Life insurer could not make reserve interest-rate elections on amended returns

Plain-English summary

A life insurance group sought to use amended returns to elect five-year recomputation of the applicable federal interest rate used for reserves on older contracts. Chief Counsel concluded that the doctrine of election bound the taxpayer to the reserve method communicated on its original returns for the fifth year after each contract’s issue year. A protective election on the original 2017 return was valid only for contracts issued in 2012, but it had no practical effect because the compared interest rates were equal and the recomputation rule did not apply after 2017. Allowing elections for older contracts would permit hindsight after tax-law changes, impose administrative burdens, and treat similarly situated insurers inconsistently.

Ruling snapshot

• Questions: Could the taxpayer make the former section 807(d)(4)(A)(ii) election on amended returns or on its original 2017 return?
• Outcome: advice given, the amended-return elections were barred, and the 2017 election was valid only for 2012 contracts but had no reserve effect
• Key authorities: Former IRC § 807(d)(4)(A)(ii); IRC §§ 801, 803, 805, and 846; doctrine of election; Pacific National; Grynberg; Rev. Rul. 94-74

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201939003
           Release Date: 9/27/2019
           CC:FIP:B02:BJAudet
           POSTF-113135-19

 UILC:     807.03-00, 807.03-03

  date:    June 27, 2019

     to:   Associate Area Counsel - Boston (CC:LB&I:BOS)
           Attn: Frances Kelly, Senior Attorney
           (Large Business & International)

  from:    Rebecca L. Baxter
           Senior Technician Reviewer (CC:FIP:B04)
           (Financial Institutions & Products)


subject:   Election to Apply Updated AFIR

           This Chief Counsel Advice responds to your request for assistance dated February 25,
           2019. This advice may not be used or cited as precedent.

           LEGEND

           Taxpayer    =   --------------------------------------------------------------
           Parent      =   -------------------------------------------------------------------
           Year 1      =   -------
           Year 2      =   -------
           Year 3      =   -------
           Amount 1    =   -------------------
           Amount 2    =   ----------------------
           Amount 3    =   ----------------------


           ISSUES

           May Taxpayer use amended Year 1, Year 2, and Year 3 returns (“Amended Returns”)
           to make an election under former1 § 807(d)(4)(A)(ii) of the Internal Revenue Code to

           1
            Unless otherwise noted or clear from the context, Internal Revenue Code references in this
           memorandum refer to Code sections as they existed prior to the enactment of “An Act to provide

POSTF-113135-19                                   2

recompute the applicable Federal interest rate (“AFIR”) every five years for life
insurance contracts issued during taxable years beginning after December 31, 1987
(“Contracts”)?

May Taxpayer use an original 2017 return to make an election under § 807(d)(4)(A)(ii)
to recompute the AFIR every five years for Contracts?

CONCLUSIONS

The doctrine of election precludes Taxpayer from making § 807(d)(4)(A)(ii) elections on
Amended Returns.

Taxpayer’s § 807(d)(4)(A)(ii) election on its originally filed 2017 return is valid for
Contracts issued in 2012. However, the election has no effect on Taxpayer’s reserves
for any taxable year because, for Contracts issued in 2012, the interest rates computed
under §§ 807(d)(2) and (d)(4)(A)(ii) (computed as Interest Rate A and Interest Rate B in
the Table below) were equal, and the recomputation under § 807(d)(4)(A)(ii) does not
apply after December 31, 2017.

The doctrine of election also precludes Taxpayer from making a § 807(d)(4)(A)(ii)
election on its originally filed 2017 return with respect to Contracts issued five or more
years prior to 2017. Permitting Taxpayer to make the § 807(d)(4)(A)(ii) election on
Amended Returns or an original 2017 return with respect to Contracts issued five or
more years before 2017 would allow Taxpayer to benefit from the use of hindsight to
claim additional deductions for increases in reserves due to decreases in the AFIR,
while not having to bear any risk of increases in the AFIR in future years (due to a
change in law). Further, permitting Taxpayer to make the § 807(d)(4)(A)(ii) elections for
Contracts issued five or more years prior to 2017 would impose an undue administrative
burden on the Commissioner, would promote inconsistent accounting practice among
taxpayers, and would hinder the provision of an equitable and fair tax system by treating
similarly situated taxpayers dissimilarly. Therefore, Taxpayer may not apply
§ 807(d)(4)(A)(ii) to compute reserves with respect to Contracts issued five or more
years prior to 2017.

