Section 197(f)(5) provides that, in the case of any amortizable section 197 intangible resulting from an assumption reinsurance transaction, the amount taken into account as the adjusted basis of such intangible is the excess of (A) the amount paid or incurred by the acquirer under the assumption reinsurance transaction over (B) the amount required to be capitalized under section 848 in connection with the transaction. Under section 848, an insurance company is required to capitalize an amount of otherwise deductible expenses equal to a percentage of the net premiums for the taxable year for certain categories of insurance contracts. The capitalized amounts, commonly referred to as deferred acquisition costs, or “DAC,” are amortized on a straight-line basis over 120 months.

Section 197(f)(5) is designed to ensure that the DAC amounts attributable to an assumption reinsurance transaction are amortized over the period specified by section 848 rather than the longer period under section 197. To achieve this result, the adjusted basis of the amortizable section 197 intangible resulting from an assumption reinsurance transaction is recognized only to the extent that the amount paid or incurred by the acquirer for the relevant contracts exceeds the DAC taken into account under section 848 as a result of the transaction.

The proposed regulations provide rules to determine the amounts paid or incurred for amortizable section 197 intangibles with respect to contracts acquired as a result of assumption reinsurance transactions occurring as part of transactions governed by section 1060 or section 338. The proposed regulations also provide rules for purposes of determining the DAC amounts for the transactions. See proposed §1.197-2(g)(5).

Under the proposed regulations, the amount paid or incurred by the acquirer under the assumption reinsurance transaction in a transaction governed by section 338 or 1060 is the amount of adjusted grossed up basis (AGUB) or consideration allocable to the insurance contracts under the residual method. The amount required to be capitalized under section 848 in connection with the assumption reinsurance transaction is determined by multiplying the acquirer’s specified policy acquisition expenses for the taxable year by a fraction, the numerator of which is the total tentative positive capitalization amount for the relevant group of acquired insurance contracts and the denominator of which is the total tentative required capitalization amount for the taxable year for all specified insurance contracts. The tentative positive capitalization amount for the relevant group of acquired insurance contracts is the net positive consideration received for the contracts in the assumption reinsurance transaction multiplied by the percentage factor applicable to the contracts under section 848(c).

An insurance company’s DAC amount may not exceed the company’s general deductions for the taxable year. See section 848(c). The amortization of intangibles under section 197 is a general deduction relevant in computing DAC. However, the amount of amortization under section 197 cannot be calculated until section 197(f)(5) is applied. To avoid complex calculations, for purposes of calculating the basis of amortization, the proposed regulations presume that one-half of the consideration allocated to the insurance contracts is amortizable under section 197. See proposed §1.197-2(g)(5)(i)(D)(2). Comments were requested regarding alternative approaches to calculating the basis for DAC amounts and section 197 amortization.

A number of comments were received relating to the proposed regulations under section 197(f)(5). Commentators requested that the final regulations clarify that section 197(f)(5) applies only to assumption reinsurance transactions, and not to indemnity reinsurance transactions. Commentators asked that the final regulations clarify that the full amount of consideration allocable to the reinsured contracts is currently deductible under section 848(g) when the provisions of section 848 apply to an indemnity reinsurance transaction that occurs as part of a section 1060 acquisition of an insurance business. Commentators also expressed concern that the proposed regulations could cause an acquirer’s DAC under section 848 to be subject to the general deductions cap in section 848(c) despite the existence of a substantial ceding commission. Commentators requested that the final regulations clarify that the election under §1.848-2(g)(8) is available to allow old target and new target in a deemed asset sale governed by section 338(h)(10) to determine the amount of DAC attributable to the transaction without regard to the general deductions limitation.

The temporary and proposed regulations generally follow the proposed rules under section 197(f)(5), subject to several modifications. In particular, the temporary and proposed rules build on the method under §1.848-2(g) of the existing regulations for determining the amounts capitalized under section 848 for a reinsurance agreement. Under the temporary and proposed rules, the amount of expenses capitalized under section 848 as a result of an assumption reinsurance transaction equals the lesser of (A) the required capitalization amount for the transaction, or (B) the amount of general deductions allocable to the transaction. The temporary and proposed rules also clarify that in the event that the acquirer purchases more than one category of specified insurance contracts, the determination of the amount capitalized under section 848 is made as if each category were transferred in a separate assumption reinsurance transaction.

The temporary and proposed regulations also modify the special rule in the proposed regulations with respect to the interplay between section 197(f)(5) and section 848 as regards the determination of the acquirer’s general deductions under section 848(c)(2). Under the temporary and proposed rules, an acquirer will determine its general deductions as if the entire amount paid or incurred for the acquired contracts were allocable to an amortizable section 197 intangible.

If the acquirer has a capitalization shortfall (i.e., the amount of general deductions allocable to the assumption reinsurance transaction is less than the required capitalization amount for the transaction), the temporary and proposed regulations permit the acquirer and the ceding company to elect under §1.848-2(g)(8) to determine the amount capitalized under section 848 without regard to the general deductions limitation. The additional amounts capitalized by the acquirer as a result of the election are treated as first reducing the adjusted basis of the amortizable section 197 intangible with regard to the insurance contracts acquired in the assumption reinsurance transaction, before reducing the acquirer’s otherwise deductible expenses. The temporary and proposed rules generally allow the acquirer to amortize a larger amount over the period specified by section 848 as compared to the proposed regulations.

The temporary and proposed regulations generally apply, on a cut-off basis, to acquisitions and dispositions on or after April 10, 2006. Thus, there is no adjustment under section 481(a). Taxpayers must make the change on their income tax return and should not file a Form 3115, Application for Change in Accounting Method. Taxpayers are permitted, however, to apply the regulations to acquisitions before that date on a transaction-by-transaction basis, with an adjustment under section 481(a). The temporary and proposed regulations provide a procedure for taxpayers to obtain automatic consent of the Commissioner to do so.

