SCRIBNER, HALL & THOMPSON, LLP

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1 SCRIBNER, HALL & THOMPSON, LLP THOMAS C. THOMPSON, JR. MARK H. KOVEY STEPHEN P. DICKE PETER H. WINSLOW SUSAN J. HOTINE BIRUTA P. KELLY GREGORY K. OYLER LORI J. BROWN SAMUEL A. MITCHELL LYNLEE C. BAKER-GARBETT SUITE IO5O l875 EYE STREET, N. W. WASHINGTON, D. C (202) FAX (202) FRED C. SCRIBNER, JR. ( ) LEONARD W. HALL ( ) TAX ISSUES SUMMARY HIGHLIGHTS: I.R.C. 338 and 1060 IRS Issues Final Regulations on the Sale, Acquisition of Insurance Companies The IRS released final and temporary regulations under I.R.C. 197, 338, 381, 848, and 1060, effective April 10, 2006, that deal with taxable reinsurance transactions by insurance companies. The two types of transactions highlighted in the regulations are elections under I.R.C. 338 (whereby a taxable purchase of the stock of the target insurance company is treated instead as a deemed assumption reinsurance transaction) and an actual indemnity or assumption reinsurance transaction where the assuming company also acquires significant business assets to which goodwill or going concern value could attach under I.R.C principles. The final regulations adopt, with some modifications, the proposed regulations (REG ) that were published in March See Company Issues. I.R.C IRS Issues Temporary and Proposed Regulations on Tacking Rules for Life Insurance Companies The IRS has issued temporary regulations (T.D. 9258) which favorably modify the tacking rules under Treas. Reg for including a new life insurance company, which was previously part of an old member of a consolidated return, in the life-nonlife consolidated return. Specifically, the temporary regulations eliminate the separation requirement, which was a prior regulatory requirement for the tacking rules. See Company Issues.

2 Page 2 LEGISLATION In General Congress returned from its mid-april recess a few days ago and tax conferees have started back where they ended. Word from Capitol Hill is that a conference agreement on the 2006 tax reconciliation bill will be reached today and include a two-year extension of reduced rates for capital gains and dividends, some form of alternative minimum tax relief (most likely for one year), a two-year extension of increased small business expensing under I.R.C. 179 and an extension of the subpart F exemption for active financing. The revenue raiser being considered to offset the cost of the extension of reduced rates for capital gains and dividends is the removal of the income limits on conversions of traditional IRAs to Roth IRAs, thinking that would lead high-income taxpayers to convert their traditional IRAs to Roth IRAs and pay tax on the amount converted. This revenue-raiser has garnered some opposition among fiscal conservatives. Although the use of some revenue-raising provisions may allow several other provisions to be included in the reconciliation bill, it is likely that many of the popular tax cut extensions (e.g., the so-called business extenders and the deduction for state and local sales taxes) will be left to move in a separate bill without reconciliation protections. With respect to the pension bill conference, conferees working on the tax portion of that bill hope to limit the tax provisions therein to better ensure passage. Budget conferees have not given up on reaching a budget resolution, but it generally is recognized that appropriators can and will move forward without a budget resolution as the summer nears (and the remaining legislative days diminish). Although the fiscal year 2007 budget blueprint approved on March 29, 2006 by the House Budget Committee would give lawmakers the option to fund a two-year extension of alternative minimum tax (AMT) relief, this does not seem to be taking pressure off having the relief in the 2006 tax reconciliation bill, nor to be helping passage of a budget for Finally, the Senate has been promised a vote on estate tax repeal in May. Because everyone seems to be skeptical that full repeal will receive the required 60 votes, it is likely that some form of compromise legislation that would permanently lower the rate and raise the exemption amount will follow the repeal vote. POLICYHOLDER ISSUE I.R.C. 403(b) and 691 Contractual Distribution of Annuity Completed After Participant s Death is Not IRD In Ebery v. Commissioner, T.C. Summ. Op , the United States Tax Court determined that the contractual provisions of a 403(b) retirement plan, which allow a plan participant s withdrawal request to be effective as of the date the participant signs the request, are not voided because the participant died prior to the plan administrator s receipt of the request. In the facts of the case, William Eberly submitted to TIAA-CREF, by mail, a signed Request for a Retirement Annuity Withdrawal form, as well as a signed designation of beneficiary naming his sons as beneficiaries of the plan. The withdrawal request directed TIAA-CREF to withdraw $600,000 from Eberly s accumulated annuity fund balance and deposit these funds into a designated savings account. Eberly died the same day the

