IRS Provides Important Guidance on Changes in Basis of Computing Reserves under Section 807(f)
By Art Schneider and Mark Smith
Taxing Times, March 2021
In the fall of 2020, the Internal Revenue Service (“IRS”) issued Revenue Ruling (“Rev. Rul.”) 2020-19[1] to provide updated guidance on what constitutes a change in basis of computing reserves under section 807(f)[2] of the Internal Revenue Code (“Code”). The ruling was issued contemporaneously with final regulations regarding the computation and reporting of reserves for life insurance companies,[3] which obsoleted most of the prior IRS guidance on changes in basis of computing reserves that had been issued in the preceding six decades.[4] The ruling provides important, detailed guidance for insurance tax practitioners and for actuaries involved in the determination of reserves for statutory accounting and tax reporting purposes.
The need for updated guidance on changes in basis of computing reserves had become increasingly evident for three reasons. First, prior IRS guidance predated significant changes to the determination of reserves for statutory accounting purposes—in particular, the adoption of the National Association of Insurance Commissioners (“NAIC”) Valuation Manual and Principle-Based Reserve (“PBR”) methodologies for both life insurance and annuity contracts. Prior IRS guidance did not address specific issues that arise as a result of these nontax developments. Second, prior IRS guidance also predated significant changes that the Tax Cuts and Jobs Act of 2017 (“TCJA”) made to section 807(d).[5] In fact, much of the IRS’s prior guidance predated the last major pre-TCJA change in life insurance company taxation—the Deficit Reduction Act of 1984. Third, although the TCJA did not change the standard for determining what a change in basis is, it did change the manner in which such a change is accounted for.
The most recent significant guidance under section 807(f) was Rev. Rul. 94-74. Two of the four factual situations addressed in that ruling were rendered obsolete by TCJA changes to section 807(d). In addition, the methodology for effecting changes in basis was rendered obsolete by TCJA changes to section 807(f), and the situations described in the ruling did not take into account fundamental changes to the determination of reserves for statutory accounting purposes. For these reasons, during 2019, the life insurance industry had informally recommended updating Rev. Rul. 94-74, with facts, analysis, and holdings for situations that the industry believed would address more current fact patterns, including those related to PBR and the TCJA.
In mid-2020, the industry commented more formally on changes in basis of computing reserves in response to the proposed regulations on the computation and reporting of reserves for life insurance companies.[6] The proposed regulations indicated IRS intentions to obsolete one notice and fourteen revenue rulings (including Rev. Rul. 94-74) that previously had provided guidance on changes in basis for computing reserves. The American Council of Life Insurers (“ACLI”) submitted a comment letter dated June 1, 2020 on the proposed regulations, which included an Appendix with nine suggested fact situations to update IRS guidance under section 807(f). In response to these informal and formal comments, the IRS modified Rev. Rul. 94-74 in 2019[7] and obsoleted it in its entirety in 2020.[8]
Rev. Rul. 2020-19 largely follows the ACLI recommendations, and significantly updates the tax law guidance on changes in basis. Rev. Rul. 2020-19 now provides guidance on modern actuarial valuation standards such as PBR, as well as on tax valuation standards revised by the TCJA.
Rev. Rul. 2020-19 includes ten fact situations—nine of them based on the situations set forth in Appendix C of the ACLI comment letter, plus one other (Situation 3). The first five fact situations involve changes that result in changes in basis under section 807(f), while the last five involve changes that are not changes in basis. This article groups the ten situations as follows:
- Tax-only change in basis—Situations 1 and 3.
- Tax and statutory change in basis—Situations 2, 4 and 5.
- Tax and statutory no change in basis—Situations 6 and 7.
- Tax-only no change in basis—Situations 8, 9 and 10.
In each situation, IC is a calendar-year life insurance company within the meaning of section 816(a). IC issues life insurance and annuity contracts directly and also reinsures the risks on such contracts issued by other companies. IC is required to determine life insurance reserves under section 807(d) with respect to both directly written and reinsured contracts, and to take net increases or decreases in the reserves into account in computing life insurance company taxable income. IC computes the amount of the life insurance reserve for a contract in accordance with the net surrender value (“NSV”) floor of section 807(d)(1)(A) and (B) and the statutory cap of section 807(d)(1)(C).