Proposed §1.197-2(g)(5)(ii)(A)(2) provides that basis recovery with respect to a section 197(f)(5) intangible transferred through indemnity reinsurance is permitted when sufficient economic rights relating to the insurance contracts that gave rise to the section 197(f)(5) intangible have been transferred. Sufficient economic rights are treated as transferred when the ceding company transfers the right to future income on the contracts. The proposed regulations also provide rules governing the amount of loss recognized on the disposition of a section 197(f)(5) intangible. The proposed regulations requested comments whether additional guidance should address other situations or issues.

Several commentators requested that the final regulations clarify when sufficient economic rights in a section 197(f)(5) intangible are transferred through indemnity reinsurance as well as additional examples to address situations relating to transfers through indemnity reinsurance of less than 100 percent of the insurance contracts that gave rise to the section 197(f)(5) intangible. The IRS and Treasury Department continue to believe that the rules contained in these regulations should refer to general tax principles, and will as needed, address these issues in future published guidance.

When a section 338 election is made for an insurance company, §1.338-11(d) of the proposed regulations provides that new target must capitalize its increases in reserves for any acquired contracts in the deemed asset sale. Similar principles apply for an applicable asset acquisition of an insurance business under section 1060. The proposed regulations generally require capitalization of increases in reserves for the acquired contracts in excess of cumulative annual increases of two percent per year from the acquisition date reserves. However, the proposed regulations do not require capitalization to the extent the increases in reserves reflect the time value of money, to the extent the increases in reserves occur while new target is under state receivership, or to the extent the deduction for the increases in reserves is spread over the 10 succeeding taxable years under section 807(f).

Many commentators objected to the rule requiring capitalization for increases in reserves after the transaction date. They questioned the justification for the rule, stating that the rule was inconsistent with, and overrode, principles established under subchapter L for determining losses incurred. Commentators argued that, under subchapter L principles, reserve liabilities are not treated like contingent liabilities and that it was inappropriate to treat the reserves as contingent liabilities even for the limited purposes of the regulation. Commentators also requested that the application of the rule be restricted to cases of abuse because the ceding company’s reserves assumed in the transaction are fair and reasonable estimates under Subchapter L as of the transaction date.

The commentators’ objections largely ignore the fact that the proposed regulations blend elements of the asset purchase model common to most taxpayers that dispose of or acquire assets for consideration that includes the discharge of liabilities and the services model that generally applies to insurance companies. Treating increases in reserves for acquired contracts similarly to contingent liabilities under the asset purchase model is just one aspect of that amalgam.

Under the asset purchase model, assumed contingent liabilities are an element of the consideration for which a buyer acquires assets. Thus, a buyer includes the contingent liability in its cost for the acquired assets. However, a buyer may not include the contingent liability in its cost until the liability is incurred for Federal income tax purposes. The buyer must capitalize the liability in the cost of the acquired assets even if the buyer could have currently deducted the liability had it arisen in the buyer’s historic business. Under the asset purchase model, the buyer does not realize any income for the assumption of the contingent liability; the buyer merely has bought assets. See Commissioner v. Oxford Paper, 194 F.2d 190 (2d Cir. 1951).

Under the services model, the seller (or ceding company) is treated as paying a premium to the buyer (or reinsurer) to assume the risk on its insurance contracts. The reinsurer includes in income the receipt of the premium and has a deduction for its increase in reserves for the additional risks assumed in the transaction. The amount of the premium income is generally equal to the consideration paid by the ceding company, that is, the fair market value of the assets that the ceding company transfers to the reinsurer in the transaction (though it may not be less than the amount of the reinsurer’s increase in tax reserves, see §1.817-4(d)(2)(iii)). Thus, when the fair market value of the assets that the ceding company transfers exceeds the reinsurer’s increase in tax reserves for the additional risks assumed in the transaction, the reinsurer has net income. See §1.817-4(d)(3) Example 4. Under the services model, no liabilities are treated as contingent liabilities. The reserve rules effectively treat increases to reserves for new risks as fixed liabilities and increases to reserves for existing risks as period expenses (similar to interest).

The proposed regulations blend the asset purchase model and the services model by—

(1) Using the residual method of sections 338 and 1060 to determine the value of goodwill and going concern value (which assumes that the value of all assets other than goodwill and going concern value is readily determinable) rather than the residual method of §1.817-4(d) to determine the value of insurance in force (which assumes that the value of all assets other than insurance in force is readily determinable);

(2) Treating the amount of old target’s tax reserves as a fixed liability as of the close of the acquisition date that is taken into account in determining the seller’s aggregate deemed sales price (ADSP) under §1.338-4 and the buyer’s AGUB under §1.338-5;

(3) Treating certain of new target’s increases in reserves for any insurance contracts acquired in the deemed asset sale as a contingent liability as of the close of the acquisition date that becomes fixed when new target increases its reserves;

(4) Assuming that the amount of reinsurance premium is equal to the amount of old target’s tax reserves, even though the ceding company would have to pay the reinsuring company an amount greater than the tax reserves in an arm’s length reinsurance transaction. This rule ensures that the acquirer of an insurance business will not have immediate net taxable income merely as a result of the acquisition; and

(5) Not requiring capitalization for new target’s increases in reserves due to the time value of money for any insurance contracts acquired in the deemed asset sale.

The proposed regulations generally treat an insurance company’s assumption of contingent liabilities related to insurance contracts more favorably than a noninsurance company’s assumption of a similar contingent liability. The proposed regulations also treat an insurance company’s assumption of contingent liabilities related to insurance contracts more favorably than subchapter L does. As discussed previously, under subchapter L, a reinsurer may have net income when entering into an assumption reinsurance transaction. The amount of the income is the amount of the bargain, that is, the excess of fair market value of the assets the seller transfers over the amount of the consideration the buyer pays at closing (in an assumption reinsurance transaction, the latter measured by the reinsurer’s increase in tax reserves for the risks assumed in the transaction). The proposed regulations, unlike subchapter L, require income to be recognized if there is an increase in certain reserves for the acquired insurance contracts.

