Life insurer may deduct partnership investment fees

Plain-English summary

Chief Counsel addressed how a life insurer should calculate its share of dividends-received deductions for separate-account assets invested through partnerships. The insurer includes its distributive share of partnership gross investment income in gross investment income under section 812 without netting investment expenses. Counsel also concluded that partnership investment fees paid through the insurer's general account may be included in the amount retained under the applicable regulation. Finally, section 811(c)(3) does not bar a deduction for those fees merely because they were paid from dividend income that also generated a dividends-received deduction, since the income and expense are not the same item.

Ruling snapshot

• Question: How do partnership investment income and fees affect a life insurer's section 812 proration and deductions?
• Outcome: Gross investment income is not netted by the fees, the fees may enter the amount retained, and section 811(c)(3) does not disallow their deduction
• Key authorities: IRC §§ 243, 702, 805, 811, and 812; Treas. Reg. § 1.801-8(e)

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201603023
       Release Date: 1/15/2016
       CC:FIP:B04:SYHorn                                     Third Party Communication: None
       POSTF-120531-14                                       Date of Communication: Not Applicable

UILC: 812.00-00

date: July 17, 2015

 to:   Reid M. Huey
       Associate Area Counsel (St. Paul)
       (Large Business & International)

       Attn: Terri Jackson, Attorney
       CC:LB&I:RFTH:STP:TL

from: Alexis A. MacIvor
Branch Chief, Branch 4
(Financial Institutions & Products)

subject: ---------------------------------------------------
EIN: -----------------

       You requested assistance with respect to calculating, under the proration rules of § 812,
       company’s share of dividends received deductions (DRD) for separate account assets
       invested in partnership funds. This advice may not be used or cited as precedent.

       FACTS

       ----------------------------------- is the common parent of an affiliated group of corporations
       filing consolidated returns. It owns ----------------------------------------------------------------------
       ----------------------------------------------------------------------------------------(Taxpayer), a life
       insurance company as defined in § 816.

       Taxpayer issues variable annuity contracts. The variable annuity contract holders pay
       Taxpayer certain contract related charges, such as mortality and expense charges,
       through a transfer of funds from the contract holders’ separate accounts to Taxpayer’s
       general account. Taxpayer reports this amount as income.

POSTF-120531-14 2

The variable annuity contracts are supported by separate accounts.1 The separate
accounts invest in funds, some of which are organized as partnerships.2 With respect
to these funds, Taxpayer pays investment expenses to its nonlife affiliate.

ISSUES

1. Whether the proration calculation under § 812 requires Taxpayer to compute its
   gross investment income for separate accounts invested in partnership funds net
   of investment expenses.

2. Whether including the partnership fund investment fees in amount retained is
   consistent with Treas. Reg. § 1.801-8(e).

3. Whether § 811(c)(3) precludes Taxpayer from deducting the investment fees
   because it paid them with funds derived from dividend income for which it
   received a DRD.

LEGAL BACKGROUND

Life Insurance Company Taxable Income

Life insurance company taxable income (LICTI) under § 801(b) refers to life insurance
company gross income under § 803(a)(1), less the life insurance deductions under
§ 804. Life insurance gross income includes premiums, decreases in reserves, and all
other amounts includible in gross income under subtitle A of the Code.3 Life insurance
deductions include the deductions listed in § 805 and, subject to certain modifications,
other deductions under the Code.4

With respect to variable contracts, a life insurance company must separately account for
the various income, exclusion, deduction, assets, reserve and other liability items
properly attributable to such variable contracts.5

Life Insurance Company DRD

Section 805(a)(4)(A)(ii) permits a deduction under § 243 for the life insurance
company’s share of dividends received deduction (other than 100%). Section 243(a)
allows a corporation a deduction for amounts received as dividends from a domestic

1
Each separate account is registered as unit investment trusts under the Investment Company Act of
1940.
2
This memorandum is based on the treatment of the partnership funds as a partnership under
Subchapter K and not as a publicly traded partnership, corporations, or trusts for Federal income tax
purposes.
3
See, e.g., §§ 61(a)(7) (dividends), 61(a)(13) distributive share of partnership gross income, and 702
(income of a partner).
4
Sections 804(1), 805(a)(8).
5
Section 817(c).
POSTF-120531-14 3

corporation.6 Depending on the receiving corporation’s stock ownership percentage in
the dividend-paying corporation, and other factors, the corporate shareholder receives a
70%,7 80%,8 or 100%9 DRD.

