[Federal Register Volume 67, Number 88 (Tuesday, May 7, 2002)]
[Rules and Regulations]
[Pages 30547-30549]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-11035]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8993]
RIN 1545-AY60


Debt Instruments With Original Issue Discount; Annuity Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
federal income tax treatment of annuity contracts issued by certain 
insurance companies. The regulations provide guidance on whether 
certain annuity contracts are excluded from the definition of a debt 
instrument under the original issue discount provisions of the Internal 
Revenue Code.

DATES: Effective Date: These regulations are effective June 6, 2002.
    Applicability Dates: For dates of applicability, see Sec. 1.1275-
1(k)(3).

FOR FURTHER INFORMATION CONTACT: Patrick E. White, (202) 622-3920 (not 
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    Sections 163(e) and 1271 through 1275 of the Internal Revenue Code 
(Code) provide rules for the treatment of debt instruments with 
original issue discount (OID). Section 1275(a)(1)(A) defines the term 
debt instrument to include a bond, debenture, note, or

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certificate or other evidence of indebtedness. Sections 
1275(a)(1)(B)(i) and (ii), however, exclude certain annuity contracts 
from the definition of a debt instrument. This document contains rules 
concerning the exception for annuities described in section 
1275(a)(1)(B)(ii). A notice of proposed rulemaking (REG-125237-00, 
2001-12 I.R.B. 919) was published in the Federal Register (66 FR 2852) 
on January 12, 2001. One individual commented anonymously on the 
proposed regulations. The individual primarily expressed concern that 
the proposed guidance should not limit the investment options of U.S. 
investors. No public hearing was requested or held. The proposed 
regulations are adopted as proposed.

Explanation of Provisions

    In general, the OID provisions apply to issuers and holders of debt 
instruments. The term debt instrument generally means any instrument or 
contractual arrangement that constitutes indebtedness under general 
principles of income tax law. See section 1275(a)(1)(A) and 
Sec. 1.1275-1(d) of the Income Tax Regulations.
    If a contract is a debt instrument with OID, section 1272 generally 
requires the holder of the contract to include OID in income currently 
on a constant yield basis, regardless of the holder's overall method of 
accounting. By contrast, the holder of an annuity contract to which 
section 72 applies generally is allowed to defer recognizing 
economically earned income until distributions are made on the 
contract.
    Section 1275(a)(1)(B) excepts two types of annuity contracts from 
the definition of a debt instrument. First, section 1275(a)(1)(B)(i) 
excepts an annuity contract to which section 72 applies if the contract 
``depends (in whole or in substantial part) on the life expectancy of 1 
or more individuals.'' Second, section 1275(a)(1)(B)(ii) excepts an 
annuity contract to which section 72 applies under certain 
circumstances if the contract ``is issued by an insurance company 
subject to tax under subchapter L (or by an entity described in section 
501(c) and exempt from tax under section 501(a) which would be subject 
to tax under subchapter L were it not so exempt). . . .''
    The regulations provide that an annuity contract issued by a 
foreign insurance company is treated under section 1275(a)(1)(B)(ii) as 
issued by an insurance company subject to tax under subchapter L if the 
insurance company is subject to tax under subchapter L with respect to 
income earned on the annuity contract. The IRS and Treasury conclude 
that this is the most appropriate application of the language of 
section 1275(a)(1)(B)(ii) and is consistent with the use of that phrase 
elsewhere in the Code and regulations. See, e.g., sections 953(e)(3)(C) 
and 1297(b)(2)(B); Sec. 1.848-2(h).

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because 
these regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking preceding these regulations was submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Drafting Information

    The principal author of these regulations is Patrick E. White, 
Office of the Associate Chief Counsel (Financial Institutions & 
Products). However, other personnel from the IRS and Treasury 
Department participated in their development.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.1271-0 is amended by adding entries for 
paragraphs (k) through (k)(3) to Sec. 1.1275-1 to read as follows:


Sec. 1.1271-0  Original issue discount; effective dates; table of 
contents.

* * * * *


Sec. 1.1275-1  Definitions.

