[Federal Register Volume 68, Number 146 (Wednesday, July 30, 2003)]
[Proposed Rules]
[Pages 44689-44691]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-19367]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-163974-02]
RIN 1545-BB77


Diversification Requirements for Variable Annuity, Endowment, and 
Life Insurance Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document proposes removing provisions of the Income Tax 
Regulations that apply a look-through rule to assets of a nonregistered 
partnership for purposes of satisfying the diversification requirements 
of section 817(h) of the Internal Revenue Code. The Treasury Department 
and the IRS believe that removal of these provisions will eliminate any 
possible confusion regarding the prohibition on ownership of interests 
by the public in a nonregistered partnership funding a variable 
contract.

DATES: Written or electronic comments and requests for a public hearing 
must be received by October 28, 2003.

ADDRESSES: Send submissions to: CC:PA:RU (REG-163974-02), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Comments may be hand delivered Monday through Friday between 
the hours of 8 a.m. and 4 p.m. to CC:PA:RU (REG-163974-02), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., 
Washington, DC. Alternatively, taxpayers may submit electronic comments 
directly to the IRS Internet site at www.irs.gov/regs.

FOR FURTHER INFORMATION CONTACT: James Polfer, (202) 622-3970 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    Section 817(d) defines a variable contract as an annuity contract, 
a life insurance contract, or a contract that provides funding of 
insurance on retired lives as described in section 807(c)(6). A 
variable contract must provide for the allocation of all or part of the 
amounts received under the contract to an account that is segregated 
from the general asset accounts (a segregated asset account) of the 
company under State law. In the case of an annuity contract, the 
amounts paid in, or the amounts paid out, must reflect the investment 
return and the market value of the segregated asset account. Section 
817(d)(3)(A). In the case of a life insurance contract, the amount of 
the death benefit (or the period of coverage) must be adjusted on the 
basis of the investment return and the market value of the account. 
Section 817(d)(3)(B). In the case of a contract for funding of 
insurance on retired lives, the amounts paid in, or the amounts paid 
out, must reflect the investment return and the market value of the 
account. Section 817(d)(3)(C).
    Section 817(h)(1) provides that a variable contract based on a 
segregated asset account shall not be treated as an annuity, endowment, 
or life insurance contract unless the segregated asset account is 
adequately diversified in accordance with regulations prescribed by the 
Secretary. Under section 817(h)(1), if a segregated asset account fails 
to be adequately diversified for a period, then the contracts supported 
by that segregated asset account shall not be treated as annuity, 
endowment, or life insurance contracts for that period and subsequent 
periods, even if the segregated asset account is adequately diversified 
in those subsequent periods. Section 1.817-5(c)(1) defines period as a 
calendar quarter. If a segregated asset account is not adequately 
diversified, income earned by that segregated asset account is treated 
as ordinary income received or accrued by the policyholders.\1\
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    \1\ Section 1.817-5(a)(2) provides a mechanism for insurance 
companies to avoid this result if certain enumerated correction 
procedures are satisfied.
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    Section 817(h) was enacted by Congress in the Deficit Reduction Act 
of 1984 (Pub. L. 98-369). Congress enacted the diversification 
requirements of section 817(h) to ``discourage the use of tax-preferred 
variable annuity and variable life insurance primarily as investment 
vehicles.'' H.R. Conf. Rep. No. 98-861, at 1055 (1984). In section 
817(h)(1), Congress granted the Secretary broad regulatory authority to 
develop rules to carry out this intent. Pursuant to this authority, 
Sec.  1.817-5 sets forth the standards a segregated asset account must 
meet to be treated as adequately diversified within the meaning of 
section 817(h).
    Section 817(h)(4) provides a look-through rule under which 
taxpayers do not treat the interest in a regulated investment company 
(RIC) or trust as a single asset of the segregated asset account but 
rather apply the diversification tests by taking into account the 
assets of the RIC or trust. Section 817(h) further provides that the 
look-through rule applies only if all of the beneficial interests in a 
RIC or trust

[[Page 44690]]

