02)-$200], 
and E equals $0. Under the formula, new T is not subject to an 
adjustment for 2003 because new T's undiscounted unpaid losses at 
the end of the taxable year ($435) do not exceed $437.50, the 
adjusted amount of undiscounted unpaid losses used in computing AGUB 
reduced by loss payments through the end of the taxable year [($625 
x  1.02)-$200].
    Example 2--(i) Facts. Assume the same facts as in Example 1. 
Further assume that during 2004 new T deducts total loss and expense 
payments of $375 with respect to losses incurred by old T prior to 
the acquisition date. On December 31, 2004, new T reports 
undiscounted unpaid losses of $150 with respect to losses incurred 
prior to the acquisition date. The related amount of discounted 
unpaid losses (as defined in section 846) for those losses is $125.
    (ii) Analysis. New T must determine whether any amounts by which 
it increased its unpaid loss reserves during 2004 will be treated as 
an additional premium under paragraph (d) of this section. New T 
applies the formula of paragraph (d)(3) of this section, where A 
equals $500, B equals $625, C equals $150, D equals $75 [($625  x  
1.04)-$575], and E equals $0. Pursuant to paragraph (d) of this 
section, new T must recognize additional premium income in 2004 of 
$60.00 (($500/$625)  x  ($150--[$75+$0]) to offset the section 
832(b)(5) deduction for amounts by which it increased those reserves 
and must adjust the amount of AGUB allocable to acquired insurance 
contracts (Class VI assets) to reflect the increase in AGUB 
attributable to the $60.00 adjustment for increases in reserves. See 
section 197 and the regulations thereunder for the treatment of the 
amounts allocable to the insurance contracts.
    Example 3--(i) Facts. Assume the same facts as in Example 2. 
Further assume that on January 1, 2005, new T reinsures the 
outstanding liability with respect to losses incurred by old T prior 
to the acquisition date through a portfolio reinsurance transaction 
with R, another non-life insurance company. In this transaction, R 
agrees to assume any remaining liability with respect to losses 
incurred prior to the acquisition date in exchange for a reinsurance 
premium of $175. Accordingly, as of December 31, 2005, new T reports 
no undiscounted unpaid losses with respect to losses incurred by old 
T prior to the acquisition date.
    (ii) Analysis. New T must determine whether any amounts by which 
it increased its unpaid loss reserves will be treated as an 
additional premium under paragraph (d) of this section. New T 
applies the formula of paragraph (d)(3) of the section, where A 
equals $500, B equals $625, C equals $0, D equals -$87.50 [($625  x  
1.06)-($575 + $175) = -$87.50], and E equals $75. New T must include 
$10.00 (($500/$625)  x  ($0-[-$87.50 + $75]) in gross income for 
2005 to offset the section 832(b)(5) deduction for increases to its 
unpaid loss reserve and must increase the AGUB allocable to the 
acquired insurance contracts (Class VI assets) by this amount. See 
section 197 and the regulations thereunder for the treatment of the 
amounts allocable to the insurance contracts.

    (e) Effect of section 338 election on old target's capitalization 
amounts under section 848--(1) Determination of net consideration for 
specified insurance contracts. For purposes of applying section 848 and 
Sec. 1.848-2(f) to the deemed assumption reinsurance transaction, old 
target's net consideration (either positive or negative) with respect 
to each category of specified insurance contracts is an amount equal 
to--
    (i) The allocable portion of the ceding commission (if any) 
relating to contracts in that category; less
    (ii) The amount by which old target's tax reserves for contracts in 
that category has been reduced as a result of the deemed assumption 
reinsurance transaction.
    (2) Determination of capitalization amount. Except as provided in 
Sec. 1.381(c)(22)-1(b)(13)--
    (i) If, after the deemed asset sale, old target has an amount 
otherwise required to be capitalized under section 848 for the taxable 
year or an unamortized balance of specified policy acquisition expenses 
from prior taxable years, then old target deducts such remaining amount 
or unamortized balance as an expense incurred in the taxable year that 
includes the acquisition date; and
    (ii) If, after the deemed asset sale, the negative capitalization 
amount resulting from the reinsurance transaction exceeds the amount 
that old target can deduct under section 848(f)(1), then old target's 
capitalization amount is treated as zero at the close of the taxable 
year that includes the acquisition date.

