NOTE WILLAM M. GATESMAN

Transcription

1 NOTE COLONIAL AMERICAN LIFE INSURANCE CO. v. COMMISSIONER: SUPREME COURT DISREGARDS CONGRESSIONAL INTENT THAT INDEMNITY REINSURANCE CEDING COMMISSIONS BE DEDUCTIBLE WILLAM M. GATESMAN INTRODUCTION In Colonial American Life Insurance Co. v. Commissioner,' the Supreme Court established that a reinsurer cannot take a current period deduction for the commission it pays to enter into an indemnity reinsurance contract. 2 Although the dissent criticized the Court for deciding a statutory question on the basis of general principles s the Court's holding has a statutory basis in the Internal Revenue Code. 4 Nevertheless, the Court failed to recognize Congressional intent to exempt indemnity reinsurance ceding commissions from that statu S. Ct (1989). 2. Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2418 (1989). For purposes of this note, the term "indemnity reinsurance" does not encompass yearly renewable term, or risk-premium, reinsurance. See infra notes and accompanying text (describing various types of indemnity reinsurance). 3. Id. at 2418 (Stevens, J., dissenting). Cf. Note, Treatment of Ceding Commissions Paid Under Indemnity Reinsurance Agreements: Colonial American Life Insurance Co. v. Commissioner, 43 TAx LAW. 375, (1990) [hereinafter Treatment of Ceding Commissions] (criticizing Court for overlooking fundamental differences in types of reinsurance but failing to consider congressional intent and special rule of statutory construction and not addressing the Court's change of position with respect to the National Association of Insurance Commissioners' role in determining proper accounting treatment of ceding commissions for tax purposes). 4. See infra notes and accompanying text (discussing statutory application to ceding commissions). The Internal Revenue Code is equivalent of 26 U.S.C., and the designation "I.R.C" is interchangeable with "26 U.S.C." for citation purposes. A UNIFORM SYsTmM OF CrrATON (14th ed. 1989). This note cites to the Internal Revenue Code using the designation "I.R.C." 1267

2 1268 THE AMERICAN UNIVERSITY LAW REVIEw[Vol. 39:1267 tory provision. 5 The Court also misread the applicable statutory provisions authorizing a current period deduction. 6 In so doing, it violated the special rule of statutory interpretation that requires a strict construction of tax statutes. 7 This Note examines the issue of indemnity reinsurance ceding commission deductibility in light of Colonial American Life Insurance Co. v. Commissioner. 8 Part I describes reinsurance in general and discusses the various types of reinsurance transactions. It also analyzes the treatment of an indemnity reinsurance ceding commission for United States income tax purposes. Part II examines the facts and the procedural history of Colonial American, and summarizes the majority and dissenting opinions. Part III scrutinizes the Court's analysis. The Note concludes that, by determining that indemnity reinsurance ceding commissions are not currently deductible, the Court misinterpreted the applicable provisions of the Internal Revenue Code and ignored the special rule of statutory interpretation requiring strict construction of tax statutes. I. BACKGROUND A. Reinsurance Generally When a life insurance company writes an insurance policy, it agrees to pay a specified sum of money to the insured's beneficiary at the time the insured individual dies. The life insurance company assumes, in exchange for premium income, a risk of loss for each life 5. See infra notes and accompanying text (discussing legislative history). 6. See infra notes and accompanying text (discussing Court's strained reading of statute). 7. See 3A N. SINGER, SUTHRLAm ON STATUTORY CONSTRUCTION, 66.01, at & na (Sands 4th ed. 1986) [hereinafter Statutory Construction] (citing White v. Aronson, 302 U.S. 16 (1937) (applying this special rule); Morrisey v. Commissioner, 296 U.S. 344 (1935) (applying this special rule); Old Colony R.R. Co. v. Commissioner, 284 U.S. 552 (1932)) (applying this special rule). Judicial attitudes regarding whether a statute should be accorded a liberal or strict construction are often determined by the nature of the interests affected. 2A Statutory Construction, at 715. Tax laws are consistently construed in favor of the taxpayers, particularly in cases where there is doubt as to the meaning of the tax statute. See 3A Statutory Construction, at 288. This judicial preference to strictly construe tax statutes, however, is counterbalanced by a tendency on the part of the courts to spend little time interpreting tax legislation. See 3A Statutory Construction, at 297. The reason for this tendency is twofold. First, a stable social order depends upon taxation as a means to finance government and its programs. Id. Second, legislatures carefully craft tax statutes to ensure that such laws are comprehensive and precise. Id. See infra note 190 and accompanying text (discussing interpretation of words in tax statutes); see also infra note 164 and accompanying text (describing fundamental precept of statutory analysis) S. Ct (1989); see infra notes and accompanying text (describing the three types of indemnity reinsurance and stating that this note shall use term "indemnity reinsurance" to refer to only two of those types).