The company’s share is determined under § 812. The company’s share is the amount
of net investment income that remains after the life insurance company pays or credits
amounts to policyholders.10 This allocation between life insurance company’s share
and the policyholder’s share of net investment income, as provided in § 812, is intended
to eliminate the double tax benefit that would arise if the company were allowed to fund
deductible reserve increases with tax exempt or tax preferred income. Proration limits
the exclusion of tax exempt income, or the amount of DRD, to the company’s share of
such income.

Partnership and Partner DRD

In determining taxable income, each partner takes into account separately the partner’s
distributive share of taxable income or loss (excluding certain items for which the Code
requires a separate computation), including the dividends that qualify for the DRD under
§ 243.11

The character of any item of income, gain, loss, deduction, or credit included in a
partner’s distributive share under § 702(a) is determined as if the partner realized the
income directly from the source (rather than through the partnership), or incurred the
item in the same manner as incurred by the partnership.12

Under § 702(a)(5), dividends the partnership receives that qualify for the DRD pass
separately to the partners. Under § 702(b), the dividends retain their character when
allocated to the partners.13

6
The DRD prevents double taxation of income (operating/investment income to the corporation and
dividend income to its corporate shareholder) for multi-level corporate structures.
7
Section 243(a)(1).
8
Section 243(c) provides that a corporate shareholder receiving a dividend from a 20% owned
corporation (any corporation if 20% or more of the stock of such corporation (by vote and value) is owned
by the corporate shareholder) is allowed an 80% DRD.
9
The 100% DRD applies to dividends received by a small business investment company and for
qualifying dividends. Section 243(a)(2) and (3).
10
Joint Committee on Taxation, “General Explanation of the Revenue Provisions of the Tax Reform Act of
1984,” p. 625.
11
Sections 702(a)(5) and (8).
12
Section 702(b).
13
In Treas. Reg § 1.701-2(d), Ex. 5, Corporation X and Corporation Y form Partnership. Partnership
purchases Z common stock allocating the dividend income from the stock to provide Corporation X a
floating-rate return based on the London Inter-Bank Offered Rate, allocating the remainder of the dividend
income to Corporation Y, and permitting X and Y to claim the § 243 DRD on dividends allocated to each.
POSTF-120531-14 4

LAW AND ANALYSIS

ISSUE 1: Whether the proration calculation under § 812 requires Taxpayer to compute
its gross investment income for separate accounts invested in partnership funds net of
investment expenses.

Section 805(a)(4) prevents a life insurance company from funding its deductible
reserves with tax preferred dividends by limiting the company’s dividends received
deduction to the company’s share of the dividends received.14

Section 812 provides, for purposes of § 805(a)(4), the calculation of the company’s
share. Under § 812(d), this calculation starts with the life insurance company's gross
investment income for the taxable year.

LB&I suggests that Taxpayer should compute its gross investment income for separate
accounts invested in partnership funds net of investment expenses. However,
Taxpayer does not compute its gross investment income for separate accounts invested
in partnership funds net of investment expenses.

Partnerships distribute gross investment income to their partners and the partners
receive their distributive share of the corporate dividends and a flow-through of their
share of partnership investment expenses. Section 702(a)(5). A partner that is a life
insurance company includes its distributive share of the partnership gross investment
income in its gross investment income under § 812(d). Taxpayer does not reduce its
gross investment income by investment expenses when computing its gross investment
income under § 812(d).

