107 T.C. 363 (T.C. 1996), 4694-94, The North West Life Assurance Company of Canada v. Commissioner of Internal Revenue

Docket Nº:4694-94
Citation:107 T.C. 363, 107 T.C. No. 19
Opinion Judge:HAMBLEN, Judge:
Party Name:THE NORTH WEST LIFE ASSURANCE COMPANY OF CANADA, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Attorney:Jerome B. Libin, James V. Heffernan, Richard J. Safranek, and Steven M. Sobell, for petitioner. [1] Gary D. Kallevang, Diane D. Helfgott, Charles M. Ruchelman, Elizabeth U. Karzon, George Soba, and Sharon J. Bomgardner, for respondent.
Judge Panel:HAMBLEN, Judge; COHEN, CHABOT, JACOBS, GERBER, PARR, WELLS, WHALEN, BEGHE, LARO, and VASQUEZ, JJ., agree with this majority opinion. CHIECHI, J., did not participate in the consideration of this opinion. HALPERN, J., concurring; RUWE, J., dissenting; SWIFT, COLVIN, FOLEY, and GALE, JJ., agree wit...
Case Date:December 12, 1996
Court:United States Tax Court
 
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Page 363

107 T.C. 363 (T.C. 1996)

107 T.C. No. 19

THE NORTH WEST LIFE ASSURANCE COMPANY OF CANADA, Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 4694-94

United States Tax Court

December 12, 1996

Decision will be entered for petitioner.

SYLLABUS

P, a Canadian insurance company, operated through a permanent establishment in the United States for purposes of the income tax convention between the United States and Canada. P reported its net investment income effectively connected with its conduct of an insurance business within the United States pursuant to sec. 842(a), I.R.C., without regard to the minimum amount of net investment income that sec. 842(b), I.R.C., treated as effectively connected. P claimed under the Convention With Respect to Taxes on Income and on Capital, Sept. 26, 1980, U.S.-Can., T.I.A.S. No. 11087, 1986-2 C.B. 258 (Canadian Convention), to be exempt from sec. 842(b), I.R.C. Held, art. VII(2) of the Canadian Convention requires that profits attributed to a permanent establishment be measured based on the permanent establishment's facts and by reference to the establishment's separate accounts insofar as those accounts represent the real facts of the situation. Held, further, sec. 842(b), I.R.C. in prescribing a statutory minimum amount of net investment income that must be treated as effectively connected with the conduct of P's insurance business within the United States, fails to attribute profits to P's permanent establishment based on the establishment's facts. Held, further, sec. 842(b), I.R.C. fails to attribute profits by the same method each year. Held, further, pursuant to art. VII(2) of the Canadian Convention, P is taxable under subch. L, part I on its income effectively connected with its conduct of any trade or business within the United States without regard to sec. 842(b), I.R.C.

Jerome B. Libin, James V. Heffernan, Richard J. Safranek, and Steven M. Sobell, for petitioner. [1]

Gary D. Kallevang, Diane D. Helfgott, Charles M. Ruchelman, Elizabeth U. Karzon, George Soba, and Sharon J. Bomgardner, for respondent.

HAMBLEN, Judge; COHEN, CHABOT, JACOBS, GERBER, PARR, WELLS, WHALEN, BEGHE, LARO, and VASQUEZ, JJ., agree with this majority opinion. CHIECHI, J., did not participate in the consideration of this opinion. HALPERN, J., concurring; RUWE, J., dissenting; SWIFT, COLVIN, FOLEY, and GALE, JJ., agree with this dissent.

OPINION

Page 364

HAMBLEN, Judge:

Respondent determined deficiencies in petitioner's Federal income and branch profits tax for the taxable years 1988, 1989, and 1990, in the amounts of $ 518,102, $ 23,730, and $ 71,662, respectively.

Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the taxable years at issue, and all Rule references are to the Tax Court Rules of Practices and Procedure. The sole issue for decision is whether the Convention and Protocols Between the United States and Canada with Respect to Taxes on Income and Capital, Sept. 26, 1980, T.I.A.S. No. 11087 (effective August 16, 1984), 1986-2 C.B. 258 (Canadian Convention), override section 842(b), which requires a foreign company conducting an insurance business in the United States to treat a minimum amount of net investment income as effectively connected

Page 365

with its conduct of that business. For the reasons set forth below, we hold that article VII of the Canadian Convention, 1986-2 C.B. at 260, overrides section 842(b).

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly. The stipulation of facts and accompanying exhibits are incorporated herein by this reference. The facts found are those which, unless otherwise specified, existed during the years at issue.