3 1990] COLONIAL AM. LIFE INS. Co. v. COMMISSIONER 1269 insurance policy it issues. 9 A life insurance company can enter into a reinsurance contract with another insurance company and thereby reduce the risk of loss associated with a particular group of policies.' 0 In such a contract, the reinsurer agrees to either assume or to indemnify the primary insurer for a specified portion of any loss arising out of the reinsured policies in exchange for a portion of the premium income earned on such policies." There are two basic types of reinsurance contract-assumption reinsurance and indemnity reinsurance.1 2 In an assumption reinsurance contract, the reinsurer assumes all or some of the primary insurer's liabilities with respect to the reinsured policies, as well as its responsibility to maintain reserves to cover claims on those policies. 13 In an indemnity reinsurance contract, on the other hand, the reinsurer agrees only to reimburse the primary insurer for an agreed upon percentage of the claims and expenses associated with the reinsured policies.' 4 In exchange, the primary insurer pays the reinsurer a percentage of the premiums generated by the reinsured policies.' 5 In an indemnity reinsurance contract, the primary insurer remains at risk with respect to the reinsured policies, but covers this risk by way of the indemnity reinsurance contract.' 6 9. C. FRcIK, THE LAW OF LIFE INSURANCE 3 (1903) (describing life insurance contract); see generally G. Buss, THE LAW OF LIFE INSURANCE 6 (2d ed. 1874) (addressing various forms life insurance agreements can take); M. CRAWFORD & W. BEADLES, LAW AND THE LIFE INSUR- ANCE CONTRACT 615 app. B (6th ed. 1989) (reprinting life insurance policy form which states that beneficiary shall receive proceeds paid under life insurance contract); THE LIFE INSUt- ANCE POLICY CoNTRACT (H. Kreuger & L. Waggoner ed. 1953) (discussing legal implications of life insurance contract beneficiary dauses). 10. Colonial Am. Life Ins. Co. v. Commissioner, 51 T.C.M. (CCH) 1123, 1124 n.1 (1986), rev'd, 843 F.2d 201 (5th Cir. 1988), aff'd, 109 S. Ct (1989). Some of the reasons a life insurance company would reinsure its risks are: 1) to insulate a diversification of its business; 2) to isolate existing risks from the policies of another, indirectly acquired, insurance company; 3) to prevent over-concentration of risk in one segment of the company's business or one geographic area; and 4) to prevent a reduction in equity resulting from the expenses and reserve requirements associated with new policies. See id at 1124 n.1; see generally LIFE AND HEALTH INSURANCE HANDBOOK ch. 66 (D. Gregg & V. Lucas ed. 1973) (describing reinsurance). Reserve requirements are statutorily imposed, and require an insurer to keep a legal reserve to cover the liabilities associated with its outstanding insurance policies. 2A COUCH ON INSURANCE 2D 21.35, at (rev. ed. 1984). 11. Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2411 (1989). 12. Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435 (7th Cir. 1988) (discussing two basic types of reinsurance), cert. granted, vacated, remandedforfurther consideration in light of Colonial American, 109 S. Ct (1989). See also Treatment of Ceding Commissions, supra note 3, at 376 n.10 (discussing reinsurance). 13. Treas. Reg (a)(7)(ii) (1990). 14. Merit Life, 853 F.2d at lad 16. S. REP. No. 291, 86th Cong., 1st Sess (1959) (defining indemnity reinsurance and specifically modified coinsurance for purposes of Life Insurance Company Income Tax Act of 1959).