The IRS and Treasury Department believe that a rule requiring capitalization of increases to reserves is a necessary corollary to the rule in the proposed regulations linking the amount of reinsurance deemed paid to the amount of old target’s tax reserves at the time of the assumption reinsurance transaction (with the concomitant result that new target has no income). The logical implication of the commentators’ arguments would be that the buyer should have premium income in a bargain purchase. In addition, without requiring capitalization of at least some increases to reserves, there is an incentive for sellers to defer increases in reserves. This incentive results from the fact that while the seller is generally indifferent to an increase in reserves (the immediate deduction to the seller would be offset by a corresponding increase in amount realized of ADSP in the sale), a buyer would be entitled to an immediate deduction rather than increased basis from an increase in the seller’s reserves.

In response to comments, the IRS and Treasury Department have decided to issue temporary regulations with these final regulations that continue to require capitalization (and concomitant treatment as premium) of certain reserve increases, but further limit the capitalization rule of the proposed regulations in a manner consistent with the application of subchapter L principles. See §1.338-11T(d). After the deemed asset sale, the temporary regulations apply subchapter L principles to new target. Under the temporary regulations, capitalization is required only for increases in reserves that clearly reflect a so called “bargain purchase” (that is, when the application of the residual method clearly indicates the initial understatement of the reserve). The amount of the bargain purchase is the amount of income the reinsurer would have otherwise recognized under §1.817-4(d) if the final regulations (and proposed regulations) had not adopted the convention that the reinsurance premium paid by the seller to the buyer is deemed to equal the seller’s closing tax reserves, and were it not necessary to employ a residual method to account for the presence of non-insurance intangible assets.

Under the temporary regulations, new target is required to capitalize any increases in reserves for acquired contracts if the AGUB allocated to assets in Class I through Class V is less than the fair market value of the assets in those classes. Any deductions would continue to be capitalized until the basis of the assets in Class I through Class V is equal to their fair market value. This mechanism avoids the problem of valuing Class VI and Class VII intangibles. The approach of the temporary regulations essentially treats the ceding company as transferring no Class VI or Class VII assets to the reinsurer for the reinsurer’s assumption of the liabilities on the acquired contracts. Because the temporary regulations limit the total amount of capitalization for increases in reserves for acquired contracts, the IRS and Treasury Department believe that it is no longer necessary to provide a time limit on when increases in reserves for acquired contracts are to be capitalized or to provide a floor below which increases in reserves are not capitalized. However the temporary regulations retain the other limits on capitalization in the proposed regulations.

Proposed §1.338-11(b)(2) provides a rule that for purposes of allocating AGUB and ADSP, the fair market value of a specific insurance contract or group of insurance contracts is the amount of the ceding commission a willing reinsurer would pay a willing ceding company in an arm’s length transaction for the reinsurance of the contracts if the gross reinsurance premium for the contracts were equal to old target’s tax reserves for the contracts.

Commentators questioned the reliance of the proposed regulations upon tax reserves as a basis for valuing the contracts and asked that the value of the contracts be based on GAAP or statutory reserves, or an amount upon which the parties agree. The IRS and Treasury Department believe that using tax reserves as a basis for valuing the contracts is consistent with other areas in which tax reserves, not GAAP or statutory reserves, are used to compute taxable income. See, e.g., section 807 (prescribing rules for taking life insurance reserves and certain other reserves into account for purposes of computing life insurance company taxable income); section 846 (prescribing a methodology for discounting unpaid loss reserves for purposes of computing insurance company taxable income); and Rev. Proc. 90-36, 1990-2 C.B. 357 (computing up-front ceding commission paid by a reinsurer as the increase in the reinsurer’s tax reserve liabilities resulting from the reinsurance transaction, minus the value of the net assets received, for purposes of capitalizing ceding commissions to comply with the Supreme Court decision in Colonial American Life Insurance Company v. Commissioner, 491 U.S. 244 (1989), (1989-2 C.B. 110, Ct. D. 2045). Moreover, in the context of a transaction governed by section 338 or 1060, the use of old target’s tax reserves as a means of valuing the contracts is consistent with both (i) the treatment of old target’s closing tax reserves as a liability in the computation of the seller’s ADSP and the buyer’s AGUB, and (ii) the general rule of §1.817-4(d)(2)(iii), which treats the assuming company in an assumption reinsurance transaction as receiving premium income equal to at least the increase in its reserves.

The proposed regulations do not provide any special rules under section 846 for new target to apply old target’s historical loss payment pattern as a result of a section 846(e) election made by old target because new target is generally treated as a new corporation that may adopt its own accounting methods without regard to the methods used by old target. See §1.338-1(b).

Commentators believed that this result was inconsistent with the purpose of allowing a company to make a section 846(e) election. Commentators noted that a section 846(e) election is made for all eligible lines of business, determined by reference to the accident years for the line of business shown on the insurance company’s annual statement. Additionally, commentators noted that the availability of the election should not depend upon the tax identity of new target after the section 338 election because the historical loss payment pattern is not a tax account, the pattern is determined by reference to nontax factors, and new target continues to operate in the same manner and legal form as old target.

In response to these comments, the temporary regulations contain a new rule that treats new target and old target as the same corporation for purposes of a section 846(e) election to use an insurance company’s historical loss payment pattern. See §1.338-1T(b)(2)(vii). Therefore, if old target has a section 846(e) election in effect, new target will continue to use the historical loss payment pattern of old target to discount unpaid losses, unless new target chooses to revoke the election. If new target revokes old target’s section 846(e) election, new target will use the industry-wide factors determined by the Secretary to discount unpaid losses incurred in accident years beginning on or after the acquisition date. See §1.338-11T(e)(2).

