IRS has privately ruled that for income tax purposes a life insurance company, and not its variable annuity contract holders, is treated as the owner of the underlying investment assets held in certain variable contract segregated asset accounts. IRS determined that the contract holders didn't possess sufficient investment control or other incidents of ownership over the assets so as to require them to include in income earnings from the assets.
Background. Code Sec. 817(d) defines a “variable contract,” for purposes of the life insurance company rules of Code Sec. 801 through Code Sec. 818, as a contract that provides for the allocation of all or part of the amounts received under the contract to an account that, pursuant to state law or regulation, is segregated from the general asset accounts of the company and that provides for the payment of annuities, or is a life insurance contract. Under Code Sec. 817(h)(1), a variable contract that is 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 in accordance with regs.
Code Sec. 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. The look-through rule applies only if all of the beneficial interests in a RIC or trust are held by one or more insurance companies (or affiliated companies) in their general account or segregated asset accounts, or by fund managers (or affiliated companies) in connection with the creation or management of the RIC or trust. (Code Sec. 817(h))
For purposes of Code Sec. 817(h) and Reg. §1.817-5, the investments of a segregated asset account will be considered to be “adequately diversified” if: (i) no more than 55% of the value of the total assets of the account is represented by any one investment; (ii) no more than 70% by any two investments; (iii) no more than 80% by any three investments; and (iv) no more than 90% by any four investments.
Under Reg. §1.817-5(f)(1), if look-through treatment is available, a beneficial interest in a RIC, real estate investment trust, partnership, or grantor trust is not 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 is treated as an asset of the segregated asset account. The look-through rule applies to any investment company, partnership, or trust if (a) all the beneficial interests in the entity are held by one or more segregated asset accounts of one or more insurance companies; and (b) public access to the investment company, partnership, or trust is available exclusively through the purchase of a variable contract (except as otherwise permitted in Reg. §1.817-5(f)(3)). (Reg. §1.817-5(f)(2)(i))
Facts. Taxpayer is a life insurance company that issues deferred and immediate annuity contracts. The contracts offer only a fixed investment option and a number of variable investment options that can only be added or removed by Taxpayer. The portion of a premium allocated by the contract holder to the fixed investment option under the contract is held in Taxpayer's general account, and the portion allocated to variable investment options is held in a separate account.
The assets of the separate account are allocated among sub-accounts corresponding to the variable investment options. One type of sub-account is a “lifecycle” sub-account, where the investment strategy is based on the approximate year of the contract holder's retirement. Each lifecycle sub-account invests all of its assets in shares of a corresponding mutual fund (lifecycle insurance fund). Each lifecycle insurance fund is a business trust, is a RIC, is taxable as a separate corporation under Code Sec. 851(g), and is registered as an investment company. The lifecycle insurance funds also support variable annuity contracts issued by Taxpayer's wholly owned subsidiary.
Taxpayer represents that: (i) the assets supporting the contracts are maintained in the separate account, which is divided into multiple sub-accounts, each of which meets the Code Sec. 817(h) diversification requirements; (ii) except as otherwise permitted, all beneficial interests in each lifecycle insurance fund are held by one or more insurance companies; and (iii) public access to each lifecycle insurance fund is available exclusively through the purchase of a variable contract.
The specific assets held by each lifecycle insurance fund are determined by an investment manager and are subject to change. Contract holders can allocate premiums and transfer funds among the various lifecycle sub-accounts, but the investment decisions are made solely by the investment manager. Contract holders have no ownership interest in or specific knowledge of any of the lifecycle insurance fund assets.
The lifecycle funds currently invest exclusively in shares of other insurance-dedicated RICs for which Taxpayer or an affiliated company (collectively, the group) serves as the investment manager. Taxpayer proposes to allow the lifecycle insurance funds to also invest some of their assets in (a) group-managed RICs that are open for direct investment by the general public (public funds), and (b) certain group-managed RICs and partnerships that are available exclusively to group-managed entities and accounts, some of which are open for direct public investment (central funds). According to Taxpayer, these types of investments will give the investment managers greater flexibility and the potential for better performance results and greater investment risk diversification for contract owners.
Conclusion. IRS determined that the lifecycle insurance funds' investment in either public or central funds won't cause the contract owners to be treated as owners of shares of the lifecycle insurance fund for tax purposes. Examining related guidance, IRS reasoned that the contract owners didn't have sufficient investment control or other incidents of ownership over the underlying assets in the lifecycle sub-accounts to be considered their owner. Accordingly, provided that the contracts continue to satisfy Code Sec. 817(h) 's diversification requirements, the assets of each lifecycle sub-account will be treated as owned by Taxpayer, not the contract owners.
References: For variable contracts, see FTC 2d/FIN ¶E-5050 et seq.; United States Tax Reporter ¶8174.