4 1270 THE AMERICAN UNIVERSrrY LAw REVIEW[Vol. 39:1267 Indemnity reinsurance comes in three forms. The first is yearly renewable term, or risk-premium, reinsurance. 17 With risk-premium reinsurance, the primary insurer covers its risk by purchasing renewable annual term insurance from a reinsurance company. 18 The second form of indemnity reinsurance is conventional coinsurance.' 9 With this form, the primary insurer turns the premiums generated by the reinsured life insurance policies over to the reinsurer, and the reinsurer reimburses the primary insurer for any expenses incurred with respect to those policies. 20 With conventional coinsurance, a ceding company transfers its obligation to maintain reserves with respect to the reinsured policies to the reinsurer. 21 The final form of reinsurance, known as modified coinsurance, is similar to conventional coinsurance except that the primary insurer retains the reserves associated with the reinsured policies and manages the investment of those reserves. 22 Further, the primary insurer pays the reinsurer the investment income, less additions to reserves. 23 Only the latter two types of indemnity reinsurance were at issue in Colonial American. Consequently, this Note will use the term "indemnity reinsurance" to refer only to the latter two types. B. Tax Treatment of Ceding Commissions In either an assumption or an indemnity reinsurance contract, the reinsurer typically pays the primary insurer a fee to enter into the contract. 24 This fee is referred to as a ceding commission, and the primary insurer is known as the ceding company. 25 Of the various types of reinsurance for which a reinsurer pays a ceding commission, 26 only the commission on conventional coinsurance and its equivalent was subject to controversy over its proper federal tax treatment Id. 18. Id 19. Id 20. Id 21. Beneficial Life Ins. Co. v. Commissioner, 79 T.C. 627, (1982) (describing conventional coinsurance). 22. S. REP. No. 291, 86th Cong., Ist Sess (1959). 23. Id.; see also Modem Am. Life Ins. Co. v. Commissioner, 830 F.2d 110, 110 n.2 (8th Cir. 1987) (describing modified coinsurance). 24. Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2411 n.1 (1989). 25. Id 26. A risk-premium reinsurance contract does not give rise to a ceding commission. ColonialAmerican, 109 S. Ct at This type of indemnity reinsurance instead resembles a normal insurance policy in that the ceding company pays a premium to cover the risk with respect to certain of its life insurance policies. Id at 2411 n The nature of the modified coinsurance arrangement gives rise to the possibility of a double tax on the same revenue, first to the primary insurer as investment income, and second to the reinsurer as underwriting gain. S. REP. No. 291, 86th Cong., Ist Sess. 39 (1959).

