Common Myths In Interpreting The Company Tax Provisions of the 1984 Act

When I joined our law firm in 1979 to specialize in insurance taxation, the Life Insurance Company Income Act of 1959 was already 20 years old and seemed well-entrenched. Many participants in the drafting of the 1959 Act were still around and there was a detailed legislative history that made interpretation of the basic structure and purpose of the statutory provisions relatively straightforward. Yes, the three-phase system was complex and, yes, there was a lot of litigation. But, Congress’ underlying tax policy was not really in dispute particularly after 1961 when comprehensive regulations were promulgated with extensive industry input and comments.

I cannot say the same thing about the Tax Reform Act of 1984. It is now 25 years old and we seem to be debating fundamental principles about what Congress had in mind and what the statute really says. There are a few of us still around who were there at the 1984 Act genesis. We think we know what was intended and are frequently frustrated by revisionist interpretations. So, as my contribution to the 25th anniversary of the 1984 Act, here are some common myths about Congress’ tax policy underlying the 1984 Act that I would like to debunk.

MYTH 1 – In the 1984 Act, Congress enacted a completely new tax regime for life insurance companies.NOT TRUE.

By the early 1980s, the 1959 Act’s three-phase system had become broken. The Menge Formula incorporated into taxable investment income (Phase I) was out-of-date and the phase system could be gamed to reduce tax liability, particularly with reinsurance. So, Congress wanted to eliminate the primary source of the problem—the three-phase system—in favor of a single phase based on gain from operations. If we were to compare the 1984 Act gain from operations with its predecessor in the 1959 Act, there is remarkably little difference. The changes made basically fall within three categories: 1) special deductions were eliminated as part of the repeal of Phase III; 2) life insurance reserves went from a net level premium basis to a preliminary term basis through the repeal of former section 818(c) and the adoption of section 807(d); and 3) simplification and clarification changes were made in an attempt to avoid much of the litigation that had occurred under the 1959 Act. Thus, for example, the definition of net investment income was simplified for proration in section 812 and premium recognition was placed on an accrual basis (thereby eliminating recognition of deferred and uncollected premiums). So, when we look at gain from operations in the 1984 Act, we are really just seeing a stream-lined version of the 1959 Act. That is why the legislative history tells us in effect: In reading the 1984 Act, do not try to reinvent the wheel; if the 1984 Act did not make a specific change, you should just go back to the 1959 Act for guidance. The basic point here is that most of the statutory provisions under the 1984 Act are carried over from the 1959 Act and the original well-established tax policy underlying those provisions did not change.

MYTH 2 – Congress' primary goal in the 1984 Act was to raise revenue.NOT TRUE.

The late 1970s and early 1980s were a period of great change in the life insurance industry. The advancements in computer technology gave insurers the ability to unbundle their contracts and make mortality charges and interest credits transparent. Universal life was born and policyholders were given flexibility within the contract to determine the level of premiums they would pay and the amount of death benefits they desired. The popularity of universal life, which credited excess interest and adjusted mortality charges for favorable experience, prompted stock companies to issue contracts that had many of the same economic benefits of participating whole life insurance issued by mutual companies. Mutual companies responded by offering their own universal life contracts so that their products would have the unbundled transparency that the marketplace was demanding. The convergence of product offerings, coupled with a broken and out-of-date three-phase tax system, called for a legislative solution. How should the tax law be changed to ensure a level playing field in light of the rapidly changing and converging marketplace? Mutual and stock companies disagreed bitterly for many years whether the 1984 Act achieved its goal of fairness among segments of the industry and, thankfully, the repeal of section 809 has put an end to that corrosive debate. But, in interpreting the 1984 Act, the fundamental point to remember is that the changes in law were primarily driven by a Congressional desire to provide a level playing field among segments of the industry.