July 2007
by F. Roy Sedore, New York
In January 2007, the Internal Revenue Service issued two rulings, one a Private Letter Ruling, the other a Revenue Ruling, regarding the investor control rules applicable to variable insurance contracts. While the two Rulings broke no new ground, they provide a useful restatement of the applicable law and IRS position regarding variable contracts, as well as a welcome clarification of the conformity of the investor control and diversification rules. The first Ruling, PLR 200701016, which was published January 5, 2007, analyzed the application of the “investor control rules” to group variable annuity contracts sold to various 501(c)(3) organizations. The premium received by the insurer would be allocated to one of two Accounts; each Account was invested in a separate Fund. Fund 1 was a limited partnership investing primarily in undeveloped real estate assets in the U.S.; Fund 2 was a regulated investment company which invested in short-term fixed income obligations and cash. Each of the Funds had the right, in its sole discretion, to invest and reinvest amounts invested in the Fund. A contract owner could allocate and reallocate assets between the Funds, but could not select or identify particular investments to be made or have the investment objective of the Funds changed. Likewise, the contract owner had no opportunity to influence, determine, specify or otherwise control the decision to buy, sell, retain or manage any specific investment, group of investments or the Accounts in general, nor were there any informed arrangements regarding investment of the Accounts. Investments in the Funds were restricted to insurance company segregated accounts, and were available only through ownership of a variable annuity or variable life insurance contract issued by an insurance company. The general public could not invest directly in the Accounts or in the assets underlying the Accounts. The Accounts were stated to be adequately diversified within the meaning of Section 817(h) of the Code, and the Regulations thereunder.
The Ruling reviewed the law applicable to variable contracts, and in particular the authorities regarding investor control. The Ruling first discussed Rev. Rul. 77-85, 1977-1 C.B. 12, in which the individual purchaser of a variable annuity contract retained the right to direct the custodian of the account supporting the annuity to purchase, sell or exchange specific securities or other assets held in the custodial account. The annuity purchaser was also able to exercise an owner’s right to vote the securities held in the account, either through the custodian or individually. Under those circumstances, the Service held in Rev. Rul. 77-85 that the contract holder would be treated as the owner of the underlying assets, and taxed currently on income derived from those assets.
PLR 200701016 next discussed Rev. Rul. 80-274, in which depositors in certain savings and loan associations could transfer cash, existing passbook accounts or certificates of deposit to an insurance company in exchange for annuity contracts; the insurance company deducted expenses and premium taxes, and deposited the net amount into a separate account at each contract holder’s savings and loan association, which invested those amounts in its own certificates of deposit for a term specified by the contract holder. Except for the ability to withdraw a deposit from a failing savings and loan, the insurer could not dispose of a deposit or convert it to other assets; in the event of a withdrawal from a failing savings and loan, the insurance company was required to deposit the funds in another federally chartered savings and loan. Reinvestment of a maturing certificate of deposit was likewise strictly restricted. Again the Service concluded that the contract holder retained sufficient control over the investment to be considered the owner of the underlying assets.
Revenue Ruling 81-225, 1981-2 C.B. 12, dealt with five situations in which assets in a segregated account would be invested in mutual funds. In situations 1 and 2 the funds would be invested in a single, specified publicly available mutual fund. In situation 3, the segregated account could be allocated, at the contract holder’s discretion, among 5 sub-accounts. Again, each sub-account was invested solely in a single, predetermined, publicly available mutual fund. Situation 4 was the same as situation 3, except that the mutual fund was available for purchase indirectly (rather than directly) by the general public. In each of these cases, the contract holder was held to have sufficient control over the investment to be 11 Baker & McKenzie treated as the owner of the underlying assets. Only in situation 5, in which the shares in the mutual fund were only available to purchasers of insurance contracts, was the contract holder held not to be the owner of the underlying assets. The Service acknowledged that in situations 1 through 4 the contract holder could not influence the individual investments made by the mutual fund; however, the shares of the mutual fund were themselves securities which the contract holder was effectively able to select, and the ownership of which would be attributed to him.
In contrast, in Rev. Rul. 82-54, the purchasers of annuity contracts were able to direct the investment of funds among three mutual funds which were not available to the general public, and which had differing general investment strategies (common stock, bonds and money market instruments). In that case the ability of the contract holder to choose among general investment strategies was not considered sufficient control to cause the contract holders to be treated as owners of the investments.
PLR 200701016 went on to discuss Rev. Ruls. 2003-91 and 2003-92. Rev. Rul. 2003-91 in essence expanded Rev. Rul. 82-54 to a situation with as many as 20 sub-accounts, again each with a different investment strategy, and again each available only through the purchase of an insurance contract. Other than the contract holder’s right to reallocate among sub-accounts, all investment decisions were made by the insurance company or independent investment advisors in their sole and absolute discretion. Contract holders could not choose or recommend particular investments or strategies, nor could they communicate directly or indirectly with the insurer or investment manager regarding the selection, quality or rate of return of any specific investment or group of investments held in the sub-account. Under those circumstances the contract holder again was not held to have sufficient control to be considered the owner of the investments. Revenue Ruling 2003-92 involved variable policies with 10 sub-accounts, each of which invested in a specific partnership. The partnerships were not publicly traded,but were available to qualified purchasers and accredited investors in private placement offerings. In that case, the Service treated the partnerships in the same manner as mutual funds available to the general public, and the contract holder was treated as the owner of the investments. In essence, in Rev. Rul. 2003-92, the Service considered qualified investors in private placements to be the functional equivalent of the general public. Revenue Ruling 2007-7, which was issued on January 11, 2007, further clarified and amplified Rev. Ruls. 81-225 and 2003-92.
Revenue Ruling 2007-7 concerned a situation in which all assets in the separate account were invested in a regulated investment company (“RIC”). All beneficial interests in RIC were held either by segregated asset accounts of the insurance company, or by persons described in Treas. Reg. § 1.817-5(f)(3) and access to shares in RIC was available exclusively either through purchase of a variable contract, or to investors described in Treas. Reg. § 1.817-5(f)(3). Persons listed in Treas. Reg. § 1.817-5(f)(3) are trustees of a qualified pension or retirement plan. The Service treated RIC as not being available to the general public, and held that the contract holders were not the owners of the underlying assets.
Section 817(h) and Treas. Reg. § 1.817-5 deal not with investor control, but rather with the diversification requirements applicable to variable contracts. Treas. Reg. § 1.817-5(f) provides a look through rule for use in determining whether the diversification requirements have been met, which in turn relies, in certain circumstances, on an investment being available only through the purchase of a variable insurance contract. In testing compliance with this requirement under the diversification rules,Treas. Reg. § 1.817-5(f) ignores the ability of trustees of qualified pension or retirement plans to purchase shares in RIC. Rev. Rul. 2007-7 in essence concludes that, if the ability of trustees of qualified pension or retirement plans to purchase funds is not treated as availability to the general public for purposes of the diversification rules, it should also not be treated as availability to the general public for purposes of the investor control rules. The conclusion in Rev. Rul. 2007-7 is a logical and welcome one. By applying the same standard under the investor control rules and the diversification rules for determining whether a fund available under a variable insurance contract is also available to the general public, the Ruling makes it easier for issuers of variable contracts to ensure that they are complying with the law. F.Roy Sedore New York