Section 1.381(c)(22)-1(b)(7)(i) of the proposed regulations provides that if one corporation distributes or transfers a substantial portion (50 percent or more) of an insurance business to another corporation in a transaction to which section 381 applies, then the acquiring corporation succeeds to the distributor or transferor corporation’s shareholders surplus account, policyholders surplus account, and other accounts. However, under §1.381(c)(22)-1(b)(7)(ii) of the proposed regulations, if an acquiring corporation in the section 381 transaction acquires less than 50 percent of the distributor or transferor corporation’s insurance business, then the acquiring corporation succeeds only to a ratable portion (determined by reference to reserves) of the distributor or transferor corporation’s shareholders surplus account, policyholders surplus account, and other accounts.

Commentators questioned whether the IRS and Treasury Department have the authority to relate the carryover of PSA to the percentage of business that was transferred to the acquiring corporation in a section 381 transaction. The IRS and Treasury Department believe that the rule in the proposed regulations is appropriate and that there is sufficient authority for the proposed rule. The legislative history to the 1984 Tax Reform Act indicates that the term indirect distribution is to be interpreted broadly to include any use of PSA funds for the indirect benefit of shareholders. H.R. Rep. No. 432, pt. 2, 98th Cong., 2d Sess. at 1410-11; Staff of the Joint Committee on Taxation, 98th Cong., 2d Sess., General Explanation of the Revenue Provisions of the Tax Reform Act of 1984, at 594 (1984), as well as Bankers Life and Casualty Co. v. United States, 79 AFTR2d (RIA) 1726 (N.D. Ill. 1996), aff’d on other grounds, 142 F.3d 973 (7th Cir. 1998), cert denied, 525 U.S. 961 (1998) (section 338(g) transaction results in an indirect distribution of old target’s PSA). Accordingly, the final regulations adopt the rule as proposed in §§1.338-11(f) and 1.381(c)(22)-1(b)(7).

Section 1.381(c)(22)-1(b)(13) of the proposed regulations provides that any remaining balances of DAC or excess negative DAC carry over to a successor insurance company in a section 381 transaction. One commentator questioned whether a nonlife insurance company may succeed to DAC attributes under §1.381(c)(22)-1. Another commentator believed positive DAC should not be carried over to a successor corporation in a section 381 transaction.

The IRS and Treasury Department believe that in a section 381 transaction, positive DAC, like negative DAC, is an attribute that is carried over to the acquiring corporation. Thus, the final regulations retain the rule in the proposed regulations that the remaining balances of DAC or excess negative DAC carry over to a successor insurance company in a section 381 transaction. See §1.381(c)(22)-1(b)(13). However, the IRS and Treasury Department believe that a proportionality rule similar to the one the final regulations adopt at §1.381(c)(22)-1(b)(7) for policyholder surplus accounts is appropriate because DAC is a tax accounting convention that relates to a line of business. Thus, the final regulations provide that when the acquiring corporation acquires 50 percent or more of the distributor or transferor corporation’s insurance business (measured by its reserves for all of its contracts immediately before the earlier of the distribution or transfer or the adoption of the plan of liquidation or reorganization), the acquiring corporation will succeed to the distributor or transferor corporation’s entire positive or negative DAC amount. To the extent an acquiring corporation in the section 381 transaction acquires less than 50 percent of the distributor or transferor corporation’s insurance business, then only that percentage of positive or negative DAC remains. In addition, because some attributes under section 381(c)(22) and §1.381(c)(22)-1 are equally relevant for life and nonlife insurance companies, the final regulations clarify that, except as otherwise provided, the rules in §1.381(c)(22)-1 apply to any insurance company, whether a life or a nonlife company.

The final and temporary regulations are effective for transactions on or after April 10, 2006. Commentators asked for an election to apply the final regulations to transactions completed before April 10, 2006. The IRS and Treasury Department believe that the elective retroactivity of the final regulations is warranted and administrable. Thus, the final regulations permit new target and old target an election to apply the final regulations, in whole, to qualified stock purchases occurring before April 10, 2006, if all taxable years for which the consequences of the section 338 election affect the computation of tax are open. In the case of a section 338 election for which a section 338(h)(10) election is made (or a section 338 election for a foreign target), new target’s ability to elect to retroactively apply the final regulations does not depend upon old target making the election. Similarly, old target’s ability to elect to retroactively apply the final regulations does not depend upon new target making the election. However, in the case of a section 338 election for a domestic target for which no section 338(h)(10) election is made, the purchasing corporation generally controls both the filing of new target’s returns and old target’s final return. Accordingly, when no section 338(h)(10) election is made and the target is a domestic corporation, new target and old target must both elect to retroactively apply the final regulations. If one of new target or old target cannot make the election, the other is not permitted to make the election. See §1.338(i)-1(c).

This section lists the headings that appear in §§1.197-2 and 1.197-2T.

* * * * *

(g) * * *

(5) Treatment of certain insurance contracts acquired in an assumption reinsurance transaction.

(i) In general.

(ii) Determination of adjusted basis of amortizable section 197 intangible resulting from an assumption reinsurance transaction.

(iii) Application of loss disallowance rule upon a disposition of an insurance contract acquired in an assumption reinsurance transaction.

(A) Disposition.

(1) In general.

(2) Treatment of indemnity reinsurance transactions.

(B) Loss.

(C) Examples.

(iv) Effective dates.

(A) In general.

(B) Application to pre-effective date acquisitions and dispositions.

(C) Change in method of accounting.

(1) In general.

(2) Acquisitions and dispositions on or after effective date.

(3) Acquisitions and dispositions before the effective date.

* * * * *

(a) through (g)(5)(i) [Reserved].

(ii) Determination of adjusted basis of amortizable section 197 intangible resulting from an assumption reinsurance transaction.

(A) In general.

(B) Amount paid or incurred by acquirer (reinsurer) under the assumption reinsurance transaction.

(C) Amount required to be capitalized under section 848 in connection with the transaction.

(1) In general.

(2) Required capitalization amount.

(3) General deductions allocable to the assumption reinsurance transaction.

(4) Treatment of a capitalization shortfall allocable to the reinsurance agreement.

(i) In general.

(ii) Treatment of additional capitalized amounts as the result of an election under §1.848-2(g)(8).

(5) Cross references and special rules.