FACTS

Taxpayer is an affiliated group of corporations that files a consolidated federal income
tax return on a calendar year basis. Parent is the common parent of Taxpayer. Certain
members of Taxpayer are life insurance companies subject to tax under § 801 (“Life
Members”). Parent, on Taxpayer’s originally filed Year 1, Year 2, and Year 3 returns,
computed life insurance reserves for Life Members for Contracts in accordance with
§ 807(d)(2), using the greater of (1) the AFIR, or (2) the prevailing State assumed


for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal
year 2018,” P.L. 115-97 (the “Act”).

     POSTF-113135-19                                             3

     interest rate (as defined in § 807(d)(4)(B)) (“PSAIR”), for the calendar year in which
     each Contract was issued (“Interest Rate A”).

     In 2018, Parent filed Amended Returns for Taxpayer on which Parent purported to
     make § 807(d)(4)(A)(ii) elections to recompute reserves for Life Members for Contracts
     using the greater of (1) the AFIR applicable to the first year of the current recomputation
     period (defined in § 807(d)(4)(A)(ii)(II)) for each Contract, or (2) the PSAIR applicable to
     the calendar year in which each Contract was issued (“Interest Rate B”).

     As a result of these purported § 807(d)(4)(A)(ii) elections, Taxpayer took into account on
     Amended Returns the difference between the life insurance reserves computed using
     Interest Rate A and the life insurance reserves computed using Interest Rate B.
     Specifically, Taxpayer claimed increased life insurance reserves of Amount 1, Amount
     2, and Amount 3 for Year 1, Year 2, and Year 3, respectively. These increases in life
     insurance reserves were reported as negative adjustments to Taxpayer’s consolidated
     taxable income. See §§ 807(b)(1) and 1.1502-47.

     Additionally, Parent attached to Taxpayer’s originally filed 2017 return a purported
     “protective election” under § 807(d)(4)(A)(ii) for Contracts, to be operative in case its
     elections on Amended Returns were considered invalid.

     The following table shows, for a given contract year, relevant figures and deadlines for
     making the § 807(d)(4)(A)(ii) election, including Interest Rate A, the proper tax year to
     make the § 807(d)(4)(A)(ii) election, the first year of the current recomputation period,
     Interest Rate B, and the current recomputation period benefit from making the
     § 807(d)(4)(A)(ii) election for the taxable years 1988-2012.
Contract   AFIR for    PSAIR     Interest   Tax Year Return      Year of Current   AFIR for Year of     Interest       Current
 Year      Contract      for     Rate A        on Which          Recomputation          Current         Rate B     Recomputation
            Year      Contract              § 807(d)(4)(A)(ii)       Period         Recomputation                    Period Rate
                        Year                 Election Could                        Period If Election                Reduction if
                                            Have Been Made                          Made in Proper                 Election Made in
                                                                                         Year                        Proper Year
 1988       7.77       6.00       7.77            1993                2013               2.16            6.00            (1.77)
 1989       8.16       6.00       8.16            1994                2014               1.79            6.00            (2.16)
 1990       8.37       5.50       8.37            1995                2015               1.68            5.50            (2.87)
 1991       8.42       5.50       8.42            1996                2016               1.56            5.50            (2.92)
 1992       8.40       5.50       8.40            1997                2017               1.46            5.50            (2.90)
 1993       8.10       5.25       8.10            1998                2013               2.16            5.25            (2.85)
 1994       7.45       5.00       7.45            1999                2014               1.79            5.00            (2.45)
 1995       6.99       4.50       6.99            2000                2015               1.68            4.50            (2.49)
 1996       6.63       4.50       6.63            2001                2016               1.56            4.50            (2.13)
 1997       6.33       4.50       6.33            2002                2017               1.46            4.50            (1.83)
 1998       6.31       4.50       6.31            2003                2013               2.16            4.50            (1.81)
 1999       6.30       4.50       6.30            2004                2014               1.79            4.50            (1.80)
 2000       6.09       4.50       6.09            2005                2015               1.68            4.50            (1.59)
 2001       6.00       4.50       6.00            2006                2016               1.56            4.50            (1.50)
 2002       5.71       4.50       5.71            2007                2017               1.46            4.50            (1.21)
 2003       5.27       4.50       5.27            2008                2013               2.16            4.50            (0.77)
 2004       4.82       4.50       4.82            2009                2014               1.79            4.50            (0.32)
 2005       4.44       4.50       4.50            2010                2015               1.68            4.50            None
 2006       3.98       4.00       4.00            2011                2016               1.56            4.00            None
 2007       3.97       4.00       4.00            2012                2017               1.46            4.00            None