are held by one or more general or segregated asset accounts of 
insurance companies (or affiliated companies), or by fund managers (or 
affiliated companies) in connection with the creation or management of 
the RIC or trust. ``In authorizing Treasury to prescribe 
diversification standards, the conferees intend that the standards be 
designed to deny annuity or life insurance treatment for investments 
that are publicly available to investors * * * A H.R. Conf. Rep. at 
1055.''
    Section 1.817-5(f)(1) of the regulations implements the 
Congressional directive to prescribe diversification standards by 
providing that if look-through treatment is available, a beneficial 
interest in a RIC, real estate investment trust, partnership, or trust 
that is treated under sections 671 through 679 as owned by the grantor 
or another person (investment company, partnership or trust) will not 
be treated as a single investment of a segregated asset account for 
purposes of testing diversification. Instead, a pro rata portion of 
each asset of the investment company, partnership, or trust will be 
treated as an asset of the segregated asset account.
    Section 1.817-5(f)(2) provides more detailed rules for determining 
whether look-through treatment is available. Under Sec.  1.817-
5(f)(2)(i), the look-through rule applies to any investment company, 
partnership, or trust if: (A) All the beneficial interests in the 
investment company, partnership, or trust are held by one or more 
segregated asset accounts of one or more insurance companies; and (B) 
public access to such investment company, partnership, or trust is 
available exclusively through the purchase of a variable contract. 
Section 1.817-5(f)(iii) provides exceptions to the general ownership 
limitations of Sec.  1.817-5(f)(2)(i), specifically permitting life 
insurance company general accounts, managers of the investment company, 
partnership or trust, pension or retirement plan trustees, and certain 
individuals whose investment falls into one of two limited classes.
    Under Sec.  1.817-5(f)(2)(ii), the look-through rule applies to a 
partnership interest that is not registered under a Federal or State 
law regulating the offering or sale of securities. Unlike Sec.  1.817-
5(f)(2)(i), satisfaction of the non-registered partnership look-through 
rule of Sec.  1.817-5(f)(2)(II) is not explicitly conditioned on 
limiting the ownership of interests in the partnership to certain 
specified holders.
    Under Sec.  1.817-5(f)(2)(iii), the look-through rule applies to a 
trust that is treated under sections 671 through 679 as owned by the 
grantor or another person if substantially all of the assets of the 
trust are represented by Treasury securities.
    Section 1.817-5(g) provides examples of the application of the 
look-through rules of Sec.  1.817-5(f). Example (3) of Sec.  1.817-5(g) 
provides an example of the application of the Sec.  1.817-5(f)(2)(ii) 
non-registered partnership look-through rule.

Explanation of Provisions

    This document contains proposed amendments to 26 CFR part 1 under 
section 817(h). These proposed amendments would remove Sec.  1.817-
5(f)(2)(ii), which requires taxpayers to look through an interest in a 
nonregistered partnership, as defined in Sec.  1.817-5(f)(2)(ii), to 
determine whether a segregated asset account supporting a variable 
contract is adequately diversified within the meaning of section 817(h) 
and Sec.  1.817-5. In addition, the proposed regulations would conform 
the other provisions of Sec.  1.817-5 to the removal of Sec.  1.817-
5(f)(2)(ii), and would remove Example (3) of Sec.  1.817-5(g).
    The application of Sec.  1.817-5(f)(2)(i) to interests in 
nonregistered partnerships will be unchanged by the removal of Sec.  
1.817-5(f)(2)(ii). Thus, look through treatment will be available for 
interests in a nonregistered partnership if: (A) All the beneficial 
interests in the nonregistered partnership (other than those described 
in Sec.  1.817-5(f)(3)) are held by one or more segregated asset 
accounts of one or more insurance companies; and (B) public access to 
such nonregistered partnership is available exclusively (except as 
otherwise permitted in Sec.  1.817-5(f)(3)) through the purchase of a 
variable contract.

Reasons for Change

    The Treasury Department and the IRS are concerned that Sec.  1.817-
5(f)(2)(ii) is not consistent with Congressional intent because it is 
not explicitly subject to the public availability limitation of section 
817(h). The Treasury Department and the IRS believe that removal of 
Sec.  1.817-5(f)(2)(ii) will eliminate any possible confusion regarding 
the prohibition on ownership of interests by the public in a non-
registered partnership funding a variable contract.
    In addition, the Treasury Department and the IRS understand that 
certain taxpayers are purchasing contracts invested in partnerships 
that rely on the nonregistered partnership rule of Sec.  1.817-
5(f)(2)(ii) to satisfy the diversification requirements of section 
817(h). The Treasury Department and the IRS are concerned that these 
contracts are funded by interests in partnerships that are also 
available to certain limited classes of investors, specifically 
individuals that are ``qualified purchasers'' within the meaning of 15 
U.S.C. 80a-2(a)(51) or ``accredited investors'' as defined in 
Regulation D of the Securities Act of 1933.\2\ The Treasury Department 
and the IRS believe that Congress intended to treat qualified 
purchasers and accredited investors as part of the general public when 
determining whether an investment is available for the purchase by the 
general public. Elimination of Sec.  1.817-5(f)(2)(ii) will limit 
access to interests in non-registered partnerships to the same holders 
that are permitted under Sec.  1.817-5(f)(2)(i), which does not include 
either qualified investors or accredited investors.
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    \2\ The Treasury Department and the IRS understand that many of 
the partnership interests that are available under these 
arrangements are interests in partnerships that operate as hedge 
funds, often established and operated in foreign jurisdictions. In 
many cases, interests in these partnerships are available for 
purchase directly by the general public as well as through the 
purchase of a variable contract. Taxpayers that purchase a variable 
annuity or life insurance contract are indirectly investing in 
partnership interests that are available for direct investment by 
the general public. By indirectly investing in these partnership 
interests through the purchase of a variable contract taxpayers 
defer tax on partnership earnings that might otherwise be currently 
taxable. The Treasury Department and the IRS believe that these 
arrangements (often marketed as ``insurance wrappers'') are the type 
of overly investment oriented insurance and annuity arrangements 
that Congress sought to prevent when it enacted the diversification 
rules of section 817(h).
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Proposed Effective Date

