American Mutual Insurance v. U.S.

• Decision Date: 03 October 2001
• Docket Number: No. 00-5078,00-5078
• Citation: 267 F.3d 1344
• Parties: (Fed. Cir. 2001) AMERICAN MUTUAL LIFE INSURANCE COMPANY AND SUBSIDIARIES, Plaintiff-Appellant, v. UNITED STATES, Defendant-Appellee
• Court: U.S. Court of Appeals — Federal Circuit

Page 1344

267 F.3d 1344 (Fed. Cir. 2001)

AMERICAN MUTUAL LIFE INSURANCE COMPANY AND SUBSIDIARIES, Plaintiff-Appellant, v. UNITED STATES, Defendant-Appellee.

No. 00-5078

United States Court of Appeals for the Federal Circuit

October 3, 2001

Appealed from: United States Court of Federal Claims Chief Judge Lawrence M. Baskir

Norman Sinrich, Kostelanetz & Fink, LLP, of New York, New York, argued for plaintiff-appellant. With him on the brief was Nancy W. Pierce. Of counsel was Judy Kramer.

David I. Pincus, Attorney, Tax Division, Department of Justice, of Washington, DC, argued for defendant-appellee. With him on the brief were Paula M. Junghans, Acting Assistant Attorney General; and Edward T. Perelmuter, Attorney.

Before BRYSON, GAJARSA and LINN, Circuit Judges.

GAJARSA, Circuit Judge.

DECISION

American Mutual Life Insurance Co. ("American Mutual") appeals from a grant of summary judgment by the United States Court of Federal Claims finding that income resulting from releases in life insurance reserves was required to be included as taxable income because the tax benefit rule is unavailable where the event, in this case the releases, does not meet the "fundamental inconsistency" test and where the taxpayer receives a tax benefit. Am. Mut. Life Ins. Co. v. United States, 46 Fed. Cl. 445 (2000). For the reasons discussed below, we affirm.

BACKGROUND

The tax benefit rule, codified in part as section 111 of the Internal Revenue Code of 1986 ("the Code"), was established to ensure that if a taxpayer takes a deduction attributable to a specific event, and the amount is recovered in a subsequent year, income tax consequences of the later event depend in some degree on the prior related tax treatment. Hillsboro Nat'l Bank v. Comm'r, 460 U.S. 370, 380-82 (1983). For certain types of events, when the deduction and recovery occur in the same tax year, taxpayers are typically able to offset the tax consequences of the deduction against those associated with the recovery. Where the recovery occurs in a different tax year, the "inclusionary" aspect of the rule, or alternatively, a provision of the Code, may require the recovery to be taken into taxable income. The "exclusionary" aspect of the rule may limit the inclusion if the "exclusionary" aspect applies. Id. at 379 n.8.

The "inclusionary" aspect of the rule enables the government to tax as income an amount recovered in a later year corresponding to an event for which a deduction was taken by the taxpayer in an earlier year. For instance, a taxpayer might write off a bad debt as a loss and take a deduction in that year. Should the taxpayer recover that amount in a later tax year, the taxpayer would receive that income tax-free were it not for the rule. Thus, the rule prevents the taxpayer from receiving a windfall by deeming the recovery to be taxable income.

The "exclusionary" component of the rule permits a taxpayer to exclude from deemed income amounts recovered. Where deductions taken in earlier tax years, including those associated with life insurance reserve increases, result in no tax benefit, taxpayers may be entitled to exempt from deemed income funds recovered in a later tax year.

In accordance with state law, each time a life insurance company issues a policy it must allocate a sufficient amount to a reserve to pay the benefits should the policy come due. Until adequately funded pursuant to actuarial determinations, the reserve amount increases each year. Additions to reserves contribute to deductions while annual decreases in reserves are added to income.

As the Court of Federal Claims indicated in its decision, pursuant to the Internal Revenue Code of 1954, as amended by the Life Insurance Company Income Tax Act of 1959, Subchapter L, investment income was taxed differently from underwriting income (which includes, inter alia, premiums on life insurance policies). Taxes were assessed against the lesser of the underwriting income and investment income. Sec. 802(b). Where underwriting income exceeded investment income, the previous version of the Code, 26 U.S.C. § 802 (1954) (amended 1959), imposed a tax on the net investment income (less a standard deduction of $250,000), and taxed 50% of underwriting income that exceeded the investment income. Sec. 802(b).