[[Page 10651]]

    (3) Section 381 transactions. For transactions described in section 
381, see Sec. 1.381(c)(22)-1(b)(13).
    (f) Effect of section 338 election on policyholders surplus 
account. Except as specifically provided in Sec. 1.381(c)(22)-1(b)(7), 
the deemed asset sale effects a distribution of old target's 
policyholders surplus account to the extent the grossed-up amount 
realized on the sale to the purchasing corporation of the purchasing 
corporation's recently purchased target stock (as defined in 
Sec. 1.338-4(c)) exceeds old target's shareholders surplus account 
under section 815(c).
    (g) Effect of section 338 election on section 847 special estimated 
tax payments. If old target had elected to claim an additional 
deduction under section 847 for taxable years prior to and including 
the acquisition date, the amount remaining in old target's special loss 
discount account under section 847(3) must be reduced to the extent it 
relates to contracts transferred to new target and the amount of such 
reduction must be included in old target's gross income for the taxable 
year that includes the deemed assumption reinsurance transaction. Old 
target may apply the balance of its special estimated tax account as a 
credit against any tax resulting from such inclusion in gross income. 
Any special estimated tax payments remaining after this credit are 
voided and, therefore, are not available for credit or refund. Pursuant 
to section 847(1), new target is permitted to claim a section 847 
deduction with respect to losses incurred prior to the deemed asset 
sale, subject to the general requirement that new target makes timely 
special estimated tax payments equal to the tax benefit resulting from 
this deduction. See Sec. 1.381(c)(22)-1(c)(14) regarding the carryover 
of the special loss discount account attributable to contracts 
transferred in a section 381 transaction.
    (h) Effective date. This section applies to a section 338 election 
for a target if the acquisition date is on or after the date this 
section is filed as a final regulation with the Federal Register.
    Par. 7. Section 1.381(c)(22)-1 is amended by:
    1. Adding a sentence to the end of paragraph (b)(7)(i).
    2. Redesignating existing (b)(7)(ii) as paragraph (b)(7)(iv) and 
adding new paragraphs (b)(7)(ii) and (b)(7)(iii).
    3. Adding paragraphs (b)(7)(v), and (b)(13) and (b)(14).
    The revisions read as follows:


Sec. 1.381(c)(22)-1  Successor life insurance company.

* * * * *
    (b) * * *
    (7)(i) * * * However, any amounts attributable to money or other 
property distributed to a person other than the acquiring corporation 
under section 381(a) (e.g., boot) shall be treated as a distribution 
under section 815.
    (ii) Notwithstanding paragraph (b)(7)(i) of this section, if the 
transferor corporation transfers less than 50 percent of its insurance 
business to the acquiring corporation, then the acquiring corporation 
shall succeed to a ratable portion of the dollar balances in the 
transferor's shareholders surplus account, policyholders surplus 
account, and other accounts. The percentage of such accounts to which 
the acquiring corporation succeeds is determined by the ratio of the 
transferor's insurance reserves for the contracts transferred to the 
acquiring corporation, as maintained under section 816(b), to the 
transferor's reserves for all of its contracts maintained under section 
816(b) immediately before the earlier of the distribution or transfer 
or the adoption of the plan of liquidation or reorganization. For 
transactions in which the transferor liquidates pursuant to an election 
under section 338(h)(10), see Sec. 1.338-11(f) for the treatment of its 
remaining policyholders surplus account. For all other transactions 
subject to this paragraph, the transferor must take into account as 
income its remaining policyholders surplus account to the extent the 
fair market value of its assets (net of liabilities) transferred to the 
acquiring corporation or to the transferor's shareholders pursuant to 
the plan of liquidation or reorganization exceeds the transferor's 
remaining shareholders surplus account.
    (iii) If, pursuant to a plan in existence at the time of the 
liquidation or reorganization, the acquiring corporation transfers any 
insurance or annuity contract it received in the liquidation or 
reorganization to another person, then, for purposes of paragraph 
(b)(7)(ii) of this section, that contract shall be deemed to have been 
transferred by the transferor to that other person after the adoption 
of the plan of liquidation or reorganization. If the transferor is an 
old target within the meaning of Sec. 1.338(h)(10)-1(d)(2), any 
transfer by the acquiring corporation to the purchasing corporation (as 
defined in Sec. 1.338-2(c)(11)) or to any person related to the 
purchasing corporation within the meaning of section 197(f)(9)(C) 
within two years of the transfer described in section 381(a) will be 
presumed to have been pursuant to a plan in existence at the time of 
the liquidation or reorganization.
* * * * *
    (v) The provisions of this paragraph (b)(7) are illustrated by the 
following examples:

