[Federal Register Volume 70, Number 39 (Tuesday, March 1, 2005)]
[Rules and Regulations]
[Pages 9869-9872]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-3825]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9185]
RIN 1545-BB77


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

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations 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.

DATES: Effective Date: These regulations are effective as of March 1, 
2005. However, arrangements in existence on March 1, 2005, will be 
considered to be adequately diversified if: (i) Those arrangements were 
adequately diversified within the meaning of section 817(h) prior to 
March 1, 2005, and (ii) by December 31, 2005, the arrangements are 
brought into compliance with the final regulations.
    Applicability Date: For dates of applicability, see Sec.  1.817-
5(i).

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

SUPPLEMENTARY INFORMATION:

Background

    Under section 817(h), a variable contract based on a segregated 
asset account is not treated as an annuity, endowment, or life 
insurance contract unless the segregated asset account is adequately 
diversified. For purposes of testing diversification, section 817(h)(4) 
and Sec.  1.817-5(f) of the regulations provide a look-through rule for 
assets held through certain investment companies, partnerships, or 
trusts. Section 1.817-5(f)(2)(i) provides that look-through treatment 
is available with respect to any investment company, partnership, or 
trust only if 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 public access to such 
investment company, partnership, or trust is available exclusively 
(except as otherwise permitted by section 1.817-5(f)(3)) through the 
purchase of a variable contract. 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 
nonregistered 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.
    On July 30, 2003, the Treasury Department and the IRS published a 
notice of proposed rulemaking (REG-163974-02) under section 817 in the 
Federal Register (68 FR 44689). The proposed regulations would remove 
the rule that applies specifically to nonregistered partnerships for 
purposes of testing diversification. The proposed regulations also 
would remove an example that illustrates that rule.
    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 all the beneficial 
interests in the partnership are held by one or more segregated asset 
accounts of one or more insurance companies and public access to the 
partnership is available exclusively (except as otherwise permitted by 
Sec.  1.817-5(f)(3)) through the purchase of a variable contract.
    Written comments were received in response to the notice of 
proposed rulemaking. A public hearing on the notice of proposed 
rulemaking was held on April 1, 2004. After consideration of all the 
comments and the hearing testimony, the proposed regulations are 
adopted as amended by this Treasury decision.

Explanation and Summary of Comments

    In addition to requesting comments on the clarity of the proposed 
rule and how the rule could be made easier to understand, the Treasury 
Department and the IRS specifically requested 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

[[Page 9870]]

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.

1. Comments on the Proposed Regulations

    Two comments on the proposed regulation concerned the definition of 
``security'' in Sec.  1.817-5(h)(6). Under Sec.  1.817-5(b)(1)(ii)(A), 
all securities of the same issuer are treated as one investment for the 
purposes of satisfying the diversification requirements. Section 1.817-
5(h)(6) provides that the term security includes ``a cash item and any 
partnership interest registered under a Federal or state law regulating 
the offering or sale of securities,'' but does not include `` any other 
partnership interest.'' The commentators stated that the definition of 
``security'' that applies to Sec.  1.817-5 should be amended to include 
an interest in a non-registered partnership. The Treasury Department 
and the IRS agree that, in light of the revocation of former Sec.  
1.817-5(f)(2)(ii), the definition of security should be modified to 
remove the distinction between registered and nonregistered partnership 
interests. The final regulations reflect this change.
    A number of commentators also suggested that the regulation should 
be clarified by adding to or otherwise revising the examples contained 
in Sec.  1.817-5(g). In response to these comments, the final 
regulations revise Sec.  1.817-5(g) Example 1 to remove the reference 
to partnership P as a publicly registered partnership. The Treasury 
Department and the IRS believe that, with this change, the examples 
contained in Sec.  1.817-5(g) adequately explain the application of 
Sec.  1.817-5 to partnership interests. Any questions concerning the 
application of Sec.  1.817-5 to more specific factual scenarios may be 
addressed by the letter ruling process or by subsequent published 
guidance.
    Two commentators urged that existing arrangements either should be 
grandfathered in some fashion or should be given additional time to be 
brought into compliance with the final regulations. The notice of 
proposed rulemaking provided that 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 the regulation, the arrangements are brought into compliance with 
the final regulations. The Treasury Department and the IRS do not 
believe it is appropriate to grandfather existing arrangements 
indefinitely. In response to these comments, however, the transition 
period for existing arrangements to be brought into compliance with the 
regulations is two calendar quarters longer than the period provided in 
the proposed regulations.
    Finally, one commentator questioned the authority of the Treasury 
Department and the IRS to enact this final regulation because ``the 
only substantive impetus for the regulation is a general statement in 
the legislative history.'' 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), and granted the 
Secretary broad regulatory authority to develop rules to carry out this 
intent. The Treasury Department and the IRS have determined that this 
final regulation and the rest of the regulations contained in Sec.  
1.817-5 were prescribed within the delegation of authority provided by 
Congress.

