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The deficiencies of the Life Insurance Company Income Tax Act of 1959 emphasize the need for an entirely new approach to the taxation of life insurance. This approach should be guided by the following objectives:

1. Substantial parity with the taxation of personal income from competing forms of investment.

2. Substantial equality with the tax treatment of corporate income from competing lines of business such as casualty insurance companies.

3. Preservation of competition between different forms of organization, such as mutual and stock companies.

4. Substantial equality of tax treatment of profits realized by life insurance companies and other businesses operated for a profit.

5. Tax parity among insurance companies that follow different policies with respect to interest, reserves, and other matters. A permanent program for the Federal taxation of life insurance and closely related types of income is suggested below. In summary, it includes:

1. Assessment of a moderate, flat tax on policyholders' interest, to be collected from the life insurance company.

2. Taxation of net investment income of all private pension funds at the same tax rate.

3. Taxation of all net gains from operation of mutual and stock insurance companies, after dividends to policyholders, at corpo

rate rates. Taxation of policyholders

A flat rate of tax assessed on net investment income allocated to policyholders (including pension reserves) would recognize the generally accepted fact that this is the only source of personal income generated by life insurance companies. În light of the fact that this income almost wholly escapes Federal personal income tax, except for interest income reported by annuitants, it would be appropriate to impose a withholding tax at a standard flat rate. However, no attempt should be made to allocate the tax to individual policyholders. 48 In the case of participating policies of both mutual and stock companies, the tax would reduce policy dividends. Stock companies could recoup the tax on nonparticipating policies through their premium-loading charges.

While the lowest bracket income tax rate would be appropriate for this purpose, the tax could initially be imposed at a lower rate and gradually increased over a transition period. A 20-percent rate would raise about $525 million, at 1958 levels.

In consideration of its imposition as a withholding tax on policyholder income, provision could be made for a tax credit of an equivalent amount when and if such income is later included in the personal income tax returns of the insured and annuitants. Annuitants would be most concerned. Present law already provides a tax credit of 20 percent on unearned incomes up to $2,400, which could be enlarged for this purpose. Income of pension trusts

48 Vickrey has suggested including in the policyholder's income the interest earned on reserves as it accrues, but he acknowledges this would impose a considerable reporting burden on the company. W. Vickrey, “Insurance Under the Federal Income Tax," Yale Law Journal 52: 3 (June 1943), pp. 562–565.

Imposition of a comparable tax on the net investment income of trusteed pension funds would tap another rapidly growing source of income that now escapes current taxation. Employees are the sole beneficiaries of this income which, together with employer contributions, is not taxed until received upon retirement. Åt 1958 levels, a 20-percent rate would produce an estimated $150 million revenue.

Since investment earnings on noninsured pension funds are comparable to the earnings of insured pension funds, it is difficult to justify taxing one without the other. Discriminatory taxation of life insurance funds (together with State premium taxes and other factors) has placed insurance companies at à competitive disadvantage and helped contribute to a declining share of the business. In view of the growing importance of these earnings, which enjoy a preferred tax status, it would appear desirable to tax the net investment income of both insured and noninsured funds rather than to exempt it.

The incidence of such tax would depend on the type of pension plan adopted. Where employers contribute simply a percentage of the employee's compensation, the tax would tend to reduce pension benefits unless it could be shifted to employers through higher contributions. Where employers provide a fixed retirement benefit based on average earnings, length of service, and other factors, it would increase employers' costs. In the long run, therefore, the tax on employer contributions would not be reflected in lower pension benefits. Taxation of insurance companies

Since the life insurance company itself typically retains substantial gains from operations, which benefit policyholders only incidentally, it would appear appropriate to tax such retained earnings as corporation profits. Such taxable income would include all gains not irrevocably set aside for the policyholders, and would, therefore, exclude any additions to policyholders' reserves. No distinction should be made among different types of business, including insurance, individual and group annuities, credit life, health and welfare, and related businesses.

The proper measure of such taxable earnings would be "net gains from operations after dividends to policyholders,” adjusted to insure comparability among insurance companies and conformity to established income tax conventions. Credit probably should be allowed for dividend income recived. After appropriate adjustments, a tax of this sort should yield over $200 million annually, against the $40 million estimated revenues for 1958.

Full taxation of stock company underwriting profits is clearly dictated by the need to close more tightly this major gap in the Federal income tax structure. There is nothing in the nature of the insurance business or structure of the industry that justifies continued preferential treatment of its earnings. The incidence of such tax would be on the stockholders, and stock companies would not be placed at a competitive disadvantage in the net cost of their insurance contracts. Comparable taxation of mutual companies' surplus not allocated to policyholders would further insure tax parity in this respect. Insurance companies would also be brought into better alinement with casualty companies in the taxation of income on accident and health insurance.

APPENDIX A. STOPGAP LEGISLATION, 1950–59 The need for a new approach to life insurance taxation has been officially recognized since 1947, when operation of the 1942 formula completely freed the insurance business from tax.49 The 1942 act, like predecessor acts since 1921, taxed only the so-called free investment income of insurance companies; that is, net investment income in excess of their interest requirements on policyholders' reserves. The deduction was determined each year by the Secretary of the Treasury on the basis of a weighted average of the actual interest assumed by insurance companies, and an arbitrary 314-percent rate on policyholders' reserves. 50 The net investment income remaining after deduction of the reserve interest credit was subject to the corporation income tax rates. Although perhaps representatives of conditions in the early 1940's, the fixed 314-percent rate, weighted 65 percent, soon departed from reality as insurance companies adopted Iower interest rates of 2 to 234 percent on new policies, in line with lower market interest levels.

