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Cuna Mutual Life Insurance Co. v. United States

February 09, 1999


Before Rader, Circuit Judge, Friedman, Senior Circuit Judge, and Bryson, Circuit Judge.

The opinion of the court was delivered by: Friedman, Senior Circuit Judge

Appealed from: United States Court of Federal Claims Judge Robert H. Hodges, Jr.

A provision of the Internal Revenue Code requires a mutual life insurance company to reduce a particular deduction from its income (and thereby increase its taxable income) by "the excess of" the "imputed earnings rate [of stock life insurance companies] over . . . the average mutual [life insurance company] earnings rate." The appellant mutual life insurance company contends that if "the average mutual earnings rate" is greater rather than less than "the imputed earnings rate," it may increase its deduction (and thereby decrease its taxable income) by that amount. The Court of Federal Claims rejected the company's theory, and we affirm.


A. Life insurance companies traditionally rebate to their policy holders, as excessive charges, part of the premiums paid and deduct these payments from their income. In addition to these so-called policyholder dividends, stock life insurance companies also pay dividends out of earnings to their shareholders, which the company cannot deduct. Mutual companies, however, have no stockholders; the policyholders in effect own the company. Accordingly, the policyholder dividends that mutual companies pay to their policyholders also may include a distribution of earnings that cannot be identified as such because the mutual company distributes only the single category of policyholder dividends. Therefore, a deduction of policyholder dividends that does not distinguish between mutual and stock companies may give mutual companies an advantage, because they can effectively deduct otherwise non-deductible distributions of earnings.

B. In 1984 Congress revised the Code provisions governing the taxation of life insurance companies and set out new rules distinguishing between stock and mutual company policyholder dividend deductions. While allowing stock companies to deduct all their policyholder dividends, the new rules provided a series of complex calculations designed to determine what portion of a mutual life insurance company's policyholder dividends constitute a distribution of earnings and reduce the mutual insurance company's policyholder dividend deduction accordingly. I.R.C. §§ 808(c), 809 (Supp. IV 1986).

The Internal Revenue Service first compares the average earnings of the two segments of the industry - (1) an "imputed" rate for stock companies, set at 16.5 percent for 1984 and thereafter annually recomputed on a three year basis pursuant to a formula, §§ 809(c)(1)(A), (d), and (2) the actual average earnings rate for the mutual segment of the industry, albeit from "the second calendar year preceding the calendar year in which the taxable year begins," § 809(c)(1)(B), because the current average rate is unavailable before the filing deadline. The "excess" of the "imputed earnings rate" for the taxable year "over" the "average mutual earnings rate" for the earlier year, the "differential earnings rate," § 809(c)(1), is then multiplied by the particular mutual company's "average equity base," § 809(a)(3). The resulting dollar "differential earnings amount" is then deducted from the amount paid or accrued as policyholder dividends in the taxable year. § 809 (a)(1).

The House Committee Report on the legislation explained the theory of these calculations as follows:

Because mutual companies' policyholders are also the owners of the enterprise, policyholder dividends paid to them are distributions from the company that are a combination of price rebates, policyholder benefits and returns of company profits. Although there is no precise way to segregate a policyholder dividend or other payment into these various components, the committee believes that it is valid to conclude that profit oriented enterprises tend to distribute earnings to their owners in amounts that are proportional to the owners' equity in the business. Thus, the committee believes that the portion of a policyholder dividend that is a distribution of earnings can be measured as a percentage of the mutual company's equity ("the average equity base"). To determine the appropriate percentage of the equity base, the after [policyholder] dividend rates of return on equity for both stock and mutual companies were examined, and it was determined that the pre-tax return on equity of mutual companies falls below that for a comparable group of stock companies. The committee believes that this difference is attributable to distribution by mutual companies of earnings to their owners.

Under the bill, this theoretical approach to identifying ownership distributions is given effect by means of a reduction in the policyholder dividends deduction by a "differential earnings amount."

H.R. Rep. No. 98-432, pt. 2, at 1422 (1984), reprinted in 1984

U.S.C.C.A.N. 697, 1067.

Congress recognized that the use of the older average mutual earnings rate would lead to inaccuracy. Because it could not directly correct the problem it required mutual companies to base their tax calculations upon the older rate and then, in the next year, after the average mutual rate for the previous year is published, determine a recomputed differential earnings amount by making the same calculations but using the updated average mutual industry rate. § 809(f)(3). According to § 809(f)(2), where the differential earnings amount . . . exceeds . . . the recomputed differential earnings amount . . . such excess shall be allowed as a life insurance deduction for the succeeding taxable year and § 809(f)(1) states that where "the recomputed differential earnings amount . . . exceeds . . . the differential earnings amount" that "excess" should be included in income.

A hypothetical example may clarify the procedure. Assume that in 1997 a mutual company is preparing its return for 1996. The company determines its taxable income based upon the determination of its policyholder dividends deduction. Because final data on the average earnings of the mutual industry is not available when the company prepares its 1996 return in 1997, it uses the average earnings figure for 1994 to determine the differential earnings rate.

In the next year, 1998, the company prepares its 1997 return in the same way. In addition, it redetermines its 1996 tax on the basis of the final average mutual earnings rate for 1996 that the Internal Revenue Service has since announced, recomputing the "excess" for the earnings rate under § 809(c)(1) and the dollar differential earnings amount under § 809(a)(3). Instead of filing an amended return for 1996, however, § 809(f)(2) requires the company to adjust its 1997 income either up or down, depending on whether the recomputed differential earnings amount is greater or lesser than the original differential earnings amount.

C. In its taxable year 1986, the appellant CUNA Mutual Life Insurance Company paid or accrued policyholder dividends of $36,365,926 and its differential earnings amount was $11,937,382, which produced a policyholder dividend deduction of $24,428,544. When CUNA recomputed its 1986 policyholder dividend deduction the following year, however, the newly calculated 1986 average mutual earnings rate was greater than the imputed rate. CUNA took the difference between the rates, multiplied it by its 1986 average equity base, and labeled the resulting figure, $1,919,903, as a negative recomputed differential earnings amount. In its 1987 return CUNA calculated the excess of the original differential earnings amount, $11,937,382, over its recomputed amount, negative $1,919,903, at $13,857,285 and deducted that amount from its 1987 income. The calculation produced a loss for CUNA for 1987, which it carried back to 1984.

On audit, the Service disallowed the loss carryback to the extent that it relied on the recomputed "negative excess," and assessed an additional tax for 1984. After CUNA paid the ...

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