Atlantic Mut. Ins. Co. v. C.I.R.

• Citation: 111 F.3d 1056
• Decision Date: 24 April 1997
• Docket Number: No. 96-7424,96-7424
• Parties: -2272, 97-1 USTC P 50,376 ATLANTIC MUTUAL INSURANCE COMPANY, and Includible Subsidiaries v. COMMISSIONER OF INTERNAL REVENUE, Appellant.
• Court: United States Courts of Appeals. United States Court of Appeals (3rd Circuit)

Page 1056

111 F.3d 1056

79 A.F.T.R.2d 97-2272, 97-1 USTC P 50,376

ATLANTIC MUTUAL INSURANCE COMPANY, and Includible Subsidiaries v. COMMISSIONER OF INTERNAL REVENUE, Appellant.

No. 96-7424.

United States Court of Appeals Third Circuit.

Argued March 13, 1997.

Decided April 24, 1997.

John S. Breckinridge, Jr. (argued), James H. Kenworthy, LeBoeuf, Lamb, Greene & MacRae, New York City, Frederick B. Lacey, LeBeouf, Lamb, Greene & MacRae, Newark, NJ, for Appellee.

Gary R. Allen, David I. Pincus, Edward T. Perelmuter (argued), Loretta C. Argrett, Assistant Attorney General, United States Department of Justice, Tax Division, Washington, D.C., for Appellant.

Before: MANSMANN and LEWIS, Circuit Judges, and MICHEL, Circuit Judge. ^*

OPINION OF THE COURT

MANSMANN, Circuit Judge.

In this appeal, we address the "fresh start" provision of section 1023(e)(3) of the Tax Reform Act of 1986. There Congress permitted property & casualty insurers a one-time forgiveness of income resulting from the change in computing "losses incurred deductions" from undiscounted to a discounted basis as mandated by newly enacted section 846 of the Internal Revenue Code. Specifically, the Commissioner challenges the decision of the Tax Court which invalidated Treas.Reg. § 1.846-3(c) to the extent that it defines all additions to a property & casualty insurer's loss reserves as "reserve strengthening."

We find that the meaning of the term "reserve strengthening" in section 1023(e)(3)(B) of the Tax Reform Act of 1986 is ambiguous. We thus turn to the legislative history to determine Congress' intent. Utilizing the deference principles of Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 104 S.Ct. 2778, 81 L.Ed.2d 694 (1984), we conclude that Treas.Reg. § 1.846-3(c) is based on a permissible construction of the Act and implements the intent of Congress in some reasonable manner. Accordingly, we will reverse the decision of the Tax Court.

I.

The statutory provision at issue is section 1023 of Pub.L. No. 99-514, 100 Stat. 2085, 2399, of the Tax Reform Act of 1986 (TRA 1986), which added new section 846 of the Internal Revenue Code. In enacting section 846, Congress included two relief provisions--the "transition rule" and the "fresh start"--to facilitate a smooth transition to the new rules. Atlantic Mutual Insurance Co. v. Commissioner, 71 T.C.M. (CCH) 2154, 2156, 1996 WL 74797 (1996). The transition rule, set forth in section 1023(e)(2) of TRA 1986, provided that for purposes of computing the losses incurred deduction for 1987, the year-end 1986 reserves would be discounted. ¹ Absent this relief provision, section 846 would have required property & casualty ("P & C") insurers to compare undiscounted 1986 reserves with discounted 1987 reserves for purposes of computing their losses incurred deductions for 1987. As the Tax Court explained, "Such an 'apples-to-oranges' comparison would have significantly reduced the losses incurred deduction for the 1987 tax year." Id.

Notwithstanding the relief provided by the transition rule, P & C insurers were still obligated to include in their 1987 taxable income the excess of the undiscounted year-end 1986 loss reserves over the discounted year-end 1986 loss reserves, due to the application of I.R.C. § 481. ² To avoid the application of section 481, Congress allowed P & C insurers a one-time "forgiveness" of income under the "fresh start" provision of section 1023(e)(3) of TRA 1986. That section provides:

(3) Fresh Start.--

(A) In General.--Except as otherwise provided in this paragraph, any difference between--

(i) the amount determined to be the unpaid losses and expenses unpaid for the year preceding the 1st taxable year of an insurance company beginning after December 31, 1986, determined without regard to paragraph (2), [i.e., without discounting] and

(ii) such amount determined with regard to paragraph (2) [i.e., with discounting],

shall not be taken into account for purposes of the Internal Revenue Code of 1986.

In substance, the fresh start rule overrides section 481 by excluding from taxable income the difference between the amount of the year-end 1986 undiscounted loss reserves and the discounted amount of such reserves.