2. Comments on Sec.  1.817-5 More Generally

    Many comments concerned the list of permitted investors under Sec.  
1.817-5(f)(3). Notwithstanding the limitations on public access to an 
investment company, partnership, or trust that is subject to look-
through treatment under Sec.  1.817-5(f), Sec.  1.817-5(f)(3) permits 
look-through treatment if the beneficial interests of the investment 
company, partnership, or trust are held by certain other ``permitted 
investors,'' including the general account of a life insurance company 
(if certain requirements are met), the manager or a corporation related 
to the manager (if certain requirements are met), or the trustee of a 
qualified plan. Commentators suggested that the list of permitted 
investors be expanded to include, for example, qualified tuition 
programs described in section 529; segregated asset accounts of foreign 
insurance companies; foreign pension plans; persons or entities related 
to the manager of an investment company, partnership, or trust in a 
manner specified in section 707(b); certain investment professionals 
operating as service providers; or persons who receive interests in a 
partnership as a result of inadvertent transfers, such as by bankruptcy 
or death of the permitted investor. The sole speaker at the public 
hearing on the notice of proposed rulemaking testified that the list of 
investors permitted by Sec.  1.817-5(f)(3) should be expanded to 
include ``floor specialists'' as that term is defined in section 
1236(d)(2).
    Other comments suggested guidance on non-pro-rata manager 
compensation. In order for the manager (or a corporation related in a 
manner specified in section 267(b) to the manager) of an investment 
company, partnership, or trust, to be a permitted investor under Sec.  
1.817-5(f)(3)(ii), (1) its interest must be held in connection with the 
creation or management of the investment company, partnership, or 
trust; (2) the return on such interest must be computed in the same 
manner as the return on an interest held by a segregated asset account 
is computed (determined without regard to expenses attributable to 
variable contracts); and (3) there must be no intent to sell such 
interest to the public. A number of commentators stated that the 
requirement that the return on a manager's interest be computed in the 
same manner as the return on a segregated asset account's interest--
essentially a pro-rata distribution requirement--is inconsistent with 
prevailing market practices concerning manager bonuses, discourages the 
creation of insurance dedicated funds, and is not necessary to prevent 
abuse of the look-through rules contained in Sec.  1.817-5(f).
    Some comments stated there is a need to clarify the consequences to 
a variable contract and variable contract holder when the contract's 
segregated asset account contains an asset in which beneficial 
interests are held by investors (such as qualified plans) that 
qualified as permitted investors in Sec.  1.817-5(f)(2) or (3) at the 
time of initial investment, but subsequently lose their status. 
Similarly, one commentator urged that if an insurance company has a 
reasonable basis to believe that an investment company, partnership, or 
trust satisfies the requirements of Sec.  1.817-5(f)(2), a variable 
contract of that insurance company should be permitted to look-through 
that entity for purposes of testing a segregated asset account on which 
that contract is based, even if the investment company, partnership, or 
trust has investors not

[[Page 9871]]

described in Sec.  1.817-5(f)(2) or (3). The commentator suggested that 
this standard would be consistent with the standard of determination 
often used in the Federal securities laws.
    Other comments included a request for clarification of the 
treatment of fund-of-funds and master-feeder arrangements for purposes 
of testing diversification; the desirability of an updated correction 
procedure for failure to satisfy the diversification requirements of 
section 817(h) and Sec.  1.817-5; guidance concerning the use of 
independent investment advisors; and extension of the special 
diversification rules for United States Treasury securities under 
section 817(h)(3) and Sec.  1.817-5(b)(3) to variable annuity 
contracts. (The latter comment presumably would require a change to 
section 817(h)(3), as well as to the regulations.)
    Although the comments on Sec.  1.817-5 generally are not adopted in 
this Treasury decision, the Treasury Department and IRS will consider 
these comments in the event of future published guidance. For example, 
Rev. Rul. 2005-7 (2005-6 I.R.B.) (see Sec.  601.601 (d)(2)(ii)(b) of 
this chapter) provides guidance on the application of the 
diversification look-through rule to tiered investment companies.