(D) Examples.

(E) Effective date.

(g)(5)(iii) through (l) [Reserved].

Par. 3. Section 1.197-2 is amended by revising paragraph (g)(5) to read as follows:

* * * * *

(g) * * *

(5) Treatment of certain insurance contracts acquired in an assumption reinsurance transaction—(i) In general. Section 197 generally applies to insurance and annuity contracts acquired from another person through an assumption reinsurance transaction. See §1.809-5(a)(7)(ii) for the definition of assumption reinsurance. The transfer of insurance or annuity contracts and the assumption of related liabilities deemed to occur by reason of a section 338 election for a target insurance company is treated as an assumption reinsurance transaction. The transfer of a reinsurance contract by a reinsurer (transferor) to another reinsurer (acquirer) is treated as an assumption reinsurance transaction if the transferor’s obligations are extinguished as a result of the transaction.

(ii) Determination of adjusted basis of amortizable section 197 intangible resulting from an assumption reinsurance transaction. For further guidance, see §1.197-2T(g)(5)(ii).

(iii) Application of loss disallowance rule upon a disposition of an insurance contract acquired in an assumption reinsurance transaction. The following rules apply for purposes of applying the loss disallowance rules of section 197(f)(1)(A) to the disposition of a section 197(f)(5) intangible. For this purpose, a section 197(f)(5) intangible is an amortizable section 197 intangible the basis of which is determined under section 197(f)(5).

(A) Disposition—(1) In general. A disposition of a section 197 intangible is any event as a result of which, absent section 197, recovery of basis is otherwise allowed for Federal income tax purposes.

(2) Treatment of indemnity reinsurance transactions. The transfer through indemnity reinsurance of the right to the future income from the insurance contracts to which a section 197(f)(5) intangible relates does not preclude the recovery of basis by the ceding company, provided that sufficient economic rights relating to the reinsured contracts are transferred to the reinsurer. However, the ceding company is not permitted to recover basis in an indemnity reinsurance transaction if it has a right to experience refunds reflecting a significant portion of the future profits on the reinsured contracts, or if it retains an option to reacquire a significant portion of the future profits on the reinsured contracts through the exercise of a recapture provision. In addition, the ceding company is not permitted to recover basis in an indemnity reinsurance transaction if the reinsurer assumes only a limited portion of the ceding company’s risk relating to the reinsured contracts (excess loss reinsurance).

(B) Loss. The loss, if any, recognized by a taxpayer on the disposition of a section 197(f)(5) intangible equals the amount by which the taxpayer’s adjusted basis in the section 197(f)(5) intangible immediately before the disposition exceeds the amount, if any, that the taxpayer receives from another person for the future income right from the insurance contracts to which the section 197(f)(5) intangible relates. In determining the amount of the taxpayer’s loss on the disposition of a section 197(f)(5) intangible through a reinsurance transaction, any effect of the transaction on the amounts capitalized by the taxpayer as specified policy acquisition expenses under section 848 is disregarded.

(C) Examples. The following examples illustrate the principles of this paragraph (g)(5)(iii):

Example 1. (i) Facts. In a prior taxable year, as a result of a section 338 election with respect to T, new T was treated as purchasing all of old T’s insurance contracts that were in force on the acquisition date in an assumption reinsurance transaction. Under §§1.338-6 and 1.338-11(b)(2), the amount of AGUB allocable to the future income right from the purchased insurance contracts was $15, net of the amounts required to be capitalized under section 848 as a result of the assumption reinsurance transaction. At the beginning of the current taxable year, as a result of amortization deductions allowed by section 197(a), new T’s adjusted basis in the section 197(f)(5) intangible resulting from the assumption reinsurance transaction is $12. During the current taxable year, new T enters into an indemnity reinsurance agreement with R, another insurance company, in which R assumes 100 percent of the risk relating to the insurance contracts to which the section 197(f)(5) intangible relates. In the indemnity reinsurance transaction, R agrees to pay new T a ceding commission of $10 in exchange for the future profits on the underlying reinsured policies. Under the indemnity reinsurance agreement, new T continues to administer the reinsured policies, but transfers investment assets equal to the required reserves for the reinsured policies together with all future premiums to R. The indemnity reinsurance agreement does not contain an experience refund provision or a provision allowing new T to terminate the reinsurance agreement at its sole option. New T retains the insurance licenses and other amortizable section 197 intangibles acquired in the deemed asset sale and continues to underwrite and issue new insurance contracts.

(ii) Analysis. The indemnity reinsurance agreement constitutes a disposition of the section 197(f)(5) intangible because it involves the transfer of sufficient economic rights attributable to the insurance contracts to which the section 197(f)(5) intangible relates such that recovery of basis is allowed. For purposes of applying the loss disallowance rules of section 197(f)(1) and paragraph (g) of this section, new T’s loss is $2 (new T’s adjusted basis in the section 197(f)(5) intangible immediately before the disposition ($12) less the ceding commission ($10)). Therefore, new T applies $10 of the adjusted basis in the section 197(f)(5) intangible against the amount received from R for the future income right on the reinsured policies and increases its basis in the amortizable section 197 intangibles that it acquired and retained from the deemed asset sale by $2, the amount of the disallowed loss. The amount of new T’s disallowed loss under section 197(f)(1)(A) is determined without regard to the effect of the indemnity reinsurance transaction on the amounts capitalized by new T as specified policy acquisition expenses under section 848.

Example 2. (i) Facts. Assume the same facts as in Example 1, except that under the indemnity reinsurance agreement R agrees to pay new T a ceding commission of $5 with respect to the underlying reinsured contracts. In addition, under the indemnity reinsurance agreement, new T is entitled to an experience refund equal to any future profits on the reinsured contracts in excess of the ceding commission plus an annual risk charge. New T also has a right to recapture the business at any time after R has recovered an amount equal to the ceding commission.

