Union Mut. Life Ins. Co. v. U.S.
| Decision Date | 01 February 1978 |
| Docket Number | Nos. 77-1161 and 77-1162,s. 77-1161 and 77-1162 |
| Parties | 78-1 USTC P 9222 UNION MUTUAL LIFE INSURANCE COMPANY, Plaintiff-Appellee-Cross Appellant, v. UNITED STATES of America, Defendant-Appellant-Cross Appellee. |
| Court | U.S. Court of Appeals — First Circuit |
Gary R. Allen, Atty., Tax Div., Dept. of Justice, Washington, D. C., with whom Myron C. Baum, Acting Asst. Atty. Gen., Washington, D. C., George J. Mitchell, U. S. Atty., Portland, Me., and Gilbert E. Andrews, Atty., Tax Div., Dept. of Justice, Washington, D. C., were on brief, for United States.
Bruce A. Coggeshall, Portland, Me., with whom Pierce, Atwood, Scribner, Allen & McKusick, William C. Smith, and James F. Keenen, Portland, Me., were on brief, for Union Mutual Life Insurance Co.
Before COFFIN, Chief Judge, TUTTLE, * Circuit Judge, WOLLENBERG, ** District Judge.
This is an appeal by the United States and a cross-appeal by the Union Mutual Life Insurance Company from the judgment of the trial court which resolved four of the grounds stated in Union Mutual's complaint in its favor and two in the Government's favor. The United States appealed only with respect to two of the matters which the trial court decided in favor of Union Mutual. See Union Mutual Life Ins. Co. v. United States, 420 F.Supp. 1181 (D.Me.1976).
We adopt the trial court's statement as a concise and accurate description of the purposes and framework of the 1959 Life Insurance Company Tax Act:
The purpose of the 1959 Act was to come to grips with certain difficulties inherent in the income taxation of life insurance companies. The two principal difficulties identified by Congress were (1) the need to determine what portion of a company's investment income is properly allocable to reserves which the company must hold for the purpose of meeting the company's future obligations to policyholders, and what portion is properly considered income taxable to the company and (2) the problem of calculating underwriting income on a yearly, as opposed to a long-term basis. See S.Rep.No.291, 86th Cong., 1st Sess., 1959 U.S.Code & Ad.News 1577-82. The first step in Congress' approach to these difficulties was to decide that a life insurance company's taxable income would be calculated in three distinct parts or "phases." Id. at 1576. In Phase I the taxable portion of the company's investment income its "taxable investment income" is computed. Sections 804-806. In Phase II the company's gain (or loss) from operations its "underwriting gain" is computed. Sections 809-812. In Phase III the company's taxable income owing to certain distributions to stockholders is computed. Section 815. Once each of these amounts has been computed, the company's taxable income is then computed under Section 802(b) to equal the sum of (1) the lesser of Phase I or Phase II income; (2) 50% Of the excess, if any, of Phase II income over Phase I income; and (3) Phase III taxable income, if any. The sum thus calculated the company's "life insurance company taxable income" is then taxed at the normal corporate rate. Sections 802(a), 11.
The issues presented in the instant case directly concern only Phase I of the overall computation, that is, the computation of the company's taxable investment income. The purpose of Phase I, simply stated, is to divide the company's investment income into two parts, that portion which is allocable to reserves held to meet the company's obligations to policyholders, which is not taxed; and that portion which is available to the company for other purposes, which is taxed. The Phase I computation proceeds as follows:
(1) For the taxable year in question, the company calculates its "gross investment income" by adding together interest, dividends, rents, royalties and other income derived from investments or any trade or business other than the insurance business. Section 804(b). From this amount the company deducts items allowed as deductions, such as investment and investment-related expenses. Section 804(c). The result is the company's "investment yield" for that taxable year. Idem.
(2) The company then calculates its "assets," Section 805(b)(4), as of the beginning and end of the taxable year and computes the mean thereof.
(3) The company then calculates its "current earnings rate" by dividing its investment yield by the mean of its assets. Section 805(b)(2). It also calculates its "average earnings rate" by computing the average of its current earnings rates for the present and last four taxable years. Section 805(b)(3). The lower of the current and the average earnings rates is the company's "adjusted reserves rate." Section 805(b)(1).