Congress anticipated, however, the potential for abuse created by the fresh start provision--that insurers could manipulate the fresh start provision by inflating their reserves. To prevent such abuse, Congress enacted section 1023(e)(3)(B) to exclude any increases in loss reserves due to "reserve strengthening." Section 1023(e)(3)(B) provides:

(B) RESERVE STRENGTHENING IN YEARS AFTER 1985.--Subparagraph (A) shall not apply to any reserve strengthening in a taxable year beginning in 1986, and such strengthening shall be treated as occurring in the taxpayer's 1st taxable year beginning after December 31, 1986.

The meaning of the term "reserve strengthening," as used in section 1023(e)(3)(B), lies at the heart of the controversy before us. We turn now to the particular facts of this case.

II.

The parties fully stipulated to the following facts before the United States Tax Court. Atlantic Mutual Insurance Co. (Atlantic) is the common parent of an affiliated group of corporations whose principal place of business is located in Madison, New Jersey. Organized in 1842 under the laws of the State of New York as a mutual marine insurer, Atlantic eventually expanded its insurance underwriting activities to include property & casualty insurance. Centennial Insurance Company, a wholly owned subsidiary of Atlantic, is a P & C insurance company included in Atlantic's consolidated income tax return. The Commissioner's notice of deficiency relates to the activities of both Atlantic and Centennial (collectively the "taxpayer").

From 1985 through 1993, the taxpayer filed annual financial statements with the appropriate state insurance departments. ³ P & C insurers are required to report estimates of amounts they expect to pay for losses that have already occurred on the annual statement. These estimates are commonly referred to as "loss reserves" (or simply "reserves").

For the years in issue, case reserves constituted the majority of the taxpayer's loss reserves. ⁴ The taxpayer set up its case reserves by assigning a claims adjuster to examine each reported claim and to estimate the amount, if any, that would be paid to resolve it. For all years at issue, the taxpayer's case reserves totalled $255,655,141 at year-end 1985 and $277,705,661 at year-end 1986.

The Commissioner tested for "reserve strengthening" by applying the formula set forth in Treas.Reg. § 1.846-3(c)(3) to each of the taxpayer's lines of P & C insurance for pre-1986 accident years. Under the formula, the taxpayer's reserves at year-end 1985 were reduced by the claims and the loss adjustment expense (LAE) paid in 1986 with respect to those reserves. To the extent that, at year-end 1986, a reserve was greater than the amount determined under the formula, the excess was treated as a net increase to that reserve account (i.e., "reserve strengthening"). Where, at year-end 1986, a reserve was less than the amount determined under the formula, the difference was treated as a net decrease to that reserve account (i.e., "reserve weakening").

The Commissioner determined that, at year-end 1986, the taxpayer's net "reserve strengthening" totalled $6,552,739. Pursuant to I.R.C. § 846, the Commissioner then discounted the $6,552,739, resulting in an understatement of the taxpayer's 1987 income of $1,339,039. The Commissioner further determined that this understatement caused a deficiency of $519,987 in the taxpayer's 1987 income tax liability and, accordingly, issued a Notice of Deficiency on September 23, 1993. In response, the taxpayer petitioned the Tax Court for a redetermination of the deficiency.

After considering all of the evidence, the Tax Court, on February 22, 1996, issued its decision concluding that the taxpayer was not liable for the asserted deficiency. In reaching this conclusion, the Tax Court held the taxpayer's reserve increases did not constitute "reserve strengthening." Atlantic Mutual, 71 T.C.M. at 2159. The Tax Court found that the doctrine of stare decisis obligated it to reach the same result as that obtained in Western National Mutual Ins. Co. v. Commissioner, 102 T.C. 338, 1994 WL 60382 (1994), aff'd 65 F.3d 90 (8th Cir.1995), which the court found to be factually indistinguishable from this case. The Commissioner filed this timely appeal.

We have jurisdiction pursuant to 26 U.S.C. § 7482(a) and we exercise plenary review over a legal challenge to the validity of a treasury regulation. Tate & Lyle, Inc. v. Commissioner, 87 F.3d 99, 102 (3d Cir.1996) (citing Mazzocchi Bus Co., Inc. v. Commissioner, 14 F.3d 923, 927 (3d Cir.1994)).

III.

Initially, we must determine whether the meaning of "reserve strengthening" is clear from the plain language of section 1023(e)(3)(B). Our review of an agency's interpretation of a statute that it is empowered to administer is guided by the well-established principles of Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837, 104 S.Ct. 2778, 81 L.Ed.2d 694 (1984); see also, Appalachian States Low- Level Radioactive Waste Commission v. O'Leary, 93 F.3d 103, 108 (3d Cir.1996). The two-step inquiry in Chevron requires us to first determine "whether Congress has directly spoken to the precise question at issue." 467 U.S. at 842, 104 S.Ct. at 2781. If the intent of Congress is clear from the plain language of the statute, then our inquiry ends there. If we conclude, however, that Congress is silent or the statute is ambiguous regarding the issue, then the second step of our inquiry is to determine whether the agency's interpretation is based on a permissible construction of the statute. Id. at 843, 104 S.Ct. at 2781-82.

Addressing the first prong of Chevron, we turn to the plain language of section 1023(e)(3)(B...