Debt Instruments with Original
Issue Discount; Annuity Contracts

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-125237-00] RIN 1545-AY60

TITLE: Debt Instruments with Original Issue Discount; Annuity
Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations relating to the
federal income tax treatment of annuity contracts issued by certain
insurance companies. These proposed regulations provide guidance on
whether certain annuity contracts are excluded from the definition
of a debt instrument under the original issue discount provisions of
the Internal Revenue Code. This document also provides a notice of
public hearing on the proposed regulations.

DATES: Written or electronically generated comments must be received
by April 12, 2001. Requests to speak (with outlines of oral comments
to be discussed) at the public hearing scheduled for May 30, 2001,
at 10 a.m. must be submitted by May 9, 2001.

ADDRESSES: Send submission to: CC:M&SP:RU (REG-125237-00), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered between the
hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG-125237-00), Courier's
Desk, Internal Revenue Service, 1111 Constitution Ave., NW.,
Washington, DC. Alternatively, taxpayers may submit comments
electronically via the Internet by selecting the "Tax Regs" option
on the IRS Home Page, or by submitting comments directly to the IRS
internet site at http://www.irs.gov/prod/tax_regs/regslist.html. The
public hearing will be held in room 4718, 1111 Constitution Ave.,
NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Patrick
E. White, (202) 622-3920; concerning submissions of comments, the
hearing, and/or to be placed on the building access list to attend
the hearing, contact LaNita VanDyke, (202) 622-7180 (not toll-free
numbers).

SUPPLEMENTARY INFORMATION:

Background

Sections 163(e) and 1271 through 1275 of the Internal Revenue Code
(Code) provide rules for the treatment of debt instruments with
original issue discount (OID). Section 1275(a)(1)(A) defines the
term "debt instrument" to include a bond, debenture, note or
certificate or other evidence of indebtedness. Sections 1275(a)(1)
(B)(i) and (ii), however, exclude certain annuity contracts from the
definition of a debt instrument.

On February 2, 1994, the IRS and Treasury published in the Federal
Register (59 FR 4799) final regulations concerning a variety of
issues under the OID provisions. On January 8, 1998, the IRS and
Treasury published in the Federal Register (63 FR 1054) final
regulations concerning the life annuity exception of section 1275(a)
(1)(B)(i). This document contains proposed rules concerning the
exception for annuities described in section 1275(a)(1)(B)(ii).

Explanation of Provisions

In general, the OID provisions apply to issuers and holders of debt
instruments. The term debt instrument generally means any instrument
or contractual arrangement that constitutes indebtedness under
general principles of income tax law. See section 1275(a)(1)(A) and
§1.1275-1(d).

If a contract is a debt instrument with OID, section 1272 generally
requires the holder of the contract to include OID in income
currently on a constant yield basis, regardless of the holder's
overall method of accounting. By contrast, the holder of an annuity
contract to which section 72 applies generally is allowed to defer
recognizing economically earned income until distributions are made
on the contract.

Section 1275(a)(1)(B) excepts two types of annuity contracts from
the definition of a debt instrument. First, section 1275(a)(1)(B)(i)
excepts an annuity contract to which section 72 applies if the
contract "depends (in whole or in substantial part) on the life
expectancy of 1 or more individuals." Second, section 1275(a)(1)(B)
(ii) excepts an annuity contract to which section 72 applies under
certain circumstances if the contract "is issued by an insurance
company subject to tax under subchapter L (or by an entity described
in section 501(c) and exempt from tax under section 501(a) which
would be subject to tax under subchapter L were it not so exempt)."