3 Page 3 withdrawal request was received by TIAA-CREF. The beneficiary designation form was received the following day. According to the terms of the plan, Any notice of change in Beneficiary or other person named to receive payments will take effect as of the date it was signed, whether or not the signer is living at the time we received it. The IRS argued that TIAA-CREF should not have honored the withdrawal request because Eberly died before the request was received, and that the subsequent payment of the sum to Eberly s beneficiaries should be treated as income in respect of a decedent, taxed in accordance with I.R.C The court found that the terms of the plan were clear and unambiguous in the treatment of a signed withdrawal request as being effective on the date of signing rather than upon receipt. As the withdrawal Eberly requested was an effective exercise by him of his right to a lump-sum distribution during his lifetime under the terms of the plan, the court reasoned that it was not relevant that the distribution did not actually occur before his death, and so the distribution should not be included in the beneficiary s gross income as a I.R.C. 691 income in respect of a decedent. COMPANY ISSUES 1. I.R.C. 338 and 1060 IRS Issues Final Regulations on the Sale, Acquisition of Insurance Companies The IRS released final and temporary regulations under I.R.C. 197, 338, 381, 848, and 1060, effective April 10, 2006, that deal with taxable reinsurance transactions by insurance companies. The two types of transactions highlighted in the regulations are elections under I.R.C. 338 (whereby a taxable purchase of the stock of the target insurance company is treated instead as a deemed assumption reinsurance transaction) and an actual indemnity or assumption reinsurance transaction where the assuming company also acquires significant business assets to which goodwill or going concern value could attach under I.R.C principles. The final regulations adopt, with some modifications, the proposed regulations (REG ) that were published in March In response to industry comments, one modification is to allow the application of the regulations retroactively. A more significant change was made to the rules requiring capitalization as a result of increases in the tax reserves allocable to acquired insurance contracts. Now, the new target (or assuming company) is treated as receiving additional premium for any taxable year in which the new target increases its reserves for acquired contracts, which in turn is required to be capitalized as part of the AGUB (adjusted grossed-up basis) used to determine the basis of the acquired assets. However, the additional premium deemed received is limited to the excess, if any, of the fair market value of old target s assets acquired by new target in the deemed or actual reinsurance transfer over the AGUB allocated to the acquired assets. In other words, capitalization will not be required once the Class I through V assets (assets other than intangible assets and goodwill) have a basis equal to the fair market value at the time of the acquisition. The regulations also confirm that the unamortized DAC balance may be transferred to a nonlife insurance company under I.R.C. 381, but add the requirement that the successor must acquire 50% or more of the transferor corporation s insurance business in order to succeed to the entire balance. The regulations do not elaborate on the definition of a significant business asset for purposes of determining whether a reinsurance transaction is subject to the new provisions under I.R.C or is treated as mere reinsurance subject to the general rules of Treas. Reg (d).

4 Page 4 2. I.R.C. 501(c)(15) IRS Releases Guidance on Gross Receipts The IRS released Notice , which provides guidance as to the meaning of gross receipts for purposes of I.R.C. 501(c)(15). The concept of gross receipts as a qualifying measure for exemption from federal income tax under I.R.C. 501(c)(15) was added by the Pension Funding Equity Act of 2004, but was not defined. Responding favorably to expressed industry concerns, the Notice makes it clear that the gross receipts concept used to determine whether a tax-exempt entity is required to file a Form 990 is not to be used for purposes of determining whether a small insurance company is eligible for exemption from federal income tax under I.R.C. 501(c)(15). Notice states that, for purposes of I.R.C. 501(c)(15)(A), gross receipts includes amounts received from the following sources: (1) premiums (including deposits and assessments), without reduction for return premiums paid for reinsurance; (2) the gross investment income of a non-life insurance company (as described in I.R.C. 834(b)); and (3) other items that are properly included in the taxpayer s gross income under the provision for computing taxable income. Thus, gross receipts include tax-exempt interest and the gain (but not the entire amount realized) from the sale or exchange of capital assets, both of which are included in gross investment income. Other than premium income or gross investment income, gross receipts does not include any amount that is not otherwise included in gross income. Thus, it does not include contributions to capital, or salvage or reinsurance recovered (which are accounted for as offsets to losses incurred.) Items (1) and (2) of the explanation for gross receipts are essentially identical to the gross amount received standard of pre-1986 law. Item (3) is additional, but specifically is limited to items that are gross income under subchapter B of chapter 1 of the federal income tax provisions. (I.R.C ). 3. I.R.C. 817 Procedural Requirements Set Forth for Qualified Pension or Retirement Plans to Invest in Funds Meeting Diversification Requirements under the Look-Through Rule In PLR (Dec. 15, 2005), the IRS concludes again that the holding of beneficial interests in regulated investment companies (RICs) by qualified pension or retirement plans does not affect the application of the look-through rule in determining whether the diversification requirements of I.R.C. 817(h) are met, provided the funds satisfy certain administrative verification requirements. This ruling is similar to PLR (Nov. 14, 2005), which was discussed in more detail in item 4 of the Company Issues in the February Tax Issues Summary. 4. I.R.C. 847 IRS Formally Releases Field Directive on Treatment of Special Loss Discount Accounts A field directive issued by the IRS s Large and Midsize Business Division on January 13, 2006, to provide direction on the background, identification, examination and reconciliation of I.R.C. 847 special loss discount accounts, now has been released formally by the IRS. See Plan Tax Service Bulletin No , April 7, The directive includes guidelines for IRS personnel examining insurance company returns involving the election to make special estimated tax payments ( SETP ) under I.R.C. 847, including instructions regarding more technical issues. See also item 2 of the Company Issues in the January Tax Issues Summary.