* * * * *
    (k) Exception under section 1275(a)(1)(B)(ii) for annuities issued 
by an insurance company subject to tax under subchapter L of the 
Internal Revenue Code.
    (1) Rule.
    (2) Examples.
    (3) Effective date.
* * * * *

    Par. 3. Section 1.1275-1 is amended by adding paragraph (k) to read 
as follows:


Sec. 1.1275-1  Definitions.

* * * * *
    (k) Exception under section 1275(a)(1)(B)(ii) for annuities issued 
by an insurance company subject to tax under subchapter L of the 
Internal Revenue Code--(1) Rule. For purposes of section 
1275(a)(1)(B)(ii), an annuity contract issued by a foreign insurance 
company is considered as issued by an insurance company subject to tax 
under subchapter L if the insurance company is subject to tax under 
subchapter L with respect to income earned on the annuity contract.
    (2) Examples. The following examples illustrate the rule of 
paragraph (k)(1) of this section. Each example assumes that the annuity 
contract is a contract to which section 72 applies and was issued in a 
transaction where there is no consideration other than cash or another 
qualifying annuity contract, pursuant to the exercise of an election 
under an insurance contract by a beneficiary thereof on the death of 
the insured party, or in a transaction involving a qualified pension or 
employee benefit plan. The examples are as follows:

    Example 1.  Company X is an insurance company that is organized, 
licensed and doing business in Country Y. Company X does not have a 
U.S. trade or business and is not, under section 842, subject to 
U.S. income tax under subchapter L with respect to income earned on 
annuity contracts. A, a U.S. taxpayer, purchases an annuity contract 
from Company X in Country Y. The annuity contract is not excepted 
from the definition of a debt instrument by section 
1275(a)(1)(B)(ii).

    Example 2. The facts are the same as in Example 1, except that 
Company X has a U.S. trade or business. A purchased the annuity from 
Company X's U.S. trade or business. Under section 842(a), Company X 
is subject to tax under subchapter L with respect to income earned 
on the annuity contract. Under these facts, the annuity contract is 
excepted from the definition of a debt instrument by section 
1275(a)(1)(B)(ii).

    Example 3. The facts are the same as in Example 2, except that 
there is a tax treaty between Country Y and the United States. 
Company X is a resident of Country Y for purposes of the U.S.-
Country Y tax treaty. Company X's activities in the U.S. do not 
constitute a permanent establishment under the U.S.-Country Y tax 
treaty. Because Company X does not have a U.S. permanent 
establishment, Company X is not subject to tax under subchapter L 
with respect to income earned on the annuity contract. Thus, the 
annuity contract is not excepted from the definition of a debt 
instrument by section 1275(a)(1)(B)(ii).

    Example 4. The facts are the same as in Example 1, except that 
Company X is a

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foreign insurance corporation controlled by a U.S. shareholder. 
Company X does not make an election 1 under section 953(d) to be 
treated as a domestic corporation. The controlling U.S. shareholder 
is required under sections 953 and 954 to include income earned on 
the annuity contract in its taxable income under subpart F. However, 
Company X is not subject to tax under subchapter L with respect to 
income earned on the annuity contract. Thus, the annuity contract is 
not excepted from the definition of a debt instrument by section 
1275(a)(1)(B)(ii).

    Example 5. The facts are the same as in Example 4, except that 
Company X properly elects under section 953(d) to be treated as a 
domestic corporation. By reason of its election, Company X is 
subject to tax under subchapter L with respect to income earned on 
the annuity contract. Thus, the annuity contract is excepted from 
the definition of a debt instrument by section 1275(a)(1)(B)(ii).

    (3) Effective date. This paragraph (k) is applicable for interest 
accruals on or after June 6, 2002. This paragraph (k) does not apply to 
an annuity contract that was purchased before January 12, 2001. For 
purposes of this paragraph (k), if any additional investment in a 
contract purchased before January 12, 2001, is made on or after January 
12, 2001, and the additional investment is not required to be made 
under a binding written contractual obligation that was entered into 
before that date, then the additional investment is treated as the 
purchase of a contract after January 12, 2001.

    Dated: April 26, 2002.
David A. Mader,
Acting, Deputy Commission of Internal Revenue.
Pamela F. Olson,
Acting, Assistant Secretary of the Treasury
[FR Doc. 02-11035 Filed 5-6-02; 8:45 am]
BILLING CODE 4830-01-P