The legislative history of section 1275(a)(1)(B)(ii) is limited.
This exception to the OID rules first appeared when the bill emerged
from the Conference Committee in 1984. H.R. 4170, 98th
Cong., 2d Sess. § 41 (1984). At that time, section 1275(a)(1)
(B)(ii) applied to certain th annuity contracts issued by an
insurance company subject to tax under subchapter L. The 1984
Conference Report does not elaborate on the meaning of the phrase
"an insurance company subject to tax under subchapter L," nor does
it explain the purpose of the provision. H.R. Conf. Rep. No. 861,
98th Cong., 2d Sess. 802-05 (1984), 1984-3 (Vol. 2) C.B.
56-59. In 2000, a th technical correction to section 1275(a)(1)(B)
(ii) was enacted. The technical correction clarified that section
1275(a)(1)(B)(ii) also applied to annuity contracts issued by "an
entity described in section 501(c) and exempt from tax under section
501(a) which would be subject to tax under subchapter L were it not
so exempt." Consolidated Appropriations Act, 2001, Public Law 106-
554 (114 Stat. 2763).

In 1998, the IRS and Treasury promulgated §1.1275-1(j),
interpreting the life annuity exception of section 1275(a)(1)(B)(i).
Commentators had also requested guidance on the scope of the section
1275(a)(1)(B)(ii) exception, particularly with regard to foreign
insurers not engaged in a trade or business in the U.S.

The proposed regulations provide that an annuity contract issued by
a foreign insurance company is treated as issued by an insurance
company subject to tax under subchapter L if the insurance company
is subject to tax under subchapter L with respect to income earned
on the annuity contract. The IRS and Treasury believe that this is
the most natural application of the language of section 1275(a)(1)
(B)(ii) and is consistent with the use of that phrase elsewhere in
the Code and regulations. See, e.g., sections 953(e)(3)(C) and
1297(b)(2)(B); §1.848-2(h). The IRS and Treasury also believe
that the exception from the OID rules was intended to preserve a
balance between the tax treatment of holders of annuity contracts
under section 72 and the tax treatment of issuers of such contracts.
This balance does not exist when the annuity contract is issued by a
foreign person that is not required to calculate its income with
respect to the contract under subchapter L.

Proposed Effective Date

The proposed regulations are proposed to apply for interest accruals
on or after the date that is 30 days after final regulations are
published in the Federal Register on annuity contracts held on or
after that date. The regulations will not apply to an annuity
contract that was purchased before January 12, 2001. Special rules
are provided for additional investments after January 12, 2001, with
respect to an annuity contract held as of that date. This effective
date framework is similar to that provided in §1.1275-1(j)(8)
with respect to the life annuity exception of section 1275(a)(1)(B)
(i).

Special Analyses

It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It also
has been determined that section 553(b) of the Administrative
Procedure Act (5 U.S.C. chapter 5) does not apply to these
regulations, and because these regulations do not impose a
collection of information on small entities, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to
section 7805(f) of the Internal Revenue Code, this notice of
proposed rulemaking will be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its
impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any electronic or written comments (a
signed original and eight (8) copies of written comments) that are
submitted timely (in the manner described in the "ADDRESSES" portion
of this preamble) to the IRS. The IRS and Treasury request comments
on the clarity of the proposed rules and how they may be made easier
to understand. All comments will be available for public inspection
and copying.

A public hearing has been scheduled for May 30, 2001, beginning at
10 a.m. in room 4718, Internal Revenue Building, 1111 Constitution
Avenue, NW., Washington, DC. Due to building security procedures,
visitors must enter at the 10 Street entrance, located between th
Constitution and Pennsylvania Avenues, NW. In addition, all visitors
must present photo identification to enter the building. Because of
access restrictions, visitors will not be admitted beyond the
immediate entrance area more than 15 minutes before the hearing
starts. For information about having your name placed on the
building access list to attend the hearing, see "FOR FURTHER
INFORMATION CONTACT."

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit written
comments and an outline of topics to be discussed and the time to be
devoted to each topic (signed original and eight (8) copies) by May
9, 2001. A period of 10 minutes will be allotted to each person
making comments. An agenda showing the scheduling of the speakers
will be prepared after the deadline for receiving outlines has
passed. Copies of the agenda will be available free of charge at the
hearing.

Drafting Information

The principal author of these regulations is Patrick E. White,
Office of the Associate Chief Counsel (Financial Institutions &
Products). However, other personnel from the IRS and Treasury
Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.1271-0 is amended by adding entries for paragraphs
(k) through (k)(3) to §1.1275-1 to read as follows:

§1.1271-0 Original issue discount; effective dates; table of
contents.