In 1950, the Congress adopted stopgap legislation to remedy this anomalous situation, pending the development of a proper long-range approach to the taxation of life insurance companies.51 Known as the 1950 formula, this temporary provision simply dropped the arbitrary 314-percent element in the computation of the Secretary's ratio. It was made applicable to 1949 and 1950, leaving 1948 completely free of tax.

This temporary legislation was succeeded in 1951 by new stopgap legislation which converted the credit under the 1950 formula into a reduced rate of tax-at a 612-percent maximum rate on net investment income.52 Under a 52-percent rate, this was equivalent to freezing the credit ratio at 8712 percent of net investment income, the ratio anticipated for 1951 under the previous stopgap legislation. This 612percent tax rate was extended from year to year until 1954, and became increasingly favorable as interest rates rose.

Following extensive studies by a subcommittee of the Ways and Means Committee 53 in 1954, the law was changed in 1955 to provide a reserve interest deduction equal to 8712 percent of the first million dollars of net investment income and 85 percent of net investment income in excess of $1 million. At the 52-percent corporate rate, the effective rate of tax on net investment income averaged about 7.8 percent. Known as the Mills-Curtis bill, it was made applicable to 1955 only, subject to the provision that the 1942 formula would automatically apply in any year if there were no extension. Because of delays in reaching agreement on permanent legislation, this formula was subsequently extended to 1956 and 1957.

19 Statement of Secretary Snyder, Dec. 26, 1947. Press Service No. S-577.

60 In practice, the Treasury computed a ratio of statutory assumed interest requirements to actual net income on investments of life insurance companies. This Secretary's ratio was then applied to the mean reserves of the individual companies in determining its credit. In the years 1947 and 1948, the ratio was in excess of 1.0, leaving no tax liability.

61 In a letter to the Committee on Ways and Means, Aug. 16, 1948, the Treasury recommended that the Secretary's ratio be frozen at 92 percent, pending the development of a proper long-range approach. The House rejected this proposal in favor of the average industry assumed rate (H.J. Res. 371), and this was approved by the Senate.

62 In 1950, the Treasury suggested to the Committee on Ways and Means a total net income basis, but this was not supported.

69 Hearings on Federal taxation of life insurance companies, 83d Cong., 2d sess. (Dec. 13, 14, and 15, 1954).

Finally, on April 10, 1958, the Treasury announced alternative solutions to the problem that had defied permanent legislation since 1949.54 The first suggestion proposed a tax on total income, including underwriting gains as well as net investment income. The alternative proposal called for a modification of the tax on free investment income more in line with the prevailing margin of investment income above required interest on policyholders' reserves, with a minimum tax on a specified proportion of net gain from operations after policyholder dividends. This was intended to reach companies with relatively little net investment income. Later in the year, on November 17, 1958, the Treasury unveiled to the Committee on Ways and Means a plan implementing the latter proposal. This provided the basic structure for the Life Insurance Company Income Tax Act of 1959.

64 Letter from the Secretary of the Treasury to the chairman, Committee on Ways and Means, Subcommittee on Internal Revenue Taxation, hearings on taxation of income of life insurance companies (November 1958), p. 3.



John W. Scott, Jr., attorney, Lewis & MacDonald, New York, N.Y.


As I understand its purposes, the Committee on Ways and Means wishes its 1959 program of panel discussions to explore possible amendments to our Federal revenue system, consistent with the goals of equity and fairness, as well as that of revenue yield. While “equity" and "fairness" may not be subject to exact definition, they surely connote here a desire to work for that increase in the confidence of the taxpayers and the solidity of the national revenues which can be realized only if the Federal income tax falls as a like burden upon incomes of like size. My personal bias, if it be so called, is that steps must be taken to restore the income tax base. Only in this way can we achieve what I believe to be the major objectives—lower rates on earned and other presently unprivileged incomes; enhanced acceptance and compliance with the law; and diminished areas of special tax treatment, with consequent simplifying of the law and lessening of the drive for tax evasion. There must be a reversal of the trend which could lead far down the path already traveled by the revenue systems of some nations, where the decline to impotency of self-assessing taxation has surely been a factor in the decline of national strength and capacity.

The portion of the tax base with which this paper is concerned is the taxable income of fire and other casualty insurance companies, all of which I shall refer to hereafter as "casualty" companies. The committee's published agenda for these hearings indicated that its interests included insurance companies—not merely casualty insurance companies, but, presumably, life insurance companies, also. However, the taxation of life insurance companies has only this year been exhaustively reviewed, and a new mode of taxation adopted only weeks ago. This 1959 law taxing life insurers is so new, so devoid of any experience as to its actual impact, that I doubt the committee wishes now to reexamine in a half day of hearings the very problems to which it so recently devoted weeks of work. I do not mean to suggest that the new life insurance company taxation measure should be deemed perfect, and beyond reach of time and events. However, at this early date I do not think there is anything of appreciable value I could add to the many discussions so recently heard by the committee with respect to taxation of life insurance companies.

On the other hand, with regard to the methods of taxing casualty insurance companies we have 17 years of experience under existing

2 The Life Insurance Company Income Tax Act of 1959 (Public Law 86–69).

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