(ii) Analysis. The indemnity reinsurance agreement between new T and R does not represent a disposition because it does not involve the transfer of sufficient economic rights with respect to the future income on the reinsured contracts. Therefore, new T may not recover its basis in the section 197(f)(5) intangible to which the contracts relate and must continue to amortize ratably the adjusted basis of the section 197(f)(5) intangible over the remainder of the 15-year recovery period and cannot apply any portion of this adjusted basis to offset the ceding commission received from R in the indemnity reinsurance transaction.

(iv) Effective dates—(A) In general—This paragraph (g)(5) applies to acquisitions and dispositions on or after April 10, 2006. For rules applicable to acquisitions and dispositions before that date, see §1.197-2 in effect before that date (see 26 CFR part 1, revised April 1, 2001).

(B) Application to pre-effective date acquisitions and dispositions. A taxpayer may choose, on a transaction-by-transaction basis, to apply the provisions of this paragraph (g)(5) to property acquired and disposed of before April 10, 2006.

(C) Change in method of accounting—(1) In general—A change in a taxpayer’s treatment of all property acquired and disposed under paragraph (g)(5) is a change in method of accounting to which the provisions of sections 446 and 481 and the regulations thereunder apply.

(2) Acquisitions and dispositions on or after effective date. A Taxpayer is granted the consent of the Commissioner under section 446(e) to change its method of accounting to comply with this paragraph (g)(5) for acquisitions and dispositions on or after April 10, 2006. The change must be made on a cut-off basis with no section 481(a) adjustment. Notwithstanding §1.446-1(e)(3), a taxpayer should not file a Form 3115, “Application for Change in Accounting Method,” to obtain the consent of the Commissioner to change its method of accounting under this paragraph (g)(5)(iv)(C)(2). Instead, a taxpayer must make the change by using the new method on its federal income tax returns.

(3) Acquisitions and dispositions before the effective date. For the first taxable year ending after April 10, 2006, a taxpayer is granted consent of the Commissioner to change its method of accounting for all property acquired in transactions described in paragraph (g)(5)(iv)(B) to comply with this paragraph (g)(5) unless the proper treatment of any such property is an issue under consideration in an examination, before an Appeals office, or before a Federal Court. (For the definition of when an issue is under consideration, see, Rev. Proc. 97-27, 1997-1 C.B. 680; and, §601.601(d)(2) of this chapter). A taxpayer changing its method of accounting in accordance with this paragraph (g)(5)(iv)(C)(3) must follow the applicable administrative procedures for obtaining the Commissioner’s automatic consent to a change in method of accounting (for further guidance, see, for example, Rev. Proc. 2002-9, 2002-1 C.B. 327, as modified and clarified by Announcement 2002-17, 2002-1 C.B. 561, modified and amplified by Rev. Proc. 2002-19, 2002-1 C.B. 696, and amplified, clarified and modified by Rev. Proc. 2002-54, 2002-2 C.B. 432; and, §601.601(d)(2) of this chapter), except, for purposes of this paragraph (g)(5)(iv)(C)(3), any limitations in such administrative procedures for obtaining the automatic consent of the Commissioner shall not apply. However, if the taxpayer is under examination, before an appeals office, or before a Federal court, the taxpayer must provide a copy of the application to the examining agent(s), appeals officer, or counsel for the government, as appropriate, at the same time that it files the copy of the application with the National Office. The application must contain the name(s) and telephone number(s) of the examining agent(s), appeals officer, or counsel for the government, as appropriate. For purposes of From 3115, “Application for Change in Accounting Method,” the designated number for the automatic accounting method change authorized by this paragraph (g)(5)(iv)(C)(3) is “98”. A change in method of accounting in accordance with this paragraph (g)(5)(iv)(C)(3) requires an adjustment under section 481(a).

* * * * *

Par. 4. Section 1.197-2T is added to read as follows:

(a) through (g)(5)(i) [Reserved]. For further guidance, see §1.197-2(a) through (g)(5)(i).

(g)(5)(ii) Determination of adjusted basis of amortizable section 197 intangible resulting from an assumption reinsurance transaction—(A) In general. Section 197(f)(5) determines the basis of an amortizable section 197 intangible for insurance or annuity contracts acquired in an assumption reinsurance transaction. The basis of such intangible is the excess, if any, of—

(1) The amount paid or incurred by the acquirer (reinsurer) under the assumption reinsurance transaction; over

(2) The amount, if any, required to be capitalized under section 848 in connection with such transaction.

(B) Amount paid or incurred by acquirer (reinsurer) under the assumption reinsurance transaction. The amount paid or incurred by the acquirer (reinsurer) under the assumption reinsurance transaction is —

(1) In a deemed asset sale resulting from an election under section 338, the amount of the AGUB allocable thereto (see §§1.338-6 and 1.338-11(b)(2));

(2) In an applicable asset acquisition within the meaning of section 1060, the amount of the consideration allocable thereto (see §§1.338-6, 1.338-11(b)(2), and 1.1060-1(c)(5)); and

(3) In any other transaction, the excess of the increase in the reinsurer’s tax reserves resulting from the transaction (computed in accordance with sections 807, 832(b)(4)(B), and 846) over the value of the net assets received from the ceding company in the transaction.

(C) Amount required to be capitalized under section 848 in connection with the transaction —(1) In general. The amount required to be capitalized under section 848 for specified insurance contracts (as defined in section 848(e)) acquired in an assumption reinsurance transaction is the lesser of—

(i) The reinsurer’s required capitalization amount for the assumption reinsurance transaction; or

(ii) The reinsurer’s general deductions (as defined in section 848(c)(2)) allocable to the transaction.

(2) Required capitalization amount. The reinsurer determines the required capitalization amount for an assumption reinsurance transaction by multiplying the net positive or net negative consideration for the transaction by the applicable percentage set forth in section 848(c)(1) for the category of specified insurance contracts acquired in the transaction. See §1.848-2(g)(5). If more than one category of specified insurance contracts is acquired in an assumption reinsurance transaction, the required capitalization amount for each category is determined as if the transfer of the contracts in that category were made under a separate assumption reinsurance transaction. See §1.848-2(f)(7).

