On May 5, 2016, the IRS issued Notice 2016-32, 2016-21 I.R.B. 1, which affords relief with respect to the application of the diversification requirements of IRC § 817(h) to variable life insurance and annuity contracts (collectively, variable insurance products) that offer government money market funds as investment options. In brief, Notice 2016-32 provides that a segregated asset account supporting a variable insurance product may invest in a government money market fund, or otherwise qualify as a government money market fund itself, and still be treated as adequately diversified for purposes of IRC § 817(h) and the Treasury regulations promulgated thereunder. Notice 2016-32 also announced that the IRS and Treasury intend to amend Treas. Reg. § 1.817-5 in order to implement these changes, and that taxpayers may rely on the relief provided in the notice until any such future guidance is effective.
Overview of Pending Money Market Fund Reforms
The Securities and Exchange Commission (SEC) adopted significant reforms to the regulation of money market funds in July 2014 that have a final compliance date of October 14, 2016. In general, these reforms require all non-government money market funds to have a floating net asset value (NAV) rather than a stable $1.00 per share NAV. Non-government money market funds also will be subject to new fees and gates that will not be required for government money market funds. In this regard, the relevant SEC rules define a government money market fund as a money market fund that invests at least 99.5% of its total assets in cash, government securities, or fully collateralized repurchase agreements.
In view of these pending reforms, many in the life insurance industry have anticipated that the number of government money market funds offered as investments in support of variable insurance products will increase substantially, thereby increasing the demand for the types of government securities in which such funds invest. Two reasons generally are cited in support of this assertion: (1) it is expected that owners of variable insurance products will prefer to have money market fund investment options that maintain a stable NAV, rather than a floating NAV; and (2) there may be significant difficulties establishing appropriate fees and gates for money market funds supporting variable insurance products. (An increased demand for these types of government securities also may be attributable to non-insurance product prime money market funds converting to government money market funds.)
Potential Diversification Issues
Treas. Reg. § 1.817-5(b) generally provides that the investments of a segregated asset account (as defined in Treas. Reg. § 1.817-5(e)) established to support a variable insurance product will be considered adequately diversified for purposes of that section and IRC § 817(h) only if:
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No more than 55% of the value of the total assets of the account is represented by any one investment;
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No more than 70% of the value of the total assets of the account is represented by any two investments;
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No more than 80% of the value of the total assets of the account is represented by any three investments; and
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No more than 90% of the value of the total assets of the account is represented by any four investments.
For purposes of applying the foregoing rules, all securities of the same issuer generally are treated as a single investment, but each government agency or instrumentality is treated as a separate issuer. Thus, where a segregated asset account intends to invest solely in government securities, there must be securities of at least five different government agencies or instrumentalities available in the financial markets.
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Sutherland Observation. Although helpful, the rule treating different government agencies or instrumentalities as separate issuers for purposes of the diversification requirements of Treas. Reg. § 1.817-5(b) has little practical utility because only a few such entities issue securities that can be held by government money market funds. |
Taking into account the anticipated increase in demand for government securities due to the money market fund reforms described above, companies offering variable insurance products recognized that only a limited number of issuers of government securities could be available to them and that, as a result, government money market funds offered as investments supporting variable insurance products may have difficulties satisfying the diversification requirements of Treas. Reg. § 1.817-5(b) unless some form of relief was provided by the IRS. In response to these concerns, the IRS issued Notice 2016-32.
Relief Provided in Notice 2016-32
Notice 2016-32 provides an alternative diversification requirement for government money market funds; specifically, the notice provides that a segregated asset account will be adequately diversified for purposes of IRC § 817(h) if:
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No policyholder has investor control; and
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Either:
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The account itself is a government money market fund (i.e., a money market fund that invests at least 99.5% of its total assets in cash, government securities, or fully collateralized repurchase agreements); or
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The account invests all of its assets in an “investment company, partnership, or trust” as defined in Treas. Reg. § 1.817-5(f)(1) that satisfies the criteria of Treas. Reg. § 1.817-5(f)(2) and qualifies as a government money market fund.
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Sutherland Observations
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By referencing “investor control,” the notice incorporates the notion that, if a policyholder retains too much control over the assets supporting a variable insurance product, the policyholder generally will be treated as the owner of the assets for federal tax purposes. See, e.g., Rev. Rul. 2003-92, 2003-2 C.B. 350; Rev. Rul. 2003-91, 2003-2 C.B. 347; Rev. Rul. 81-225, 1981-2 C.B. 13; Rev. Rul. 80-274, 1980-2 C.B. 27; Rev. Rul. 77-85, 1977-1 C.B. 12. The notice’s reference to investor control seems to be an admonition against pre-arranged plans to acquire securities of a particular government agency. For example, an insurance-dedicated government money market fund that explicitly promises to invest exclusively in securities of a specific government agency or in some combination of securities of specific government agencies in a fixed proportion would contravene the IRS’s investor control rulings, even if such a fund were available for investment exclusively through the purchase of a variable insurance product. For more background on the investor control doctrine, see our Legal Alert of July 7, 2015.
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The reference in the notice to a segregated asset account that “itself is a government money market fund” covers managed-account structures; for example, where (i) a sub-account of the insurance company’s separate account invests directly in individual government securities, and (ii) the account qualifies as a government money market fund.
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The reference in the notice to a segregated asset account that “invests all of its assets in an ‘investment company, partnership, or trust’” is directed at the prevalent structure in the retail market for variable insurance products; that is, where a sub-account of the insurance company’s separate account invests in a single insurance-dedicated fund that qualifies as a government money market fund.
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Possible Next Steps
Although Notice 2016-32 states that the IRS and Treasury intend to amend Treas. Reg. § 1.817 5 to reflect the alternative diversification requirement for government money market funds, the notice also leaves room for the IRS to address these issues through future administrative guidance, such as a revenue procedure. In the meantime, taxpayers may rely on the relief provided in the notice until any such future guidance is effective.
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Sutherland Observation. The issuance of administrative guidance may be more feasible for the IRS in light of its current resource constraints and the amount of time typically required to issue proposed and final regulations. Cf. Rev. Proc. 2004-28, 2004-21 I.R.B. 984 (describing conditions under which a taxpayer that has invested in a repurchase agreement may treat its position in that repurchase agreement as a government security for purposes of qualifying as a regulated investment company under the asset diversification test of IRC § 851(b)(3)). |