Tax-only Change in Basis—Situations 1 and 3
Situation 1: Consistent impermissible application of the 92.81% factor of section 807(d)
Facts: Beginning in Year 1, IC issues variable annuity contracts within the meaning of section 817(d). On its federal income tax returns for Years 1 and 2, IC computed the amount of the reserve with regard to each of those contracts under the Commissioners' Annuities Reserve Valuation Method (“CARVM”) prescribed by the NAIC but incorrectly applied the 92.81% factor of section 807(d)(1)(B) to that entire amount, rather than only to the excess of that amount over the greater of each contract's NSV or the portion separately accounted for under section 817.
Analysis: IC applied the 92.81% factor of section 807(d) impermissibly on two consecutively filed Federal income tax returns—those for Year 1 and Year 2. IC therefore adopted an impermissible basis for computing reserves (old basis). Applying the 92.81% factor to the correct portion of the reserve determined under section 807(d)(2) (new basis) for Year 3 (year of change) is a change in basis under section 807(f). For the year of change, IC must obtain IRS consent to make this change following the applicable administrative guidance under section 446(e)[9] and section 1.446-1(e) and account for the difference between the tax reserve computed on the new basis as of Dec. 31, Year 3, and the tax reserve computed on the old basis as of Dec. 31, Year 3, attributable to contracts issued before Year 3, as an adjustment under section 481(a).
Holding: A change in the consistent, impermissible application of the 92.81% factor prescribed by section 807(d) is a change in basis.
Situation 3: Application of new computational requirements under VM-21 for variable annuity contracts beginning in the year of change
Facts: In Year 4, the NAIC makes a change to Valuation Manual 21 (“VM-21”) that imposes a new computational requirement as a component of CARVM on issuers of variable annuities with guaranteed minimum benefits. The requirement applies to the determination of statutory reserves as of Dec. 31, Year 4, with regard to contracts issued after Dec. 31, Year 3.
Analysis: The new requirement (new basis) is a change in the methodology for satisfying CARVM and therefore is a change in basis under section 807(f). IC must obtain IRS consent to make this change. Because the change only applies to contracts issued after Year 3, the change is made on a cut-off basis and no adjustment is required under section 481(a).
Holding: An NAIC Valuation Manual change in the methodology for computing reserves on contracts issued in the year of change is a change in basis.
Observation: Situation 3 was added by the IRS to the nine fact situations suggested by the ACLI. It reflects the IRS’s broad view on the application of section 446(e) and the IRS’s desire for notification of changes in basis through the administrative procedures for obtaining consent. Because section 807(f) describes a change in basis as occurring where the basis at the end of the current year differs from the basis at the end of the preceding year, it is arguable that Situation 3 should not result in a change in basis, but rather should be regarded as a change in fact, more akin to Situation 10. See additional commentary below regarding Situation 10.
Tax and Statutory[10] Reserve Change in Basis—Situations 2, 4 and 5
Situation 2: Imposition of new computational requirements under VM-21 for reserves on previously issued variable annuity contracts
Facts: In Year 4, the NAIC makes a change to VM-21 that imposes a new computational requirement as a component of CARVM on issuers of variable annuities with guaranteed minimum benefits. The requirement applies to the determination of statutory reserves as of Dec. 31, Year 4, with regard to contracts issued after Dec. 31, Year 1. On its federal income tax returns for Years 2 and 3, IC determined its reserves for these variable annuity contracts under the requirements of VM-21. As a result of the change in VM-21, IC's statutory reserves for these contracts as of Dec. 31, Year 4, will be lower than they would have been had the change not been made.
Analysis: A change to VM-21 imposes a new computational requirement as a component of CARVM on issuers of variable annuities with guaranteed minimum benefits (new basis). The requirement applies to the determination of reserves as of Dec. 31, Year 4 (year of change), and revises the prior VM-21 requirements (old basis) with regard to contracts issued after Dec. 31, Year 1. Because, for Federal income tax purposes, section 807(d)(3)(B)(ii) requires the use of the CARVM "which is applicable to the contract and in effect as of the date the reserve is determined," the change to VM-21 is required to be taken into account for purposes of applying section 807(d). The new requirement represents a change in the methodology for satisfying the CARVM as prescribed by the NAIC. The change is therefore a change in basis under section 807(f). IC must obtain IRS consent to make this change and must account for the difference between the tax reserve computed on the new basis as of Dec. 31, Year 4, and the tax reserve computed on the old basis as of Dec. 31, Year 4, attributable to contracts issued after Year 1 and before Year 4, as an adjustment under section 481(a).
Holding: An NAIC Valuation Manual change in the methodology for computing reserves on previously issued contracts is a change in basis.