(3) General deductions allocable to the assumption reinsurance transaction. The reinsurer determines the general deductions allocable to the assumption reinsurance transaction in accordance with the procedure set forth in §1.848-2(g)(6). Accordingly, the reinsurer must allocate its general deductions to the amount required under section 848(c)(1) on specified insurance contracts that the reinsurer has issued directly before determining the general deductions allocable to the assumption reinsurance transaction. For purposes of allocating its general deductions under §1.848-2(g)(6), the reinsurer includes premiums received on the acquired specified insurance contracts after the assumption reinsurance transaction in determining the amount required under section 848(c)(1) on specified insurance contracts that the reinsurer has issued directly. If the reinsurer has entered into multiple reinsurance agreements during the taxable year, the reinsurer determines the general deductions allocable to each reinsurance agreement (including the assumption reinsurance transaction) by allocating the general deductions allocable to reinsurance agreements under §1.848-2(g)(6) to each reinsurance agreement with a positive required capitalization amount.

(4) Treatment of a capitalization shortfall allocable to the reinsurance agreement—(i) In general. The reinsurer determines any capitalization shortfall allocable to the assumption reinsurance transaction in the manner provided in §§1.848-2(g)(4) and 1.848-2(g)(7). If the reinsurer has a capitalization shortfall allocable to the assumption reinsurance transaction, the ceding company must reduce the net negative consideration (as determined under §1.848-2(f)(2)) for the transaction by the amount described in §1.848-2(g)(3) unless the parties make the election provided in §1.848-2(g)(8) to determine the amounts capitalized under section 848 in connection with the transaction without regard to the general deductions limitation of section 848(c)(2).

(ii) Treatment of additional capitalized amounts as the result of an election under §1.848-2(g)(8). The additional amounts capitalized by the reinsurer as the result of the election under §1.848-2(g)(8) reduce the adjusted basis of any amortizable section 197 intangible with respect to specified insurance contracts acquired in the assumption reinsurance transaction. If the additional capitalized amounts exceed the adjusted basis of the amortizable section 197 intangible, the reinsurer must reduce its deductions under section 805 or section 832 by the amount of such excess. The additional capitalized amounts are treated as specified policy acquisition expenses attributable to the premiums and other consideration on the assumption reinsurance transaction and are deducted ratably over a 120-month period as provided under section 848(a)(2).

(5) Cross references and special rules. In general, for rules applicable to the determination of specified policy acquisition expenses, net premiums, and net consideration, see section 848(c) and (d), and §1.848-2(a) and (f). However, the following special rules apply for purposes of this paragraph (g)(5)(ii)(C)—

(i) The amount required to be capitalized under section 848 in connection with the assumption reinsurance transaction cannot be less than zero;

(ii) For purposes of determining the company’s general deductions under section 848(c)(2) for the taxable year of the assumption reinsurance transaction, the reinsurer takes into account a tentative amortization deduction under section 197(a) as if the entire amount paid or incurred by the reinsurer for the specified insurance contracts were allocated to an amortizable section 197 intangible with respect to insurance contracts acquired in an assumption reinsurance transaction; and

(iii) Any reduction of specified policy acquisition expenses pursuant to an election under §1.848-2(i)(4) (relating to an assumption reinsurance transaction with an insolvent insurance company) is disregarded.

(D) Examples. The following examples illustrate the principles of this paragraph (g)(5)(ii):

Example 1. (i) Facts. On January 15, 2006, P acquires all of the stock of T, an insurance company, in a qualified stock purchase and makes a section 338 election for T. T issues individual life insurance contracts which are specified insurance contracts as defined in section 848(e)(1). P and new T are calendar year taxpayers. Under §§1.338-6 and 1.338-11(b)(2), the amount of AGUB allocated to old T’s individual life insurance contracts is $300,000. On the acquisition date, the tax reserves for old T’s individual life insurance contracts are $2,000,000. After the acquisition date, new T receives $1,000,000 of net premiums with respect to new and renewal individual life insurance contracts and incurs $100,000 of general deductions under 848(c)(2) through December 31, 2006. New T engages in no other reinsurance transactions other than the assumption reinsurance transaction treated as occurring by reason of the section 338 election.

(ii) Analysis. The transfer of insurance contracts and the assumption of related liabilities deemed to occur by reason of the election under section 338 is treated as an assumption reinsurance transaction. New T determines the adjusted basis under section 197(f)(5) for the life insurance contracts acquired in the assumption reinsurance transaction as follows. The amount paid or incurred for the individual life insurance contracts is $300,000. To determine the amount required to be capitalized under section 848 in connection with the assumption reinsurance transaction, new T compares the required capitalization amount for the assumption reinsurance transaction with the general deductions allocable to the transaction. The required capitalization amount for the assumption reinsurance transaction is $130,900, which is determining by multiplying the $1,700,000 net positive consideration for the transaction ($2,000,000 reinsurance premium less $300,000 ceding commission) by the applicable percentage under section 848(c)(1) for the acquired individual life insurance contracts (7.7%). To determine its general deductions, new T takes into account a tentative amortization deduction under section 197(a) as if the entire amount paid or incurred for old T’s individual life insurance contracts ($300,000) were allocable to an amortizable section 197 intangible with respect to insurance contracts acquired in the assumption reinsurance transaction. Accordingly, for the year of the assumption reinsurance transaction, new T is treated as having general deductions under section 848(c)(2) of $120,000 ($100,000 + $300,000/15). Under §1.848-2(g)(6), these general deductions are first allocated to the $77,000 capitalization requirement for new T’s directly written business ($1,000,000 x .077). Thus, $43,000 ($120,000 − $77,000) of the general deductions are allocable to the assumption reinsurance transaction. Because the general deductions allocable to the assumption reinsurance transaction ($43,000) are less than the required capitalization amount for the transaction ($130,900), new T has a capitalization shortfall of $87,900 ($130,900 − $43,000) with regard to the transaction. Under §1.848-2(g), this capitalization shortfall would cause old T to reduce the net negative consideration taken into account with respect to the assumption reinsurance transaction by $1,141,558 ($87,900 ÷ .077) unless the parties make the election under §1.848-2(g)(8) to capitalize specified policy acquisition expenses in connection with the assumption reinsurance transaction without regard to the general deductions limitation. If the parties make the election, the amount capitalized by new T under section 848 in connection with the assumption reinsurance transaction would be $130,900. The $130,900 capitalized by new T under section 848 would reduce new T’s adjusted basis of the amortizable section 197 intangible with respect to the specified insurance contracts acquired in the assumption reinsurance transaction. Accordingly, new T would have an adjusted basis under section 197(f)(5) with respect to the individual life insurance contracts acquired from old T of $169,100 ($300,000 − 130,900). New T’s actual amortization deduction under section 197(a) with respect to the amortizable section 197 intangible for insurance contracts acquired in the assumption reinsurance transaction would be $11,273 ($169,100 ÷ 15).