    Example 1. P buys the stock of insurance company target, T, from 
S for $16, and P and S make a section 338(h)(10) election for T. T 
transfers no insurance contracts to S, or any related party, in 
connection with the transaction. Further, assume that T had $10 in 
its policyholders surplus account and no balance in its shareholders 
surplus account or other accounts. Immediately before the deemed 
asset sale, old T is required to include as ordinary income the $10 
in the policyholders surplus account.
    Example 2. Assume the same facts as in Example 1, except that T 
holds a block of life insurance contracts P does not wish to 
acquire, and, immediately before the sale of T stock, S causes T to 
distribute the unwanted block of insurance contracts to S. Further, 
assume that S is an insurance company, that the distribution of 
contracts is treated as pursuant to a section 332 liquidation, and 
that old T's tax reserves with respect to the distributed contracts 
represent one-tenth of old T's tax reserves with respect to all of 
its life insurance contracts. Because T transfers less than 50 
percent of its life insurance business to S pursuant to a section 
332 liquidation, S succeeds to a ratable portion of old T's 
policyholders surplus account ($1), and old T includes as ordinary 
income the remaining $9 of that account.
    Example 3. Assume the same facts as in Example 2, except that 14 
months after the deemed asset sale, S and X, a person related to new 
T under section 197(f)(9)(C), engage in an indemnity reinsurance 
transaction involving the contracts transferred to S from old T. 
Because X is related to the purchasing corporation (P) under section 
197(f)(9)(C), and X receives contracts from the acquiring 
corporation (S) that S acquired from old T within two years of the 
transfer from old T to S, the contracts are presumed to have been 
transferred pursuant to a plan in existence at the time of old T's 
liquidation. If S cannot establish otherwise, old T is treated as 
having distributed the remainder of its policyholders surplus 
account. In that case, in the taxable year of the indemnity 
reinsurance transaction, S takes into account as ordinary income the 
portion of old T's accounts ($9) that old T or S has not previously 
taken into account as income.
* * * * *
    (13) The transferor's unamortized policy acquisition expenses or 
positive or negative capitalization requirements on its specified 
insurance contracts.
    (14) The special loss discount account, provided, however, that the 
acquiring corporation will succeed to the special loss discount account 
only to the extent that it is attributable to the portion of the 
transferor's insurance business acquired by the acquiring corporation 
in the section 381 transaction.

[[Page 10652]]

    Par. 8. Section 1.1060-1 is amended by:
    1. Revising paragraph (a)(2).
    2. Adding entries in paragraph (a)(3) in the outline of topics for 
paragraphs (b)(9) and (c)(5).
    3. Adding new paragraphs (b)(9) and (c)(5).
    The revision and addition read as follows:


Sec. 1.1060-1  Special allocation rules for certain asset acquisitions.

    (a) * * *
    (2) Effective dates. In general, the provisions of this section 
apply to any asset acquisition occurring after March 15, 2001. However, 
paragraphs (b)(9) and (c)(5) of this section apply only to applicable 
asset acquisitions occurring on or after the date they are filed as 
final regulations with the Federal Register. For rules applicable to 
asset acquisitions on or before March 15, 2001, see Sec. 1.1060-1T in 
effect prior to March 16, 2001 (see 26 CFR part 1 revised April 1, 
2000).
    (3) * * *
* * * * *
    (b) * * *
    (9) Insurance business.
    (c) * * *
    (5) Insurance business.
* * * * *
    (b) * * *
    (9) Insurance business. The mere reinsurance of insurance contracts 
by an insurance company is not an applicable asset acquisition, even if 
it enables the reinsurer to establish a customer relationship with the 
owners of the reinsured contracts. However, a transfer of an insurance 
business is an applicable asset acquisition if the purchaser acquires 
significant business assets, in addition to insurance contracts, to 
which goodwill and going concern value could attach. For rules 
regarding the treatment of an applicable asset acquisition of an 
insurance business, see paragraph (c)(5) of this section.
    (c) * * *
    (5) Insurance business. If the trade or business transferred is an 
insurance business, the rules of this paragraph (c) are modified by the 
principles of Sec. 1.338-11(a) through (d). However, in transactions 
governed by section 1060, such principles apply even if the transfer of 
the trade or business is effected in whole or in part through indemnity 
reinsurance rather than assumption reinsurance, and, with respect to 
the insurer or reinsurer, an insurance contract (including an annuity 
or reinsurance contract) is a Class VI asset regardless of whether it 
is a section 197 intangible. In addition, the principles of Sec. 1.338-
11(e) through (g) apply if the transfer occurs in connection with the 
complete liquidation of the transferor.
* * * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 02-5485 Filed 3-7-02; 8:45 am]
BILLING CODE 4830-01-P