Actuary/Accountant/Tax Attorney Dialogue on Internal Revenue Code Deference to the NAIC Part III: Policyholder Tax Issues

Peter Winslow: This is the third installment of our extended dialogue on the issue of federal tax law’s deference to insurance regulation rules. We have covered in some depth the deference issue as it relates to tax reserves and to policyholder tax issues. This installment will cover what I will call insurance classification issues, including the existential question—what is insurance? To what extent does guidance from the NAIC or state regulators matter in answering this question?

In the context of life company taxation, our discussion will cover issues such as whether the company will be taxed as an insurance company, whether an insurance company will be classified as a life or nonlife company, and, of course, captive issues. Whether a transaction qualifies as reinsurance or something else also comes within this broad “what is insurance?” inquiry.

As in the past, I want to begin the discussion with our “In the Beginning” panelists, Susan Hotine and John Adney, who were both instrumental in the development of the 1984 Act, which forms the basis of current law. Susan, can you please describe for us what Congress did in the 1984 Act on the basic issues of classification of a company as an insurance company and/or a life insurance company?

LIFE INSURANCE COMPANY QUALIFICATION

Susan Hotine: Prior to the 1984 Act, the term “insurance company” was defined in the regulations under section 801 of the 1954 Internal Revenue Code as meaning “a company whose primary and predominant business activity during the taxable year is the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.” The regulation goes on to say that, although the company’s name, charter powers and regulation as an insurance company under state laws are significant, it is the character of the business activity actually done in the taxable year that determines whether the company is taxable as an insurance company.

While an insurance company was defined under pre-1984 law in the regulations, the definition of a life insurance company was set forth in the Code. The 1984 Act retained the tax definition of a life insurance company that had been in the Code under prior law—“an insurance company which is engaged in the business of issuing life insurance and annuity contracts (either separately or combined with accident and health insurance), or noncan- cellable contracts of health and accident insurance, if (1) its life insurance reserves... , plus (2) unearned premiums, and unpaid losses (whether or not ascertained), on noncancellable life, accident, or health policies not included in life insurance reserves, comprise more than 50 percent of its total reserves.” But the 1984 Act went further and defined in the Code itself the term “insurance company” for purposes of determining whether a company is a life insurance company. That Code definition is very much like the definition of an insurance company that is in the regulations developed under prior law except that, instead of looking to the primary and predominant business activity, it requires that more than half of the company’s business during the taxable year be the issuing of insurance and annuity contracts or the reinsuring of risks underwritten by insurance companies.

Peter: Do these Code and regulation definitions give any explicit deference to the NAIC or state regulators in defining an insurance company or life insurance company?

Susan: No. Looking at both prior law regulations and the current Code, neither gives deference to the NAIC or state insurance regulators for purposes of determining whether a company is a life insurance company for tax purposes. Like the definition of an insurance company under the regulations developed under prior law, the Code definition seems to present an activities test. The 1984 Act legislative history points out that whether more than half the business activity is related to the issuing of insurance and annuity contracts depends on the facts and circumstances, and that the relative distribution of the number of employees assigned to, the amount of space allocated to, and the net income derived from the various business activities are all factors to be considered. Again, there does not seem to be a deference shown to the NAIC or state insurance regulators.

Peter: How about the pre-1984 Act case law in interpreting these provisions? John, did the courts use the regulations’ definition of a life insurance company?

John Adney: Yes they did, Peter. By way of example, in deciding whether credit life insurance companies should be taxed as life insurers under part I of Subchapter L, the courts looked to a construction of the Code and the Treasury regulations rather than simply the companies’ status under state law. In United States v. Consumer Life Insurance Co., the Supreme Court focused on the reserves and risks assumed by the taxpayer as reinsurer of credit life coverage. The Court conducted a detailed examination of the statutory rules and the regulations, leading it to reject the IRS contention that “reserves follow the risk” and to uphold the taxpayer’s treatment as a part I life insurance company. Part I treatment also was upheld in the oft-cited decision in Alinco Life Insurance Co. v. United States. In that case, the Court of Claims cited the regulations chapter and verse to turn aside a broad-based government attack on Alinco’s tax treatment, a contention premised on the point that under pre-1959 Act law, the insurer could operate largely tax-free. Yet another credit life decision in the taxpayer’s favor was Central National Life Insurance Co. v. United States.