5 1990] COLONIAL AM. LIFE INS. Co. V. COMMISSIONER 1271 Prior to ColonialAmerican there were two possible ways that a reinsurer could treat a ceding commission for federal tax purposes. It could deduct the payment from gross income in the year incurred, 28 or it could capitalize the ceding commission. 29 The statutory bases for each of these treatments are discussed below. 1. Current deduction For the years at issue in Colonial American, a reinsurer might have relied on three statutory provisions to support a current deduction for indemnity reinsurance ceding commission payments. The first such provision is section 809(d)(12) of the Internal Revenue Code. 30 Section 809(d)(12) provided that life insurance companies can deduct from gross income the "ordinary and necessary" business expenses which businesses other than life insurance companies can deduct pursuant to section 162(a). 3 ' Therefore, in order for In order to prevent the imposition of a double tax on modified coinsurance, Congress enacted I.R.C. 820 (1959). Under this provision, a taxpayer could elect to treat modified coinsurance as conventional coinsurance for federal income tax purposes. Id. This provision was repealed by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), P.L , 96 Stat. 324 (1982). 28. I.R.C. 803 (1990) (defining life insurance gross income). Prior to 1984, life insurance gross premium income was defined at I.R.C. 809(c) (1970). For a detailed description of the pre-1984 approach for determining life insurance company gross income, see Anchor Nat'l Life Ins. Co. v. Commissioner, 93 T.C. 382 (1989) (op. section II, n.18 and accompanying text) (outlining three-phase method for determining life insurance company's taxable income). An expense is "incurred" in the taxable year in which the taxpayer recognizes or takes a deduction for the expense under the method of accounting used to compute taxable income. I.R.C. 461(a) (1990). A payment fully deducted in the year incurred will reduce taxable income by the amount of the payment. Generally, a taxpayer must compute taxable income using the accounting method regularly used to compute income for its books and records unless such method does not dearly reflect income. I.R.C. 446 (1990). Permissible methods of accounting include the cash receipts and disbursements method and the accrual method. I.R.C. 446(c) (1990). A life insurance company, however, cannot use the cash receipts and disbursements method of accounting. I.R.C. 811(a) (1990) (prior to 1984, this provision was I.R.C. 818(a) (1983), Priv. Ltr. Rul (Aug. 30, 1987) (stating that ceding commissions are deductible)). 29. An expenditure which is "capitalized" is reflected on the taxpayer's books and records as an asset and not as a deductible expense. Thus, the expenditure does not serve to reduce gross income. See infra note 44 (describing purpose of capitalization). 30. I.R.C. 809(d)(12) (1970). This provision is currently codified at I.R.C. 805(a)(8) (1990). 31. Section 162(a) provides for the deductibility of trade and business expenses. I.R.C. 162(a) (1970). One example of the type of expense deductible pursuant to section 809(d)(12) is the commission that a primary insurer pays its sales agents to sell individual life insurance policies. Colonial American, 109 S. Ct. at Although an agent's commission is not explicitly deductible under the Code, the Commissioner has historically permitted such a deduction, and Congress has ratified its deductibility. Id at na (citing S. REP. No. 291, 86th Cong., 1st Sess. 7, 9 (1959) and H.R. REP. No. 432, 98th Cong., 2d Sess. 1428, reprinted in 1984 U.S. CODE CONG. & ADMIN. NEWS 697); see also Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435, 1442 (7th Cir. 1988) (citing H.R. REP. No. 432, 98th Cong., 2d Sess. 1428, reprinted in 1984 U.S. CODE CONG. & ADMIN. NEWS 697 and SENATE COMM. ON FINANCE, 98th Cong., 2d Sess.