Situation 4: Application of new Actuarial Guideline to the determination of reserves in Year 3 for contracts issued before Year 1
Facts: The NAIC issues a new Actuarial Guideline that imposes a new computational requirement for the Commissioners’ Reserve Valuation Method (“CRVM”) for universal life contracts issued before Year 1. The requirement applies to the determination of statutory reserves for these contracts as of Dec. 31, Year 3. IC's statutory reserves for these contracts as of Dec. 31, Year 3, will be lower than they would have been had the NAIC not issued the new Actuarial Guideline.
Analysis: A newly issued Actuarial Guideline imposes a new computational requirement for the CRVM for issuers of universal life contracts (new basis). The requirement applies to the determination of reserves as of Dec. 31, Year 3 (year of change), and revises the prior CRVM requirements (old basis) with regard to contracts issued before Year 1. Because, for Federal income tax purposes, section 807(d)(3)(B)(i) requires the use of the CRVM "which is applicable to the contract and in effect as of the date the reserve is determined," the new Actuarial Guideline is required to be taken into account for purposes of applying section 807(d). The new requirement represents a change in the methodology for satisfying the CRVM prescribed by the NAIC. The change therefore is a change in basis under section 807(f). IC must obtain IRS consent to make this change and account for the difference between the tax reserve computed on the new basis as of Dec. 31, Year 3, and the tax reserve computed on the old basis as of Dec. 31, Year 3, as an adjustment under section 481(a).
Holding: A change in Actuarial Guideline that results in a change in the methodology for computing reserves is a change in basis.
Situation 5: Change in mortality table used to compute net premium reserve under VM-20
Facts: IC computes its reserves for a group of life insurance contracts under NAIC Valuation Manual 20 (“VM-20”). The group of contracts passes both the stochastic exclusion test and the deterministic exclusion test of VM-20, and the company elects to exclude the group from both the stochastic reserve calculation and the deterministic reserve calculation. Accordingly, the statutory reserve for the group is equal to the sum of the policy net premium reserves.
VM-20 prescribes the mortality standard used to compute the net premium reserves for the contracts. The NAIC changes the Valuation Manual to require the use of the Year 1 Commissioners’ Standard Ordinary (“CSO”) mortality tables to compute the net premium reserves for all contracts subject to VM-20. The requirement applies to the determination of statutory reserves for these contracts as of Dec. 31, Year 3. IC's statutory reserves for each of the contracts in the group of contracts as of Dec. 31, Year 3, will be lower than they would have been had the NAIC not changed the Valuation Manual to prescribe the use of the Year 1 CSO mortality tables.
Analysis: Under the facts in Situation 5, the statutory reserve with regard to each contract is equal to the policy net premium reserve, and the tax reserve is the greater of 92.81% of this amount or the contract's NSV (old basis). The NAIC changes to the Valuation Manual to require the use of the Year 1 CSO mortality tables to compute the net premium reserves for all contracts subject to VM-20 (new basis), effective as of Dec. 31, Year 3, represent a change in the methodology for satisfying the CRVM prescribed by the NAIC. The change, therefore, is a change in basis under section 807(f). IC must obtain IRS consent to make this change and account for the difference between the tax reserve for contracts issued prior to Year 3 computed on the new basis as of Dec. 31, Year 3, and the tax reserve for such contracts computed on the old basis as of Dec. 31, Year 3, as an adjustment under section 481(a).
Holding: A change in the NAIC-prescribed mortality tables is a change in basis.
Tax and Statutory No Change in Basis—Situations 6 and 7
Situation 6: Change from using the deterministic reserve to using the sum of the policy net premium reserves under VM-20, because of the year-over-year comparison required by VM-20
Facts: IC computes its reserves for certain life insurance contracts under VM-20. Under VM-20, the minimum statutory reserve for the contracts is equal to the sum of the policy minimum net premium reserves for the contracts, plus the excess, if any, of the greater of the deterministic reserve for the contracts and the stochastic reserve for the contracts. For the taxable years ended Dec. 31, Year 1, and Dec. 31, Year 2, the deterministic reserve exceeded both the stochastic reserve and the sum of the policy net premium reserves for the contracts, and thus was the statutory reserve reported on the NAIC annual statement. The excess of the deterministic reserve over the sum of the policy net premium reserves was allocated to individual contracts in the manner prescribed by VM-20. IC’s statutory reserves at Dec. 31, Year 3, were equal to the sum of the policy net premium reserves for the contracts because this amount exceeded the deterministic reserve and stochastic reserve as of that date. There was no change in the method of computing the deterministic reserve, the stochastic reserve, or the sum of the policy net premium reserves for the contracts in Year 3.