    The Treasury Department and the IRS intend revocation of Sec.  
1.817-5(f)(2)(ii) and Example (3) of Sec.  1.817-5(g) to be effective 
on the date the final regulations are published in the Federal 
Register. The revocation will be effective for all investments in 
nonregistered partnerships, including investments made prior to the 
effective date of the revocation that relied on the look-through rule 
of Sec.  1.817-5(f)(2)(ii) to satisfy the diversification requirements 
of section 817(h) and the regulations and do not meet the requirements 
of Sec.  1.817-5(f)(2)(i). However, arrangements in existence on the 
effective date of the revocation of Sec.  1.817-5(f)(2)(ii) will be 
considered to be adequately diversified if: (i) Those arrangements were 
adequately diversified within the meaning of section 817(h) prior to 
the revocation of Sec.  1.817-5(f)(2)(ii) and (ii) by the end of the 
last day of the second calendar quarter ending after the effective date 
of

[[Page 44691]]

the regulation, the arrangements are brought into compliance with the 
final regulations.

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 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 
the 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 Internal Revenue Code, the 
notice of proposed rulemaking will be submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on their 
impact on small business.

Comments and Request for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are timely submitted 
to the IRS. The Treasury Department and the IRS specifically request 
comments on the clarity of the proposed rule and how it may be made 
easier to understand. All comments will be available for public 
inspection and copying. A public hearing may be scheduled if requested 
in writing by any person that timely submits written or electronic 
comments. If a public hearing is scheduled, notice of the date, time, 
and place for the hearing will be published in the Federal Register.
    The Treasury Department and the IRS specifically request comments 
on: (1) Whether revocation of Sec.  1.817-5(f)(2)(ii) necessitates 
other changes to the look-through rules of Sec.  1.817-5(f), in 
particular whether the list of holders permitted by Sec.  1.817-5(f)(3) 
should be amended or expanded, and whether a non-pro-rata distribution 
of the investment returns of a segregated asset account should be 
permitted to take account of certain bonus payments to investment 
managers commonly referred to as incentive payments, (2) whether Sec.  
1.817-5 should be updated to take account of changes to variable 
contracts since the final regulations were published in 1986, and (3) 
whether regulations are needed to address when a holder of a variable 
contract will be treated as the owner of assets held in a segregated 
asset account and, therefore, required to include earnings on those 
assets in income.\3\
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    \3\ The Treasury Department and the IRS have issued a number of 
revenue rulings that provide guidance for determining whether the 
holder of a variable contract will be treated as the owner of assets 
held by a segregated asset account by virtue of the control the 
contract holder has over those assets. See Rev. Rul. 2003-92, 2003-
33 I.R.B. ---- (August 18, 2003); Rev. Rul. 2003-91, 2003-33 I.R.B. 
---- (August 18, 2003); Rev. Rul. 82-54, 1982-1 C.B. 11; Rev. Rul. 
81-225, 1981-2 C.B. 12; Rev. Rul. 80-274, 1980-2 C.B. 27; Rev. Rul. 
77-85, 1977-1 C.B. 12. See also Christoffersen v. U.S., 749 F.2d 513 
(8th Cir. 1984), rev'g 578 F. Supp. 398 (N.D. Iowa 1984). These 
rulings apply general concepts of ownership that have developed in 
case law to conclude that a contract holder was the owner of assets 
held in the account that supported the contract holder's annuity 
contract, and was therefore subject to current taxation on the 
earnings on those assets.
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Drafting Information

    The principal author of these proposed regulations is James Polfer, 
Office of the Associate Chief Counsel (Financial Institutions and 
Products), Office of Chief Counsel, Internal Revenue Service. However, 
personnel from other offices of the Treasury Department and the IRS 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income Taxes, Reporting and recordkeeping requirements.

Proposed Amendment to the Regulations

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

PART 1--INCOME TAX

    1. The authority citation for part 1 is amended by adding an entry 
in numerical order to read as follows:
Section 1.817-5 also issued under 26 U.S.C. 817(h). * * *

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


Sec.  1.817-5  [Amended]

    2. Section 1.817-5 is amended as follows:
    1. Paragraphs (f)(2)(ii) and (g) Example 3 are removed.
    2. Paragraph (f)(2)(iii) is redesignated as paragraph (f)(2)(ii).
    3. Paragraph (g) Example 4 is redesignated as paragraph (g) Example 
3.

Robert E. Wenzel,
Deputy Commissioner (Services and Enforcement).
[FR Doc. 03-19367 Filed 7-29-03; 8:45 am]
BILLING CODE 4830-01-P