A specific, detailed and comprehensive formula was used to determine the impact reserve increases had on taxable income. Suffice it to say that, because an increase in reserves resulted in a decrease in investment income, the full amount of reserve increases operated as a deduction, although the effect of the calculation could mean that each dollar deducted reduced income by a fraction of a dollar. Sec. 804 and 805. Further, full reserves, that is, the aggregate reserves for the current year and all unreleased reserves for prior years, contributed to the calculation of the deduction.

At that time, the Code listed several deductions against underwriting income that may have been taken by life insurance companies, including reserve increases and dividends paid to policyholders. The dividends-paid deduction was limited to the amount that underwriting income exceeded taxable investment income. Once underwriting income was reduced to parity with investment income, dividend deductions had no tax effect. Section 809(b)-(d); Am. Mut., 46 Fed. Cl. at 449.

During the tax years 1962 through 1978, and again in 1981, American Mutual experienced aggregate net reserve increases. Throughout the 1962-1981 period, American Mutual was taxed only on its investment income because the reserve-based deductions reduced underwriting income to the level of investment income. Before the Court of Federal Claims, American Mutual conceded that it had a repeated tax benefit from each year's net additions to reserves. The parties dispute the size of that benefit, but agree that it was more than zero, if not a full dollars worth, for each dollar of reserve increase.

American Mutual argued below that it received an insufficient tax benefit from reserve increases in the years 1962-1981. In accordance with the tax benefit rule, American Mutual argued that an amount of reserve releases generated in later tax years, equal to the amount for which the reserve increases led to no tax benefit, should be excluded from income. It estimates the excluded amounts as $12 million in 1988 and $10 million in 1989.

American Mutual argued that it received no tax benefit from the reserve deductions it took. It maintained that to determine accurately whether the reserve increases in a previous year had any tax benefit, underwriting income must be recalculated as though there were no deductions for the reserve increases actually taken. Substituting previously unused dividend deductions for the reserve deductions taken, to the extent, it argues, the Code permitted, American Mutual recalculated its underwriting income. Given such calculations, it concluded that its underwriting income remained the same and that the reserve increase deductions conferred no tax benefit. Therefore, American Mutual argued, the corresponding reserve releases in later tax years should not have been taxed as income.

The Court of Federal Claims determined that American Mutual's underwriting income in these years fell to the level of the investment income as a direct result of the deductions for reserve increases that American Mutual took against underwriting income. The court noted that American Mutual's tax returns showed that it deducted every dollar of its reserve increases, and still had "excess" underwriting income that was further reduced by dividend deductions. Accordingly, the court concluded that American Mutual took full deductions for its reserve increases.

The court concluded that because the reserve deductions reduced American Mutual's taxable income, the reserve deductions did indeed confer a tax benefit. Had there been no change in taxable income, the court suggested that American Mutual's argument would have merit. Because American Mutual realized a tax benefit for each dollar deducted, the court concluded that the tax benefit rule does not apply to American Mutual's reserve increases.

American Mutual further argued that in accordance with the language of the exclusionary aspect of the tax benefit rule, as articulated in the Code, it is entitled to recover the amounts for which the deductions failed to yield a full dollar-for-dollar benefit. The rule, codified at I.R.C. § 111(a), provides: "[g]ross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter" (emphasis added). American Mutual argued that the "to the extent" language mandates that taxpayers receive full value for deductions taken where such amounts are later recovered.

Interpreting the phrase "to the extent" to modify "reduce," and not to modify "amount of tax," the Court of Federal Claims concluded that the statute provides that once a deduction reduces taxable income by any amount, the rule becomes inapplicable. Thus, the court rejected American Mutual's contention that the deductions taken with respect to the reserve increases conferred no tax benefit.

Furthermore, the court determined that American Mutual received a full dollar's worth of reduction in underwriting income for each dollar deducted. The court found that American Mutual employed the deductions for reserve increases to decrease its underwriting income to the point that it fell to the level of the investment income. Thus, the court concluded that American Mutual received the full benefit from reserve deductions taken in accordance with the 1959 Act, and would not be entitled to additional benefits even if the rule were to be applied.

The Court of Federal Claims rejected American Mutual's claim for relief on the additional basis that the tax benefit rule does...