5 Page 5 5. I.R.C IRS Issues Temporary and Proposed Regulations on Tacking Rules for Life Insurance Companies The IRS has issued temporary regulations (T.D. 9258) which favorably modify the tacking rules under Treas. Reg for including a new life insurance company, which was previously part of an old member of a consolidated return, in the life-nonlife consolidated return. Specifically, the temporary regulations eliminate the separation requirement, which was a prior regulatory requirement for the tacking rules. Generally, the tacking rules allow the period during which an old life insurance company has been a member of the consolidated group to be tacked onto the period for a new company (which was formed from a portion of the old company s business) for purposes of the new company satisfying the five-year waiting period of I.R.C. 1504(c)(2) for becoming a member of the consolidated group. Under the separation requirement, if a new life insurance company was formed from part of an old life insurance company, the transfer of business from the old to the new company could not reasonably be expected to result in the separation of profitable activities from loss activities (the separation requirement ). The elimination of the separation requirement of the tacking rules in Tres. Reg (d)(12)(v) by the temporary regulations is effective for taxable years for which the filing due date, without extensions, is after April 25, The preamble of the regulations indicates that the separation requirement has been dropped from the tacking rules because the elimination of the three-phase system for taxing life insurance companies by the Tax Reform Act of 1984 and the practical elimination of carried-over phase three accounts by the American Jobs Creation Act of 2004 means that the opportunity for abuse at which the separation requirement was aimed no longer exists. The text of the temporary regulations serves as the text for proposed regulations (REG ), which were issued at the same time The IRS will consider comments and public hearing requests on the proposed regulations that are submitted by July 24, IRS Releases Updated Draft 2006 Schedules M-3 for Insurance Companies In a news release dated April 5, 2006, the IRS released new draft Schedules M-3 for 2006, which apply to subchapter S corporations, partnerships, and insurance companies. (IR ) Schedule M-3 is filed by insurance companies with total assets in excess of $10 million that file Forms 1120, 1120-PC, 1120-L, 1120-S, and An updated Form 8916, which reconciles taxable income reported on Schedule M-3, was released as well. The IRS requested that comments on the schedules and forms be submitted by June 1, The updated Schedules M-3 and new Form 8916 are available at 7. IASB Rejects Split Accounting for Insurance, Favors Use of Compromise Model On March 30, 2006, the International Accounting Standards Board (IASB) voted on an accounting model to deal with certain insurance contracts that are, in essence, compound instruments, comprising a liability to pay guaranteed benefits as well as an equity component. The IASB was given three accounting models to choose from, the first classifying the compound instrument as a liability, the second a split accounting model which would book the equity component separately from its compounded liability, and the third a compromise which would allow the premiums to be booked as revenue and obligations expensed against income as they arise. The third alternative was suggested by

6 Page 6 board member Jim Leisenring, who said he wants to avoid a situation where structuring opportunities could create equity. The board in its vote rejected the split accounting model, favoring instead Leisenring s compromise. The issues discussed preceding the vote continue to be under discussion and will revert to ISAB s staff for further work and consideration by the full board. IRS Circular 230 Disclosure: This newsletter is provided solely for informational purposes and is not intended to furnish legal advice with respect to the reader s particular factual circumstances. In accordance with of IRS Circular 230 requirements, you are advised that any discussion of tax issues in this newsletter is not intended or written to be used, and cannot be used, to avoid penalties imposed under the Internal Revenue Code or to promote, market or recommend to another party any transaction or matter addressed herein. The persuasiveness of this newsletter s discussion with regard to the tax issues in question and a taxpayer s good faith reliance on the newsletter will be determined under applicable provisions of the law and regulations ( 10.35(f)). For comments or questions, or if you would like to receive the Tax Issues Summary via electronic mail, please contact Katherine L. Berland at (202) or kberland@scribnerhall.com Scribner, Hall & Thompson, LLP, website: