Colonial American Life Insurance Company v. Commissioner of Internal Revenue
| Decision Date | 15 June 1989 |
| Docket Number | No. 88-396,88-396 |
| Citation | 109 S.Ct. 2408,491 U.S. 244,105 L.Ed.2d 199 |
| Parties | COLONIAL AMERICAN LIFE INSURANCE COMPANY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE |
| Court | U.S. Supreme Court |
Insurance companies commonly enter into reinsurance agreements, whereby the reinsurer pays the primary insurer, or "ceding company," an up-front fee—a "ceding commission"—and agrees to assume the ceding company's liabilities on the reinsured policies in return for the future income generated from the policies and their associated reserve accounts. Under an "assumption" reinsurance agreement, the reinsurer steps into the ceding company's shoes, becoming directly liable to the policyholders and receiving all premiums directly. In contrast, under an indemnity reinsurance agreement, the reinsurer assumes no direct liability, instead reimbursing the ceding company for a specified percentage of the claims and expenses attributable to the risks that have been insured and receiving a like percentage of the premiums generated by the insurance of those risks. In 1975 and 1976, petitioner entered into four indemnity reinsurance agreements on life insurance policies written by Transport Life Insurance Company, the ceding company, agreeing to pay Transport ceding commissions. Sections 801-820 of the Internal Revenue Code which relate to life insurance companies—do not specifically address the tax treatment of indemnity reinsurance ceding commissions. On its income tax returns for the years in question, petitioner claimed deductions for the full amount of the commissions. Respondent Commissioner of Internal Revenue disallowed the deductions on the ground that the commissions had to be capitalized and amortized over the useful life of the reinsurance agreements, a 7-year period, but the Tax Court reversed. The Court of Appeals, in turn, reversed, holding that ceding commissions are not currently deductible. It reasoned that since they represent payments to acquire an asset within an income producing life that extends substantially beyond one year, the payments must be amortized over the estimated life of the asset.
Held: Ceding commissions paid under an indemnity reinsurance agreement must be amortized over the anticipated life of the agreement. Pp. 249-260.
(a) Such commissions represent an investment in the future income stream from the reinsured policies and, as such, should be treated in the same manner as commissions involved in assumption reinsurance, which must be capitalized and amortized. See 26 CFR § 1.817-4(d). This analogy is appropriate since none of the differences between indemnity and assumption reinsurance goes to the function and purpose of ceding commissions. Whether the reinsurer assumes direct liability to the policyholder in no way alters the commissions' economic role. Less compelling is petitioner's analogy to agents' commissions incurred by a life insurance company in issuing directly written insurance, which are currently deductible as ordinary and necessary business expenses under § 809(d)(2). The agent's commission in a direct insurance setting is an administrative expense—akin to a salary and other sales expenses of writing new policies—to remunerate a third party who helps facilitate the same, whereas the payment in the reinsurance setting is for the asset sold by the ceding company rather than for services. Even accepting that petitioner's analogy were true, this would not undermine the basic character of ceding commissions as capital expenditures, but would, at most, prove that Congress decided to carve out an exception for agents' commissions, notwithstanding their arguable character as capital expenses. This Court will not extend such an exception to other capital expenditures where Congress has not so provided. Pp. 249-253.
(b) No Code provision requires that the commissions in question be currently deductible. They are not ordinary and necessary business expenses under § 809(d)(12). Nor does § 818(a) which requires life insurance companies to compute their taxes in accordance with the accounting procedures of the National Association of Insurance Commissioners (NAIC) for preparing an annual statement, except when such procedures would be inconsistent with accrual accounting rules—authorize current deduction even though NAIC prescribes such treatment of ceding commissions. NAIC's practice is inconsistent with accrual accounting rules, which require that capital expenditures be amortized. Moreover, petitioner's reading of § 818(a) is unduly expansive, since it is inconceivable that Congress intended to delegate to the insurance industry the core policy determination whether an expense is a capital outlay or a business expense. Ceding commissions also are not "return premiums, and premiums and other consideration arising out of reinsurance ceded," which § 809(c)(1) permits a company to exclude from the gross premiums included in its tax base, thereby reducing its taxable income. Such commissions—which are up-front, one-time payments to secure a share in a future income stream and bear no resemblance to premiums—fall well outside § 809(c)(1)'s intended purpose, which is to except from the general definition of premium income a small, residual category of payments that resemble premiums but, because they in fact never really accrued to the company that nominally receives them, do not fairly represent income to the recipient. Petitioner's reading of § 809(c)(1) is highly implausible since it is unlikely that Congress would have subsumed a major deduction within the fine details of its definition of premium income rather than including it with the other deductions discussed in § 809(d). Pp. 253-260.
