Liberty Nat. Life Ins. Co. v. U.S.

• Decision Date: 13 August 1979
• Docket Number: No. 77-1578,77-1578
• Citation: 600 F.2d 1106
• Parties: 79-2 USTC P 9527 LIBERTY NATIONAL LIFE INSURANCE COMPANY, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 1106

600 F.2d 1106

79-2 USTC P 9527

LIBERTY NATIONAL LIFE INSURANCE COMPANY, Plaintiff-Appellee, v. UNITED STATES of America, Defendant-Appellant.

No. 77-1578.

United States Court of Appeals, Fifth Circuit.

Aug. 13, 1979.

Gilbert E. Andrews, Act. Chief, App. Section, M. Carr Ferguson, Asst. Atty. Gen., Gary R. Allen, James E. Crowe, Attys., U. S. Dept. of Justice, Washington, D. C., Tax Div., for defendant-appellant.

Ralph B. Tate, Ira L. Burleson, Theron A. Guthrie, Jr., Birmingham, Ala., for plaintiff-appellee.

Appeal from the United States District Court for the Northern District of Alabama.

Before THORNBERRY, GOLDBERG and GEE, Circuit Judges.

THORNBERRY, Circuit Judge:

Once again ¹ we are asked to enter the "fantasy world of life insurance company accounting and taxation." Western Nat'l Life Ins. Co. v. Commissioner, 51 T.C. 824, 830 (1969). The issue we must decide is whether discounts taxpayer Liberty National Life Insurance Company gave to holders of its industrial life insurance policies who paid at least twenty-six weeks of premiums at one time were "discounts in the nature of interest" within the meaning of I.R.C. § 805(e)(3).

I.

A.

"Industrial life" insurance originated in nineteenth century England as a means of selling life insurance to the industrial workers who generally could not pay the relatively large annual premiums required by "ordinary" life policies. Three characteristics generally distinguish industrial policies from other types of life insurance. The premiums on industrial life policies are paid weekly rather than monthly or annually. The face amount of such policies is typically and, in some states, required to be less than $1,000. Last, an agent of the company collects the premium personally at the policyholder's home or place of employment. See generally, M. Davis, Industrial Life Insurance in the United States (1944). Although the weekly premiums for industrial policies are quite small, usually less than one dollar, the total premium the policyholder pays over the term of the policy is substantially higher than for an equivalent amount of ordinary life insurance.

B.

Brown-Service Insurance Company, a predecessor of taxpayer, issued burial insurance policies, which provided funeral benefits on the death of the insured. Like industrial policies, the burial policies allowed payment of premiums weekly and in small amounts. In the 1930's, however, Brown-Service began to have financial difficulties and became desperate for fund with which to pay its operating costs and claims. To obtain these funds, Brown-Service encouraged its policyholders to pay several weeks premiums in advance and granted a discount to the policyholders who did so. ² Brown-Service's practice of granting discounts became well-known and enabled the company to survive the depression. Brown-Service then began to issue industrial life policies and made the discounts available on these policies also.

In 1944, Brown-Service merged with Liberty National Life Insurance Company, the latter company surviving. Prior to the merger, Liberty National had issued industrial life insurance, but had not granted discounts. After the merger, Liberty National wished to combine the operations of the two companies and to provide services to policyholders in a uniform manner. Therefore, the surviving company adopted and formalized Brown-Service's practice by including in its own policies provisions granting a five percent discount on premiums paid twenty-six weeks in advance and a ten percent discount on premiums paid fifty-two weeks or more in advance. ³ In 1967, Liberty National eliminated this language from newly issued policies, but continued to grant the discounts to holders of these new policies as well as to the holders of policies containing such provisions.

C.

Throughout the history of the federal income tax, Congress has realized that, because of their unique financial structures, life insurance companies should not be taxed under the relatively simple formula applicable to most businesses. See Commissioner v. Standard Life & Accident Ins. Co., 433 U.S. 148, 97 S.Ct. 2523, 2526-27, 53 L.Ed.2d 653 (1977). From 1921 until 1958, Congress taxed only the investment income of life insurance companies, and did not impose any tax on amounts the companies received as premiums on outstanding policies. The 1921 Act also allowed life insurers a deduction for "(a)ll interest paid or accrued . . . on . . . indebtedness." Revenue Act of 1921, ch. 136 § 245(a)(8), 42 Stat. 227, 262. While later variations of this provision were in effect, See 8 J. Mertens, The Law of Federal Income Taxation § 44.41 (1978 rev.), two life insurance companies attempted to deduct as "interest paid" discounts they had granted on premiums paid in advance. The Commissioner disallowed these deductions and the courts affirmed, holding:

The money paid in advance by an insured to the company is not borrowed money. No indebtedness arises on the part of the company on the receipt of the money. The discount allowed is not payment for the use of borrowed money. The discounted sum received is the present value of the future amount due. The amount of the discount is the amount the company expects to earn by the use of the money before the regular due date of the premium. This amount added to the discounted value is expected to equal the amount payable on the due date had the premium not been paid in advance. This is in no sense interest on an indebtedness.