3. Comments on Investor Control

    Finally, some comments concerned the need for additional guidance 
addressing circumstances under which 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. Under Rev. Rul. 81-225, 1981-2 C.B. 12 (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), the owner of a variable annuity 
contract funded by publicly available mutual fund shares is treated as 
the owner of those shares. Rev. Rul. 2003-92, 2003-33 I.R.B. 350 (see 
Sec.  601.601(d)(2)(ii)(b) of this chapter), clarified and amplified 
Rev. Rul. 81-225 by applying the same rule to variable life insurance 
contracts, and by treating as publicly available a nonregistered 
partnership, interests in which are sold only to qualified purchasers 
that are accredited investors or to no more than one hundred accredited 
investors. See also Rev. Rul. 2003-91, 2003-33 I.R.B. 347; Rev. Rul. 
82-54, 1982-1 C.B. 11; Rev. Rul. 80-274, 1980-2 C.B. 27; Rev. Rul. 77-
85, 1977-1 C.B. 12.; Christoffersen v. U.S., 749 F.2d 513 (8th Cir. 
1984), rev'g 578 F. Supp. 398 (N.D. Iowa 1984). See Sec.  
601.601(d)(2)(ii)(b) of this chapter.
    One commentator urged that Rev. Rul. 2003-92 should not be applied 
retroactively to treat certain investors as the ``general public'' as 
that term is used in Rev. Rul. 81-225. Specifically, the commentator 
requested relief for investments in real estate partnerships, interests 
in which are held directly by (1) organizations described in section 
501(c)(3), and (2) such partnerships' investment managers, if those 
managers are not described in Sec.  1.817-5(f)(3)(ii) because of bonus 
payment arrangements. The commentator believed such relief is warranted 
because of uncertainty concerning the meaning of ``general public'' as 
that term is used in Rev. Rul. 81-225. Several other commentators 
suggested that regulations under section 817 should clarify that the 
permitted investors under Sec.  1.817-5(f)(3) do not constitute the 
``general'' public as that term is used in Rev. Rul. 2003-92 and Rev. 
Rul. 81-225. According to these commentators, it would be anomalous for 
ownership by a permitted investor under Sec.  1.817-5(f)(3) to result 
in a variable contract holder being treated as the owner of an 
investment company, partnership, or trust, when the look-through rule 
itself appears to endorse ownership by that same investor for purposes 
of testing diversification. Still another commentator noted that when 
determining whether a contract holder is treated as the owner of 
segregated account assets, communications between investment advisors 
or officers and variable contract holders should be permitted if the 
communications are consistent with Federal securities and commodities 
laws.
    One commentator suggested that the preamble to this Treasury 
decision should confirm the intended scope of Rev. Proc. 99-44, 1999-2 
C.B. 598. Under Rev. Proc. 99-44, a contract is treated as an annuity 
contract described in sections 403(a), 403(b), or 408(b), 
notwithstanding that contract premiums are invested at the direction of 
the contract holder in publicly available securities, so long as 
certain requirements are met. Those requirements include a limitation 
that no additional Federal tax liability would have been incurred if 
the employer of the contract holder had instead paid amounts into a 
custodial account in an arrangement that satisfied the requirements of 
section 403(b)(7)(A) or no additional Federal tax liability would have 
been incurred if the consideration for the contract had instead been 
held as part of a trust that would satisfy the requirements of section 
408(a), as applicable. The commentator urged that the preamble to this 
Treasury decision clarify that the ``no additional Federal tax 
liability'' limitation was intended to apply only to tax on unrelated 
business income. Finally, one commentator noted that, given the 
inherent factual nature of the determination whether a contract holder 
is treated as the owner of segregated account assets, the issue is 
better addressed by letter ruling or revenue ruling, rather than by 
regulations.
    Although the comments on investor control are not adopted in this 
Treasury decision, they are responsive to the request for comments in 
the July 30, 2003, notice of proposed rulemaking and will receive 
careful attention in the event of further guidance on investor control.

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 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 preceding these regulations was submitted 
to the Small Business Administration for comment on its impact on small 
business.

Drafting Information

    The principal author of these 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.

Adoption of Amendment to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAX

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.817-5 also issued under 26 U.S.C. 817(h). * * *


[[Page 9872]]



0
Par. 2. Section 1.817-5 is amended as follows:
0
1. Paragraphs (f)(2)(ii) and (g) Example 3 are removed.
0
2. Paragraph (f)(2)(iii) is redesignated as paragraph (f)(2)(ii).
0
3. The first sentence of paragraph (g) Example 1 is revised.
0
4. Paragraph (g) Example 4 is redesignated as paragraph (g) Example 3.
0
5. Paragraph (h)(6) is revised.
0
6. New paragraph (i)(2)(v) is added.
    The revisions read as follows:


Sec.  1.817-5  Diversification requirements for variable annuity, 
endowment, and life insurance contracts.

* * * * *
    (g) * * *

    Example 1. (i) The assets underlying variable contracts issued 
by a life insurance company consist of two groups of assets: (a) a 
diversified portfolio of debt securities and (b) interests in P, a 
partnership. * * *
* * * * *
    (h) * * *
    (6) Security. The term security shall include a cash item and any 
partnership interest, whether or not registered under a Federal or 
State law regulating the offering or sale of securities. The term shall 
not include any interest in real property, or any interest in a 
commodity.
* * * * *
    (i) * * *
    (2) * * *
    (v) A segregated asset account in existence before March 1, 2005, 
will be considered to be adequately diversified if--
    (A) As of March 1, 2005, the account was adequately diversified 
within the meaning of section 817(h) and this regulation as in effect 
prior to that date; and
    (B) By December 31, 2005, the account is adequately diversified 
within the meaning of section 817(h) and this regulation.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.

    Approved: February 15, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
[FR Doc. 05-3825 Filed 2-28-05; 8:45 am]
BILLING CODE 4830-01-P