843 F.2d 201 (CA5 1988), affirmed.
Carolyn P. Chiechi, Washington, D.C., for petitioner.
Michael R. Dreeben, Washington, D.C., for respondent.
The arcane but financially important question before us is whether ceding commissions paid by a reinsurance company to a direct insurer under a contract for indemnity reinsurance are fully deductible in the year tendered or instead must be amortized over the anticipated life of the reinsurance agreements.
This case involves the workings of the reinsurance industry. In order to spread the risks on policies they have written or to reduce required reserves, insurance companies commonly enter into reinsurance agreements. Under these agreements, the reinsurer pays the primary insurer, or "ceding company," a negotiated amount and agrees to assume the ceding company's liabilities on the reinsured policies. In return, the reinsurer receives the future income generated from the policies and their associated reserve accounts.
Reinsurance comes in two basic types, assumption reinsurance and indemnity reinsurance. In the case of assumption reinsurance, the reinsurer steps into the shoes of the ceding company with respect to the reinsured policy, assuming all its liabilities and its responsi ility to maintain required reserves against potential claims. The assumption reinsurer thereafter receives all premiums directly and becomes directly liable to the holders of the policies it has reinsured.
In indemnity reinsurance, which is at issue in this case, it is the ceding company that remains directly liable to its policyholders, and that continues to pay claims and collect premiums. The indemnity reinsurer assumes no direct liability to the policyholders. Instead, it agrees to indemnify, or reimburse, the ceding company for a specified percentage of the claims and expenses attributable to the risks that have been reinsured, and the ceding company turns over to it a like percentage of the premiums generated by the insurance of those risks.
Both the assumption and the indemnity reinsurer ordinarily pay an up-front fee, known as a "ceding commission," to the ceding company.1 The issue in this case is whether ceding commissions for indemnity reinsurance may be deducted by the reinsurer in the year in which they are paid, or whether they must be capitalized over the estimated life of the underlying policies. Petitioner writes and reinsures life, accident, and health insurance. In 1975 and 1976, petitioner entered into four indemnity reinsurance agreements to rein- sure blocks of life insurance policies written by Transport Life Insurance Company, the ceding company. The agreements required petitioner to indemnify Transport for 76.6% of Transport's liabilities under the block of reinsured policies.2 Petitioner also contracted to pay ceding commissions of $680,000 for the 1975 pair of agreements and $852,000 for the 1976 pair of agreements. In addition, petitioner paid Transport a "finder's fee" of $13,600 in 1975, which the parties agree is subject to the same tax treatment as the ceding commissions.
On its federal income tax returns for 1975 and 1976, petitioner claimed deductions for the full amount of the ceding commissions and the finder's fee. The Commissioner disallowed the deductions, concluding that the ceding commissions and finder's fee had to be capitalized and amortized over the useful life of the reinsurance agreements, a period later stipulated to be seven years. Petitioner then filed for review in the Tax Court, which agreed with petitioner that the ceding commissions could be deducted in full in the year of payment.
The Court of Appeals for the Fifth Circuit reversed, holding that ceding commissions are not currently deductible. 843 F.2d 201 (1988). The Court of Appeals reasoned that ceding commissions represent payments to acquire an asset with an income producing life that extends substantially beyond one year, and that under fundamental principles of taxation law,...
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