Example 2. (i) Facts. The facts are the same as Example 1, except that T only issues accident and health insurance contracts that are qualified long-term care contracts under section 7702B. Under section 7702B(a)(5), T’s qualified long-term care insurance contracts are treated as guaranteed renewable accident and health insurance contracts, and, therefore, are considered specified insurance contracts under section 848(e)(1). Under §§1.338-6 and 1.338-11(b)(2), the amount of AGUB allocable to T’s qualified long-term care insurance contracts is $250,000. The amount of T’s tax reserves for the qualified long-term care contracts on the acquisition date is $7,750,000. Following the acquisition, new T’s receives net premiums of $500,000 with respect to qualified long-term care contracts and incurs general deductions of $75,000 through December 31, 2006.

(ii) Analysis. The transfer of insurance contracts and the assumption of related liabilities deemed to occur by reason of the election under section 338 is treated as an assumption reinsurance transaction. New T determines the adjusted basis under section 197(f)(5) for the insurance contracts acquired in the assumption reinsurance transaction as follows. The amount paid or incurred for the insurance contracts is $250,000. To determine the amount required to be capitalized under section 848 in connection with the assumption reinsurance transaction, new T compares the required capitalization amount for the assumption reinsurance transaction with the general deductions allocable to the transaction. The required capitalization amount for the assumption reinsurance transaction is $577,500, which is determining by multiplying the $7,500,000 net positive consideration for the transaction ($7,750,000 reinsurance premium less $250,000 ceding commission) by the applicable percentage under section 848(c)(1) for the acquired insurance contracts (7.7%). To determine its general deductions, new T takes into account a tentative amortization deduction under section 197(a) as if the entire amount paid or incurred for old T’s insurance contracts ($250,000) were allocable to an amortizable section 197 intangible with respect to insurance contracts acquired in the assumption reinsurance transaction. Accordingly, for the year of the assumption reinsurance transaction, new T is treated as having general deductions under section 848(c)(2) of $91,667 ($75,000 + $250,000/15). Under §1.848-2(g)(6), these general deductions are first allocated to the $38,500 capitalization requirement for new T’s directly written business ($500,000 x .077). Thus, $53,167 ($91,667 − $38,500) of general deductions are allocable to the assumption reinsurance transaction. Because the general deductions allocable to the assumption reinsurance transaction ($53,167) are less than the required capitalization amount for the transaction ($577,500), new T has a capitalization shortfall of $524,333 ($577,500 − $53,167) with regard to the transaction. Under §1.848-2(g), this capitalization shortfall would cause old T to reduce the net negative consideration taken into account with respect to the assumption reinsurance transaction by $6,809,519 ($524,333 ÷ .077) unless the parties make the election under §1.848-2(g)(8) to capitalize specified policy acquisition expenses in connection with the assumption reinsurance transaction without regard to the general deductions limitation. If the parties make the election, the amount capitalized by new T under section 848 in connection with the assumption reinsurance transaction would increase from $53,167 to $577,500. Pursuant to §1.197-2(g)(5)(ii)(C)(4), the additional $524,333 ($577,500 − $53,167) capitalized by new T under section 848 would reduce new T’s adjusted basis of the amortizable section 197 intangible with respect to the insurance contracts acquired in the assumption reinsurance transaction. Accordingly, new T’s adjusted basis of the section 197 intangible with regard to the insurance contracts is reduced from $196,833 ($250,000 − $53,167) to $0. Because the additional $524,333 capitalized pursuant to the §1.848-2(g)(8) election exceeds the $196,833 adjusted basis of the section 197 intangible before the reduction, new T is required to reduce its deductions under section 805 by the $327,500 ($524,333 − 196,833).

(E) Effective date. This section applies to acquisitions and dispositions of insurance contracts on or after April 10, 2006. The applicability of this section expires on or before April 7, 2009.

(g)(5)(iii) through (l) [Reserved]. For further guidance, see §1.197-2(g)(5)(iii) through (l).

Par. 5. Section 1.338-0 is amended by adding entries to the outline of topics for §1.338-11, §1.338-11T and §1.338(i)-1 to read as follows:

* * * * *

(a) In general.

(b) Computation of ADSP and AGUB.

(1) Reserves taken into account as a liability.

(2) Allocation of ADSP and AGUB to specific insurance contracts.

(c) Application of assumption reinsurance principles.

(1) In general.

(2) Reinsurance premium.

(3) Ceding commission.

(4) Examples.

(d) Reserve increases by new target after the deemed asset sale.

(e) Effect of section 338 election on section 846(e) election.

(f) Effect of section 338 election on old target’s capitalization amounts under section 848.

(1) Determination of net consideration for specified insurance contracts.

(2) Determination of capitalization amount.

(3) Section 381 transactions.

(g) Effect of section 338 election on policyholders surplus account.

(h) Effect of section 338 election on section 847 special estimated tax payments.

(a) through (c) [Reserved].

(d) Reserve increases by new target after the deemed asset sale.

(1) In general.

(2) Exceptions.