Commissioner v. Monarch Life Ins. Co., 114 F.2d 314, 326 (1 Cir. 1940), Affirming 38 B.T.A. 716 (1938); Illinois Life Ins. Co. v. Commissioner, 30 B.T.A. 1160 (1934), Aff'd on other grounds, 80 F.2d 280 (7 Cir. 1935), Rev'd on such other grounds, 299 U.S. 88, 57 S.Ct. 63, 81 L.Ed. 56 (1936). In Equitable Life Assurance Soc'y v. Commissioner, 44 B.T.A. 293 (1941), Modified and aff'd on other grounds, 137 F.2d 623 (2 Cir. 1943), Aff'd, 321 U.S. 560, 64 S.Ct. 722, 88 L.Ed. 927 (1944), however, the court found that an economically equivalent practice created an allowable deduction for interest paid. Rather than merely giving policyholders a discount on premiums paid in advance, Equitable collected premiums under a "premium deposit agreement." In this agreement, Equitable contracted to accept funds from policyholders, to supplement them with accrued interest at a specified rate, and to apply the funds and interest to the payment of premiums as they became due. The Board of Tax Appeals found that the interest Equitable paid on the premium deposits was properly deductible as interest paid on an indebtedness. 44 B.T.A. at 310.

In 1959, Congress undertook a major revision of the income tax laws affecting life insurance companies. Life Insurance Company Income Tax Act of 1959, P.L. 86-69, 73 Stat. 112 (codified at I.R.C. §§ 801-820). This revision created a three phase procedure for the taxation of such companies. See 8 J. Mertens, The Law of Federal Income Taxation § 44A.04 (1978 rev.). The total tax liability of a company is based on the sum of amounts derived under each of the three phases. Each phase is determined by comparing two types of income, "gain or loss from operations," and "taxable investment income." Gain or loss from operations is the sum of the company's income from all sources, including the company's share of investment income and premiums received, minus the expenses of operation and payment of claims and dividends to policyholders. I.R.C. § 809. In computing the gain or loss from operations, only a portion of total investment income is included. Congress recognized that life insurance companies must provide for projected liabilities to their policyholders by establishing reserves to satisfy future claims, and therefore, that any income necessary to increase these reserves should not be taxed. The Code effectuates this recognition by dividing the total investment income between a nontaxable policyholders' share and a share belonging to the company, which is taxable. To determine the portion of investment income includible within the company's gain or loss from operations, the company must divide its "required interest" by the "investment yield." The required interest is basically the amount of reserves a company is required to maintain to satisfy policyholders' claims. I.R.C. § 809(a)(2). Investment yield is the company's gross investment income less specified deductions such as expenses attributable to the investments, depreciation, and depletion. I.R.C. § 804(c).

Taxable investment income is comprised solely of the company's share of its total investment income. I.R.C. § 804. In computing taxable investment income, however, a different formula from that employed in determining gain or loss from operations is used in computing what portion of the total investment income belongs to the company. The taxable investment income formula requires that the company divide its total "policy and other contract liability requirements" by the investment yield. The policy and other contract liability requirements include largely the same items included in the required interest for gain or loss from operations, but these items are determined in a slightly different manner. I.R.C. § 805. One of the items included in policy and other contract liability requirements is "interest paid." I.R.C. § 805(e)(3). It is this element that is at issue in this case.

We are concerned only with the first two phases of the life insurance company taxing formula. Phase I is the lesser of taxable investment income and gain from operations. I.R.C. § 802(b)(1). Phase II imposes a tax on fifty percent of the excess, if any, of gain from operations over taxable investment income. I.R.C. § 802(b)(2). Although it is unclear from the record, the parties and lower court apparently agree that Liberty National's gain from operations exceeded its taxable investment income for the years in question and that the latter therefore was...