* * * * *

§1.1275-1 Definitions.

* * * * *

(k) Exception under section 1275(a)(1)(B)(ii) for annuities issued
by an insurance company subject to tax under subchapter L .

(1) Rule.

(2) Examples.

(3) Effective date.

* * * * *

Par. 3. Section 1.1275-1 is amended by adding paragraph (k) to read
as follows: §1.1275-1 Definitions.

* * * * *

(k) Exception under section 1275(a)(1)(B)(ii) for annuities issued
by an insurance company subject to tax under subchapter L--

(1) Rule. For purposes of section 1275(a)(1)(B)(ii), an annuity
contract issued by a foreign insurance company is considered as
issued by an insurance company subject to tax under subchapter L if
the insurance company is subject to tax under subchapter L with
respect to income earned on the annuity contract.

(2) Examples. The following examples illustrate the rule of
paragraph (k)(1) of this section. Each example assumes that the
annuity contract is a contract to which section 72 applies and was
issued in a transaction where there is no consideration other than
cash or another qualifying annuity contract, pursuant to the
exercise of an election under an insurance contract by a beneficiary
thereof on the death of the insured party, or in a transaction
involving a qualified pension or employee benefit plan. The examples
are as follows:

Example 1. Company X is an insurance company that is organized,
licensed and doing business in Country Y. Company X does not have a
U.S. trade or business and is not, under section 842, subject to
U.S. income tax under subchapter L with respect to income earned on
annuity contracts. A, a U.S. taxpayer, purchases an annuity contract
from Company X in Country Y. The annuity contract is not excepted
from the definition of a debt instrument by section 1275(a)(1)(B)
(ii).

Example 2. The facts are the same as in Example 1, except that
Company X has a U.S. trade or business. A purchased the annuity from
Company X's U.S. trade or business. Under section 842(a), Company X
is subject to tax under subchapter L with respect to income earned
on the annuity contract. Under these facts, the annuity contract is
excepted from the definition of a debt instrument by section 1275(a)
(1)(B)(ii).

Example 3. The facts are the same as in Example 2, except that there
is a tax treaty between Country Y and the United States. Company X
is a resident of Country Y for purposes of the U.S.-Country Y tax
treaty. Company X's activities in the U.S. do not constitute a
permanent establishment under the U.S.-Country Y tax treaty. Because
Company X does not have a U.S. permanent establishment, Company X is
not subject to tax under subchapter L with respect to income earned
on the annuity contract. Thus, the annuity contract is not excepted
from the definition of a debt instrument by section 1275(a)(1)(B)
(ii).

Example 4. The facts are the same as in Example 1, except that
Company X is a foreign insurance corporation controlled by a U.S.
shareholder. Company X does not make an election under section
953(d) to be treated as a domestic corporation. The controlling U.S.
shareholder is required under sections 953 and 954 to include income
earned on the annuity contract in its taxable income under subpart
F. However, Company X is not subject to tax under subchapter L with
respect to income earned on the annuity contract. Thus, the annuity
contract is not excepted from the definition of a debt instrument by
section 1275(a)(1)(B)(ii).

Example 5. The facts are the same as in Example 4, except that
Company X properly elects under section 953(d) to be treated as a
domestic corporation. By reason of its election, Company X is
subject to tax under subchapter L with respect to income earned on
the annuity contract. Thus, the annuity contract is excepted from
the definition of a debt instrument by section 1275(a)(1)(B)(ii).

(3) Effective date. This paragraph (k) is applicable for interest
accruals on or after the.date that is 30 days after final
regulations are published in the Federal Register. This paragraph
(k) does not apply to an annuity contract that was purchased before
January 12, 2001. For purposes of this paragraph (k), if any
additional investment in a contract purchased before January 12,
2001, is made on or after January 12, 2001, and the additional
investment is not required to be made under a binding written
contractual obligation that was entered into before that date, then
the additional investment is treated as the purchase of a contract
after January 12, 2001.

David A. Mader
Acting Deputy Commissioner of Internal Revenue

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