Latest IRS Industry Director Directive on the DRD For Life Insurance Separate Accounts May Resolve Main Issue, But Does it Raise Others?

For several years the life insurance industry and the Internal Revenue Service (“the Service”) have conducted a vigorous dialogue about how to compute the company’s share of net investment income from segregated asset accounts underlying variable contracts. The industry has contended that the company should use the prior-law formula set forth in Treas. Reg. § 1.801-8(e) (“the Regulation”) as guidance for determining another appropriate rate to calculate required interest for separate account reserves; the Service generally has not agreed. The specific focus of this dialogue has been the determination of the company’s share of dividends qualifying for the dividends received deduction (“DRD”). The context for this back-and-forth discussion has included the Service’s examinations of taxpayers, administrative Appeals proceedings, and the process of issuing published guidance by the Service and the Department of the Treasury (“Treasury”). For example, initial Service guidance in the form of Technical Advice Memoranda favored use of the prior-law formula of the Regulation, until Rev. Rul. 2007-54, 2007-2 C.B. 604, came to a contrary conclusion, but the Ruling was suspended by Rev. Rul. 2007-61, 2007-2 C.B. 799, in response to industry criticism.

There are signs the dialogue is working toward a conclusion. Beginning in early May of this year, taxpayers began hearing that the IRS Appeals Division is prepared to concede the issue. Then, on May 20, 2010, Walter Harris, the IRS Industry Director for Financial Services, issued an Industry Director Directive (LMSB Control No.:LMSB-4-0510-015) regarding the examination of the DRD in connection with separate accounts of life insurance companies. The May 20 Directive (in tax jargon, an “IDD”) appears to adopt the industry position, although notably the Directive does not use the word “concede,” and so its message is less clear than it could be.

The May 20 Directive is a revised version of an IDD with the same control number that was issued on May 17, 2010. The two key clarifications of the revised Directive are significant. First, in the “Discussion” section, the May 20 Directive adds a sentence to affirm, “With respect to calculating the company’s share of a separate account’s net investment income, Treas. Reg. § 1.801-8(e) sets forth a formula to be used in computing required interest at ‘another appropriate rate.’ See TAM 200038008 (June 13, 2000) and TAM 200339049 (Aug. 20, 2002).” Second, in the “Risk Analysis” section, in advising agents that the DRD issue should be raised if the company uses a method for computing the company’s share of investment income that is inconsistent with section 812 and Treas. Reg. § 1.801-8(e), the Directive now refers to “ Treas. Reg. § 1.801-8(e) (as illustrated by TAM 200038008 and TAM 200339049).” Thus, the May 20 Directive acknowledges that the two TAMs properly apply the formula of the Regulation to determine another appropriate rate for calculating required interest for separate account reserves and for computing the company’s share of a separate account’s net investment income.