A. Petitioner

The North West Life Assurance Co. of Canada (petitioner) is a life insurance company organized under the corporation laws of Canada with its principal place of business located in Vancouver, British Columbia, Canada. Petitioner operates its life insurance business solely in the United States and Canada and is in the business of writing deferred annuities and life insurance policies. Petitioner began operating in the United States (U.S. branch) in 1971, selecting the State of Washington as its State of entry and subjecting itself to the insurance laws of that State and to regulation by that State's insurance commissioner. Petitioner maintains a sales and underwriting office in Bellevue, Washington. In addition, petitioner is licensed to transact business as a life insurance company in 20 other States.

Petitioner's U.S. branch uses a calendar year accounting period and the accrual method of accounting. Petitioner timely filed its Federal income tax returns (Forms 1120L) for tax years 1988, 1989, and 1990.

B. Petitioner's Product Mix

Petitioner's U.S. branch operates primarily in the " section 403(b) market", selling individual deferred annuities to school teachers. Petitioner has the following product mix, measured by its reserves, during the years at issue:

Page 366

United States
Individual Annuities Individual Life Policies
1988 97.00% 3.00%
1990 95.60 4.40
Canada
Individual Annuities Individual Life Policies
1988 64.73% 35.27%
1990 68.44 31.56

Petitioner's U.S. branch sold these products in the United States, and petitioner's principal office in Vancouver sold them in Canada. C. Pricing of Products Each of petitioner's annuity contracts includes an accumulation period and a payout period. During the accumulation period, petitioner collects the premiums on its annuity contracts (accumulation annuities). Petitioner does not charge fixed premiums; rather, the annuity holders pay in as much as they desire. Petitioner invested the collected premiums and guarantees its U.S. annuity holders, on a yearly basis, a specific rate of return (one-year rate guarantees). Petitioner makes primarily 5-year interest rate guarantees to its Canadian annuity holders. Petitioner's annuity holders are able to withdraw the accumulated funds from petitioner once annually during the accumulation period. These withdrawals are subject to surrender charges. The surrender charges are reduced during the first 5 to 10 years of each annuity contract's existence but are always eliminated before the payout period begins. During the payout period, petitioner pays the annuity holders fixed periodic payments over the remainder of the annuitant's life or over a specified number of years (payout annuities). Once the payout period begins, petitioner does not permit early withdrawals. Page 367 D. Investment Strategy Mr. Arthur W. Putz, vice president of investments and secretary of petitioner, is primarily responsible for handling the administrative details of petitioner's investment activity. Donald R. Francis, executive vice president and appointed actuary of petitioner, is primarily responsible for providing actuarial services to petitioner's life insurance business. As part of its investment strategy for its U.S. operations, petitioner sought to avoid the risk of fluctuations in currency-exchange and interest rates. Petitioner avoids currency-exchange risk by investing in assets in the same currencies as its insurance liabilities. Petitioner attempts to reduce its interest-rate risk by matching the duration of its assets with the maturity of its liabilities. Washington State law allows an insurance company to invest up to 65 percent of its portfolio in mortgages. Wash. Rev. Code Ann. sec. 48.13.265 (West Supp. 1990). Petitioner invested between 58 percent and 63 percent of its portfolio in mortgages during the years at issue. In order to match its investments in mortgages with the 1-year rate guarantees on its annuities and also enjoy a relatively high return from such investments, petitioner purchases mortgages with 5-year maturities, with a right of renewal for another 5 years at market-adjusted interest rates. The average duration of these mortgages is approximately 2 1/2 years. Because petitioner's 5-year mortgages are longer than the 1-year rate guarantees, part of petitioner's strategy is to balance its portfolio by also investing in assets with a duration shorter than its liabilities. Petitioner makes longer-term investments in assets backing both its individual life insurance policies and payout annuities than it does in assets supporting its accumulation annuities. Petitioner's accumulation annuities comprise approximately 99 percent of petitioner's annuity contracts arising from its U.S. branch and approximately 50 percent of the contracts arising from its Canadian office. E. Flow of Funds Petitioner collects premiums arising from its U.S. branch business in U.S. currency (U.S. dollars). Upon receipt, for administrative convenience, petitioner transfers the premium payments into a U.S. dollar-denominated account with Page 368 Toronto-Dominion Bank in Vancouver, British Columbia (Toronto bank). The Toronto bank pays nominal interest on balances in the account in excess of $ 250,000. Washington State law requires foreign insurance companies to maintain a trust account (trusteed assets) in order to qualify to transact insurance in the State. Wash. Rev. Code Ann. sec. 48.05.090 (West Supp. 1990). Petitioner maintains a trust account and an operating account at Seattle First National Bank in Seattle, Washington (Seattle bank). Periodically, petitioner transfers the premiums and interest from the Toronto bank account to the Seattle bank accounts. Petitioner transfers the majority of such funds to the trust account and the...

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