   POSTF-113135-19                                4

2008     4.06     4.00     4.06         2013           2013           2.16        4.00         (0.06)
2009     4.06     4.00     4.06         2014           2014           1.79        4.00         (0.06)
2010     3.81     4.00     4.00         2015           2015           1.68        4.00         None
2011     3.46     4.00     4.00         2016           2016           1.56        4.00         None
2012     2.89     4.00     4.00         2017           2017           1.46        4.00         None



   LAW

   Section 801(a) imposes a tax on the life insurance company taxable income of every life
   insurance company. Section 801(b) defines life insurance company taxable income to
   mean life insurance gross income, reduced by life insurance deductions. Under
   § 803(a)(2), life insurance gross income includes a net decrease in reserves as required
   by § 807(a). Under §§ 804 and 805(a)(2), life insurance deductions include a deduction
   for a net increase in reserves as required by § 807(b).

   Section 807(a) provides generally that any decrease during the taxable year of items
   described in § 807(c) is included in gross income under § 803(a)(2). Section 807(b)
   provides generally that any increase during the taxable year of items described in
   § 807(c) are taken into account as a deduction under § 805(a)(2). The items described
   in § 807(c) include life insurance reserves.

   For taxable years beginning after December 31, 1987, and before January 1, 2018,2
   § 807(d)(2)(B) provides that the interest rate used in the computation of life insurance
   reserves is the greater of (i) the AFIR or (ii) the PSAIR. Section 807(d)(4)(A) defines
   the AFIR as the interest rate prescribed under § 846(c)(2) for the calendar year in which
   a contract is issued. However, a taxpayer may elect under § 807(d)(4)(A)(ii) to
   recompute every five years the AFIR to be used in the computation of life insurance
   reserves.

   Section 807(d)(4)(A)(ii) provides:

          (I)In general. In computing the amount of the reserve with respect to any
          contract to which an election under this clause applies for periods during
          any recomputation period, the [AFIR] shall be the annual rate determined
          by the Secretary under section 846(c)(2) for the 1st year of such period.
   2
     Section 13517(a)(2) of the Act amended § 807(d) for years beginning after December 31,
   2017. For years beginning after December 31, 2017, new § 807(d)(2) provides that the “amount
   of the reserve determined under this paragraph with respect to any contract shall be determined
   by using the tax reserve method applicable to such contract.” Sections 13517(c)(2) and (3) of
   the Act provide that for the first taxable year beginning after December 31, 2017, the difference
   in the amount of the reserve with respect to any contract at the end of the preceding taxable
   year and the amount of the reserve determined as if the amendments made by section 13517 of
   the Act had applied for that year is taken into account for each of the eight taxable years
   following that preceding year, one-eighth per year. H.R. REP. NO. 115-466, at 478-79 (2017)
   (Conf. Rep.). Additionally, section 13001(b) of the Act lowered the corporate tax rate to 21
   percent of taxable income.

POSTF-113135-19                               5

       No change in the [AFIR] shall be made under the preceding sentence
       unless such change would equal or exceed 1/2 of 1 percentage point.

       (II) Recomputation period. For purposes of subclause (I), the term
       “recomputation period” means, with respect to any contract, the 5 calendar
       year period beginning with the 5th calendar year beginning after the
       calendar year in which the contract was issued (and each subsequent 5
       calendar year period).

       (III) Election. An election under this clause shall apply to all contracts
       issued during the calendar year for which the election was made or during
       any subsequent calendar year unless such election is revoked with the
       consent of the Secretary.

Section 807(d)(4)(A)(ii)(IV) provides that the 10-year spread that applies under § 807(f)
to adjustments resulting from changes in the basis of calculating reserves does not
apply to any adjustment required as a result of the use of a recomputed AFIR.

The legislative history to the § 807(d)(4)(A)(ii) election explains how the election is to be
applied:

       In general, under the provision, the interest rate to be applied in
       determining the amount of the life insurance reserves for any contract is
       the greater of the [AFIR] or the [PSAIR] for the calendar year in which
       contract is issued. Under the election, this rate continues to be applied in
       the 4 succeeding years after the year the contract is issued. For the 5th
       through 9th year after the contract is issued, the rate to be applied in
       determining reserves for such years (but not for any prior years) with
       respect to the contract is the greater of the [AFIR] for such 5th year, or the
       [PSAIR] for the calendar year in which the contract was issued. Thus, the
       rate for determining life insurance reserves with respect to any contract
       cannot be lower than the [PSAIR] for the calendar year in which the
       contract was issued.