ISSUE 2: Whether including the partnership fund investment fees in amount retained is
consistent with Treas. Reg. § 1.801-8(e).

Treas. Reg. § 1.801-8(e)(1)(i)15 defines amount retained16 as “[a]ny amount retained
with respect to all of the reserves on a segregated asset account… from gross
investment income… on segregated assets, to the extent such retained amount

14
See § 805(a)(4)(A)(ii).
15
The calculation of required interest involves multiplying the mean of reserves for the taxable year by a
rate of interest. With respect to calculating required interest at another appropriate rate the Service has
allowed a modified version of the formula, set forth in Treas. Reg. § 801-8(e), to be used to determine
another appropriate rate. Examination of Dividends Received Deduction on Separate Accounts of Life
Insurance Companies, LMSB-4-0510-015 (May 20, 2010). We express no opinion whether required
interest on life insurance reserves is determined using another appropriate rate.
16
Historically, amount retained was the amount the life insurance company held from the gross
investment income on all segregated asset accounts to cover general expenses in excess of the
expenses provided for in the charges made against premiums to cover actuarial contingencies and
increase surplus. See Senate Report No 291, 86th Cong, 1st Session 36, 43.
POSTF-120531-14 5

exceeds the deductions allowable under [prior law] § 804(c) which are attributable to
such reserves.” The regulation provides two Examples, simplified below.

 For Separate Account A, the company had retained with respect to such reserves
 from gross investment income a total of $4,720. It had allowable prior law17 § 804(c)
 deductions with respect to the account of $4,000. Therefore, the amount retained
 was $720 ($4,720 - $4,000).

 For Separate Account B, the company had retained with respect to such reserves
 from gross investment income a total of $5,720. It had allowable prior law § 804(c)
 deductions with respect to the account of $4,400. Therefore, the amount retained
 was $1,320 ($5,720 - $4,400).18

LB&I argues that including the partnership fund fees in amount retained is not
consistent with Treas. Reg. § 1.801-8(e). LB&I proposes to include in amount retained
only the amounts for fees and expenses transferred from the separate account to the
Taxpayer’s general account. However, including the partnership fund fees in amount
retained is consistent with Treas. Reg. § 1.801-8(e).

Treas. Reg. § 1.801-8(e) provides, and the related examples show, that amount
retained includes any amount of gross investment income not credited to the reserves.
Accordingly, it is consistent with Treas. Reg. § 1.801-8(e) for Taxpayer to include in
amount retained the amount transferred from the separate account and paid by
Taxpayer to its nonlife affiliate as investment fees.

ISSUE 3: Whether § 811(c)(3) precludes Taxpayer from deducting the investment fees
because it paid them with funds derived from dividend income for which it received a
DRD.

LB&I posits that § 811(c)(3) denies Taxpayer its distributive share of the investment
expense deduction because Taxpayer already received a DRD on its distributive share
of dividend investment income and allowing both gives Taxpayer a double deduction.
We disagree.

Section 811(c)(3) disallows a double deduction for the same item. However, because
the dividend for which Taxpayer received the DRD is an income item19 (albeit, due to
the DRD, subject to tax at a lower effective tax rate) and investment expenses are a
general deduction,20 they are not the same item. Furthermore, LB&I’s theory is
inconsistent with DRD proration. Once a life insurance company determines its
company’s share of DRD, it can use the resulting dividend income to pay deductible
expenses or fund its reserves just as it could with any other income. Therefore,

17
Internal Revenue Code of 1959.
18
Treas. Reg. § 1.801-8(e)(4)(c) and (d).
19
Section 812(d)
20
Section 805(a)(8).
POSTF-120531-14 6

§ 811(c)(3) does not preclude Taxpayer from deducting investment expenses even if it
paid them from dividend income for which it received a DRD.

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call 202-317-4426 if you have any further questions.

                                    _____________________________
                                    Alexis A. MacIvor
                                    Branch Chief
                                    (Financial Institutions and Products)