Analysis: The comparison of the sum of the policy net premium reserves to the stochastic reserve and deterministic reserve is required under VM-20, which is the CRVM and the tax reserve method required to be used under section 807(d)(3). As a result, a change from using the deterministic reserve to using the sum of the policy net premium reserves is not a change in basis but rather a function of the year-over-year change in those amounts. The result would be the same if there had been a statutory deterministic reserve in Years 1, 2, and 3, and under the terms of VM-20 some contracts were not allocated any deterministic reserve in Years 1 and 2, but were allocated a portion of the deterministic reserve in Year 3.
Holding: A change under VM-20 from the deterministic reserve to the sum of the policy net premium reserves due solely to the fact that the sum of the policy net premium reserves is greater is not a change in basis.
Situation 7: Change in company experience mortality rates used to compute deterministic reserve that occurs by operation of VM-20
Facts: IC computes its reserves for certain life insurance contracts under VM-20. Under VM-20, the minimum statutory reserve for the contracts is equal to the sum of the policy minimum net premium reserves for the contracts, plus the excess, if any, of the greater of the deterministic reserve for the contracts and the stochastic reserve for the contracts. For the taxable years ended Dec. 31, Year 1, and Dec. 31, Year 2, the deterministic reserve exceeded both the stochastic reserve and the sum of the policy net premium reserves for the contracts, and, thus, was the statutory reserve reported on the NAIC annual statement. Pursuant to the requirements of VM-20, this excess was allocated to individual contracts. For purposes of computing the deterministic reserve, VM-20 requires that company experience mortality rates be determined for each mortality segment and that the company experience data used to determine those rates be updated at least every three years. Because of the VM-20 mandated update, the mortality rates used for certain segments to compute the deterministic reserve as of Dec. 31, Year 2, differed from those used for purposes of computing the deterministic reserve as of Dec. 31, Year 1.
Analysis: Though the mortality rates that IC used for purposes of computing the deterministic reserve as of Dec. 31, Year 2, differed from those used for purposes of computing the deterministic reserve as of Dec. 31, Year 1, the difference resulted from a requirement of VM-20 that the company experience rates be determined for each mortality segment and that experience data used to determine those rates be updated at least every three years. Because the update in mortality rates was by operation of the reserve methodology of VM-20, which IC used consistently in both Year 1 and Year 2, the change is not a change in basis of computing reserves.
Holding: An experience-based update in mortality rates, as required by VM-20, to determine the deterministic reserve is not a change in basis.
Tax-only No Change in Basis—Situations 8, 9 and 10
Situation 8: Change from reporting 92.81% of NAIC-prescribed reserve to reporting contract net surrender values that results from the yearly comparison required by section 807(d)
Facts: On its Federal income tax return for the taxable year ended Dec. 31, Year 1, IC reported tax reserves for certain fixed annuity contracts equal to 92.81% of the CARVM reserves for the contracts because that amount for each contract exceeded the NSV for each contract. For the taxable year ended Dec. 31, Year 2, IC, instead, reported tax reserves equal to the NSV of those same contracts because that amount for each contract was greater than 92.81% of the CARVM reserve for each contract. There was no change in the CARVM or in the method of computing the NSV for any contract in Year 2.
Analysis: Just as in Situation 6, where the reserve methodology entailed a comparison of the deterministic reserve and the sum of the policy net premium reserves, the reserve methodology here entails a comparison of two amounts prescribed by section 807(d) itself. The fact that year-over-year changes in these amounts result in different calculated amounts being taken into account does not change the principle that the comparison is inherent in the reserve methodology itself, and applying that methodology consistently is not a change in basis of computing reserves.
Holding: A change from tax reserves based on 92.81% of the reserve determined under section 807(d)(2) to tax reserves based on the contract NSV resulting solely from the year-over-year change in which is greater is not a change in basis.
Situation 9: One-time omission of policy cells for certain contracts
Facts: For purposes of computing its life insurance reserves under section 807(d), IC organizes its life insurance contracts into policy groupings or cells, each consisting of policies which are identical as to plan of insurance, year of issue or contract duration, age of issue, and other factors. In Year 2, after filing its federal income tax return for the Year 1 taxable year, IC discovered that due to a computer programming error, the policy cells for certain contracts issued during Year 1 had been omitted from the computation of IC's closing Year 1 tax reserves. Had the omitted policy cells been included in IC's closing Year 1 reserves, IC's life insurance reserves under section 807(d) at Dec. 31, Year 1, would have been greater than the amounts originally claimed. The computer programming error took place in Year 1 and affected no other taxable year.