H.R. REP. NO. 100-495, at 979 (1987) (Conf. Rep.).

The doctrine of election binds a taxpayer to an initial choice on a return if the taxpayer
had the right to choose one or more alternatives or inconsistent rights, and if nothing
suggests that Congress intended to allow the taxpayer to change the initial choice after
the return filing deadline. Pac. Nat'l Co. v. Welch, 304 U.S. 191, 194-95 (1938)
(concluding taxpayer made a binding election regarding timing of income recognition by
reporting the income from the transactions in question on its return according to a
particular method). The doctrine of election as it applies to federal tax law consists of
two elements: (1) a free choice between two or more alternatives; and (2) an overt act
by the taxpayer communicating the choice to the Commissioner, that is, a manifestation

POSTF-113135-19                             6

of choice. Grynberg v. Commissioner, 83 T.C. 255, 261 (1984). A taxpayer may overtly
communicate its elective choice to the Commissioner by computing taxable income on a
return in a manner consistent with the elective choice. See Grynberg, 83 T.C. at 262;
Vischia v. Commissioner, 26 T.C. 1027, 1029 (1956).

Courts have articulated several rationales supporting the general principle that elections
are considered binding, including: (1) preventing administrative burdens and
inconvenience in administering the tax laws, particularly if the new method requires a
recalculation of tax liability for several years or for other taxpayers; (2) protecting
against loss of revenues by preventing taxpayers from using the benefit of hindsight to
choose the most advantageous method of reporting; (3) promoting consistent
accounting practice (foreclosing adjustments based on hindsight), thereby securing
uniformity in the collection of revenue; and (4) providing an equitable and fair tax system
by treating similarly situated taxpayers consistently. See J.E. Riley Inv. Co. v.
Commissioner, 311 U.S. 55, 59 (1940); Mamula v. Commissioner, 346 F.2d 1016,
1018-19 (9th Cir. 1965); Barber v. Commissioner, 64 T.C. 314, 319-20 (1975); Estate of
Curtis v. Commissioner, 36 B.T.A. 899, 906-07 (1937).

ANALYSIS

The Code, regulations, and legislative history do not provide explicit procedures for
making a § 807(d)(4)(A)(ii) election. In the absence of an explicit deadline, the
appropriate time to make an election is when a taxpayer is first faced with the necessity
of making the election or choice in computing taxable income on a return. See Bayley
v. Commissioner, 35 T.C. 288, 298 (1960) (concluding that deferral election made after
the Service determined gain was includible in income was timely), acq., 1961-2 C.B. 4.
As indicated by the legislative history, a life insurance company that makes a
§ 807(d)(4)(A)(ii) election must use the greater of the AFIR for the fifth year after the
year the contract is issued, or the PSAIR for the year in which the contract is issued, in
determining its reserves for the fifth through ninth year after the contract is issued.
Thus, Taxpayer must have made the § 807(d)(4)(A)(ii) election no later than on its
original return for the fifth year after the year a Contract was issued, because the fifth
year is the first time when Taxpayer is faced with the necessity of choosing whether to
continue to determine its life insurance reserves using the greater of the AFIR or the
PSAIR for the year the Contract was issued (under § 807(d)(2)), or to make a
§ 807(d)(4)(A)(ii) election to recompute the AFIR every five years with respect to
Contracts issued for the calendar year for which the election is made and subsequent
calendar years. Taxpayer overtly communicated its free choice between these two
alternatives to the Commissioner by computing its reserves and its taxable income
under § 807(d)(2) on its returns for the fifth year after each Contract was issued for all
taxable years prior to 2017 and for all Contracts issued before 2012. See Grynberg, 83
T.C. at 262. Taxpayer cannot reverse that choice for any Contracts issued before 2012
by filing Amended Returns, the tax years for which are each subsequent to the fifth year
after Contracts were issued. Taxpayer also cannot reverse that choice for any
Contracts issued before 2012 on an original return for 2017.