(4) The company then calculates its "adjusted life insurance reserves." Section 805(c). To do this:
(a) The company first calculates the mean of its "life insurance reserves," as defined by Section 801(b) as of the beginning and end of the taxable year. Section 805(c)(1)(A).
(b) The company then calculates the weighted average of the interest rates which it has assumed for the purpose of calculating its life insurance reserves. Section 805(c)(2). This figure, which may be termed the company's "average rate of assumed interest," is then deducted from the adjusted reserves rate.
(c) The company then determines its "adjusted life insurance reserves" by reducing its life insurance reserves by 10% For each 1% By which the adjusted reserves rate exceeds the average rate of assumed interest. Section 805(c)(1).
(5) The company then multiplies its adjusted life insurance reserves by its adjusted reserves rate. The result, with certain adjustments not at issue here, is the company's "policy and other contract liability requirements" (policy liability requirements) for the taxable year. Section 805(a)(1).
(6) The company then divides its policy liability requirements by its investment yield. The result is the percentage of investment income which the company may allocate to reserves held for the purpose of meeting its obligations to policyholders. Section 804(a)(1). The remaining portion of the investment yield, less certain deductions not at issue here, represents the company's taxable investment income. Sections 802(b)(1), 804(a)(2).
Id. at 1185-86 (footnote omitted).
Each of the issues presented on this appeal relates to one or more of the six steps of the Phase I computations. Since both parties address the separate issues in the same sequence in their briefs, we here discuss them in that same order.
I. Whether the district court correctly decided that interest on policy loans charged in advance to policyholders is includable in full in taxpayer's investment income under the pertinent provisions of the Life Insurance Company Income Tax Act of 1959 (sections 801-820 of the Internal Revenue Code of 1954, as amended) at the time such advance interest is received in cash or added to the principal balance of the policy loan in question.
The insurance policies issued by Union Mutual entitled the policyholder to obtain a loan up to the amount of the cash surrender value on the sole security of the policy itself. Annual interest on such loans is payable in advance. Thus, unless the policyholder pays the interest in advance in cash, the taxpayer charges such interest in advance from the date of the loan until the next anniversary date of the policy by adding the interest to the loan balance shown on its books, reducing the cash surrender value by that amount. If the policyholder does not pay the second annual interest installment in cash, it is also charged in advance by adding the amount of such interest to the principal of the loan.
If the policyholder repays the loan during the year, he is credited with a pro rata amount of the interest that was deducted in advance. The same adjustment is made in the event the policy is surrendered or the policy matures on the death of the insured.
It is the taxpayer's contention that since the possibility of repayment, surrender or death makes it uncertain whether it will ultimately keep the entire amount of the interest, only that part of the interest payments that has been fully earned at the end of the tax period should be reported as income. Thus, the taxpayer reports only the "earned" portion of its advance interest charges as "investment income" on its annual statements, i. e., it excludes from gross investment income that portion of such advance interest allocable to the period beyond December 31 of the year in question. 1
As stated by the trial court, two courts of appeals had at the time of its decision held that where the full interest on a policy loan is due and payable in advance and an accrual basis taxpayer receives it free of any trust or other restriction on its use, the taxpayer's right to receive such interest must be regarded as "fixed" and therefore as accrued within the meaning of Regulation 1.446-1(c)(1)(ii), citing Jefferson Standard Life Insurance Co. v. United States, 408 F.2d 842 (4th Cir.), cert. denied, 396 U.S. 828, 90 S.Ct. 77, 24 L.Ed.2d 78 (1969) and Franklin Life Insurance Co. v. United States, 399 F.2d 757 (7th Cir. 1968), cert. denied, 393 U.S. 1118, 89 S.Ct. 989, 22 L.Ed.2d 122 (1969). To these cases there must now be added a decision by the Court of Appeals for the Fifth Circuit in Southwestern Life Insurance Co. v. United States, 560 F.2d 627 (5th Cir. 1977).
This treatment of the interest payments is consistent with the accounting methods required by the statute. Section 818(a) provides:
Method of accounting. All computations entering into the determination of the taxes imposed by this part shall be made
(1) under an accrual method of accounting, or
(2) to the extent permitted under regulations prescribed by the Secretary or his delegate, under a combination of an accrual method of accounting with any other method permitted by this chapter (other than the cash receipts and disbursements...
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