Analysis: The understatement of IC's reserves at Dec. 31, Year 1, caused by the omission of the policy cells for certain contracts issued during Year 1, is the result of a mathematical or posting error. Correction of IC's omission of reserves for certain contracts is not a change in basis of computing reserves. Because this mathematical or posting error occurred only on its Federal income tax return for Year 1, IC should file an amended return for that taxable year, restating the closing reserves at Dec. 31, Year 1, to reflect the correct reserve amounts and taking these recomputed reserves into account in redetermining its life insurance company taxable income for that year.
Holding: An inclusion of policy cells that were previously omitted on a single return is a mathematical or posting error that is not a change in basis.
Observation: Situation 9 is essentially equivalent to Situation 4 of Revenue Ruling 94-74.
Situation 10: Addition of new benefit to existing policies
Facts: In Year 2, IC announced to certain policyholders that prospectively their policies would, at no increase in premium, carry an additional indemnity benefit should death result from a non-occupational vehicular accident. At the end of Year 2, IC included in its reserves for the relevant contracts an additional amount for the present value of this future unaccrued obligation. The additional amount would be a life insurance reserve under section 816(b) and was determined under a tax reserve method within the meaning of section 807(d)(2).
Analysis: There was no reserve attributable to the benefit at the close of Year 1 because the new life insurance benefit did not exist before the company became contractually liable for it in Year 2. The addition of the new benefit in Year 2 is a change in fact. An increase in reserve resulting from a change in fact is not a change in basis of computing reserves. Accordingly, the increase in reserves solely to provide for the additional contractual obligation of IC pursuant to the additional benefits provided during Year 2 under existing policies is not attributable to a change in basis of computing reserves.
Holding: The increase in reserves to provide solely for new benefits on existing contracts is not a change in basis.
Observation: The facts in situation 10 are based on those set forth in Rev. Rul. 69-444, which was obsoleted by T.D. 9911. These facts are akin to those in Situation 3, which reached the opposite conclusion—i.e., the change in that situation was determined to be a change in basis. Interestingly, the analysis of Situation 10 in Rev. Rul. 2020-19 does not include several sentences from the analysis in Rev. Rul. 69-444 that would have highlighted the similarities between the facts in Situations 3 and 10.
Notably, the ruling's analysis relies on newly issued final regulations under section 1.807-4, concerning changes in basis for computing reserves. For example, the ruling cites—
- Section 1.807-4(a) (explaining that a change in basis of computing section 807(c) reserves is a change in method of accounting for purposes of section 1.446-1(e), such that a life insurance company generally must obtain IRS consent pursuant to prescribed administrative procedures);[11]
- Section 1.807-4(b) (providing rules on the required adjustments under section 481(a)); and
- Section 1.807-4(c) (explaining how opening and closing balances of section 807(f) items are determined under section 807(a) and (b) when there is a change in basis under section 807(f)).
In addition, the ruling relies on general rules for methods of accounting providing that—
- A company adopts a method of accounting, or a basis of computing a section 807(c) reserve, when it uses a permissible basis of computing the item on the first federal income tax return that reflects the item.[12]
- If a company uses an impermissible method of accounting for one taxable year, doing so does not constitute adoption of a basis of computing the item. However, the consistent use of an impermissible method for an item on two or more consecutively filed tax returns establishes a method of accounting.[13]
- Once it has a method of accounting, a taxpayer may not change that method by amending its prior tax returns.
- A change in a section 807(c) reserve resulting from a change in underlying facts, or from correction of mathematical or posting errors, is not a change in basis.
Conclusion
Overall, Rev. Rul. 2020-19 reflects careful IRS consideration of thoughtful industry comments and provides useful updated guidance on changes in basis that reflect both industry developments in reserve valuation and TCJA changes to section 807. Accordingly, it may help in reducing future controversy between the IRS and taxpayers in examination.
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the editors, or the respective authors’ employers or clients.
Art Schneider is a consultant for the ACLI. He formerly was chief tax officer at Transamerica Corporation. He can be contacted at artschneider7661@gmail.com.
Mark Smith is a managing director in PwC’s Washington National Tax Services. He can be contacted at mark.s.smith@pwc.com.