POSTF-113135-19                             7


Moreover, all of the rationales underlying the doctrine of election support the application
of the doctrine to the § 807(d)(4)(A)(ii) election in this case. Allowing Taxpayer to make
a § 807(d)(4)(A)(ii) election subsequent to the fifth year return deadline would invite
accounting distortions leading to a loss of revenues. For years beginning after
December 31, 2017, the AFIR and PSAIR are no longer used in determining life
insurance reserves, and the Act lowered tax rates for post-2017 years. See § 807(d)(2);
see also § 11. Thus, after the passage of the Act, Taxpayer would have been able to
determine that had it made a timely § 807(d)(4)(A)(ii) election for any Contracts issued
in 2009, 2008, and 2004 and prior years, it would have been entitled to an increased
level of aggregate § 807(b) deductions across all relevant pre-Act years, which would
have offset income taxable at higher, pre-Act rates. However, Taxpayer was unable to
benefit from the increased § 807(b) deductions in years prior to the passage of the Act
because it had not made a § 807(d)(4)(A)(ii) election. Thus, Taxpayer seeks to make
the § 807(d)(4)(A)(ii) election for Contracts on Amended Returns and an original 2017
return in order to claim the difference between the opening reserve with and without the
election as a deduction on the Amended Returns or original 2017 return. In turn, by
claiming the increased deductions on the Amended Returns or original 2017 return,
Taxpayer ensures that the countervailing increased taxable income stemming from the
subsequent reduction in reserves would be recognized in post-Act years subject to
lower rates. The doctrine of election forecloses this attempt to obtain through an
untimely § 807(d)(4)(A)(ii) election both the benefit of additional deductions for
increases in reserves due to decreases in the AFIR without bearing any risk of
increases in the AFIR in future years (due to a change in law), and the benefit of paying
tax at a reduced rate on the offsetting future income resulting from the repeal of
§ 807(d)(4)(A)(ii).

Allowing Taxpayer to make § 807(d)(4)(A)(ii) elections more than five years after the
year in which a Contract is issued would also lead to the disparate treatment of similarly
situated life insurance companies and create undue administrative inconvenience for
the Commissioner. A life insurance company that made a timely § 807(d)(4)(A)(ii)
election took on the risk that the AFIR might increase in a future recomputation period
(which reduces reserves and increases taxable income) in exchange for the reward
resulting from an AFIR decrease (which increases reserves and reduces taxable
income). Under § 807(d)(4)(A)(ii)(III), the life insurance company could not opt out of
this risk/reward tradeoff without the Commissioner’s consent. Allowing Taxpayer to
make an § 807(d)(4)(A)(ii) election for pre-2012 Contracts following the passage of the
Act would allow Taxpayer to attain the now-certain benefit without taking on any of the
risk that those life insurance companies that made a timely election bore, in effect
rendering the § 807(d)(4)(A)(ii)(III) consent requirement superfluous and unfairly
rewarding the use of hindsight. Additionally, allowing Taxpayer’s § 807(d)(4)(A)(ii)
election would invite a flood of amended returns, unfairly increasing the Commissioner’s
administrative burden and, in the case of amended returns, requiring a recalculation of
tax liability based on items from tax years more than five years prior.

POSTF-113135-19                                  8

Moreover, we note that in Rev. Rul. 94-74, 1994-2 C.B. 157, Situation 2, the taxpayer
was required on examination to change its basis of computing § 807(d) reserves for
certain life insurance contracts from using the same interest rates as the taxpayer used
to compute statutory reserves for state regulatory reporting purposes, to using the
higher of the AFIR or PSAIR in effect for the year the contracts were issued. The
Service ruled that the change in the manner of computing reserves was treated as a
change in basis under § 807(f) even though the recomputation was made on an
involuntary basis. Taxpayer may claim3 that Rev. Rul. 94-74 stands for the proposition
that a taxpayer may, without being subject to the doctrine of election, change the
interest rate used to compute reserves in any post-issuance year. Rev. Rul. 94-74 is
distinguishable from this case because the doctrine of election applies to taxpayers
only. That is, the doctrine would not foreclose the Service from requiring a taxpayer to
change from an improper method of computing reserves to a proper one. Moreover, in
this case, Taxpayer is not attempting to move from an improper method to a proper
method.

For all of these reasons, once Taxpayer chose on its original return for the fifth year
after the year in which a Contract was issued to continue to compute its reserves under
§ 807(d)(2), the doctrine of election applies to prevent Taxpayer from changing its
election with respect to the Contract, either on an amended return for that fifth year or
on a subsequent year original or amended return. Taxpayer’s § 807(d)(4)(A)(ii) election
on its originally filed 2017 return is valid for Contracts issued less than five years prior to
2017. However, the election has no effect on Taxpayer’s reserves because Interest
Rate A and Interest Rate B were equal for the first recomputation period for Contracts
issued in 2012, and the recomputation under § 807(d)(4)(A)(ii) does not apply after
December 31, 2017.

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 contact Bernard Audet of this office at (202) 317-4415 if you have any further
questions.




3
    Taxpayer has not raised Rev. Rul. 94-74, but may in the future.