6 1272 THE AMERICAN UNIVERSITY LAW REviEw[Vol. 39:1267 section 809(d)(12) to encompass indemnity reinsurance ceding commissions, such commissions must be treated as "ordinary and necessary" business expenses. 32 The second statutory peg on which to base an indemnity reinsurance ceding commission deduction was Internal Revenue Code section 818(a). 3 3 Section 818(a) required life insurance companies to compute their taxes using an accounting method that is consistent with the National Association of Insurance Commissioners ("NAIC") annual statement accounting rules, unless such method is inconsistent with regular accrual accounting. 4 Because the NAIC requires life insurers to deduct indemnity reinsurance ceding commissions for annual statement purposes, such expenditures were deductible under section 818(a) to the extent that such deduction is consistent with regular accrual accounting rules. 3 5 Finally, an indemnity reinsurer seeking to deduct its ceding commission payments might have relied on Internal Revenue Code section 809(c)(1) and related regulations. 8 6 Section 809(c)(1) required a life insurance company to include premium income when comput- DEFicrr REDUCTIONS ACT OF 1984, EXPLANATION OF PROVISIONS APPROVED BY THE COMMITrEE ON MARCH 21, (S. Print 1984)), cert. granted, vacated, remandedforfurther consideration in light of Colonial American, 109 S. Ct (1989). While not controlling in Colonial American, both S. REP. No. 291 and S. PRINT No. 169 nevertheless recognize and support the proposition that an agent's sales commissions are deductible. Merit Life Ins. Co., 853 F.2d at Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2414 (1989). For a discussion of the terms "ordinary and necessary" as used in I.R.C. section 162, see PRENTICE HALL FEDERAL TAXES 2D 1624 (Sept. 6, 1990). 33. I.R.C. 818(a) (1970). This provision, now codified at I.R.C. 811(a) (1990), sets forth accounting methods for insurance companies. 34. ColonialAmerican, 109 S. Ct. at 2415 (citing Commissioner v. Standard Life and Ins. Co., 433 U.S. 148, (1977) which construes I.R.C. 818(a) and describes NAIC as national organization composed of state regulatory officials acting for various state insurance regulators and performing audits on multistate insurance companies). The regular accrual accounting rules are embodied in the Generally Accepted Accounting Principles (GAAP) promulgated by the Financial Accounting Standards Board (FASB). See Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435, 1443 (7th Cir. 1988) cert. granted, vacated, remanded for further consideration in light of Colonial American, 109 S. Ct (1989). Section 818(a) empowers the Secretary of the Treasury to prescribe an accounting method that is a combination of the accrual method and any other method permitted by Chapter One of the Internal Revenue Code, except the cash receipts and disbursements method. I.R.C. 818(a)(2) (1970). If the Secretary chooses to permit such other accounting method, then section 818(a) provides that a life insurance company shall use a method ofaccounting consistent with the NAIC annual statement accounting rules unless such method would be inconsistent with the method permitted by the Secretary. See id Cf Commissioner v. Standard Life and Accident Ins. Co., 433 U.S. 148, 159 n.21 (1977) (contrasting mandatory language in section 818(a) requiring consistency between NAIC annual statement accounting procedures and language in section 818(a)(2) that "merely allows the Secretary to permit deviations from accrual accounting"). 35. ColonialAmerican, 109 S. Ct. at I.R.C. 809(c)(1) (1970). A slightly modified version of this statutory provision is now codified at I.R.C. section 803 (1990). The two provisions are substantively identical. Only the textual presentation has changed.

7 1990] COLONIAL AM. LIFE INs. Co. v. COMMISSIONER 1273 ing its gain from operations. 37 That section defined premium income as "[tihe gross amount of premiums and other consideration,... less return premiums, and premiums and other consideration arising out of reinsurance ceded." 38 Section 809(c)(1) provided further that "premiums or other consideration returned to another insurance company in respect of reinsurance ceded" are to be included in return premiums. 3 9 Thus, return premiums and consideration arising out of reinsurance ceded reduce a life insurance company's taxable income. 40 Section (a)(1)(iii) of the Treasury Regulations provides that reinsurance ceded includes indemnity reinsurance, but not assumption reinsurance, transactions. 4 1 Hence, an indemnity reinsurer could deduct its ceding commission payments pursuant to section 809(c)(1) as long as such commissions constitute either "premiums and other consideration arising out of reinsurance ceded" or "consideration returned to another life insurance company in respect of reinsurance ceded." Capitalization The second way a reinsurer can treat its indemnity reinsurance ceding commission payments is to capitalize and amortize the ceding commission expenditure over the estimated useful life of the reinsured policies. 43 Internal Revenue Code section 263 provides the statutory authority for this type of treatment. 44 Such treatment is appropriate for amounts expended to acquire a capital asset with a determinable useful life. 45 Alternatively, the reinsurer can account 37. Id. 38. Id. 39. Treas. Reg (a)(1)(ii) (1990); see I.R.C. 809(c)(1) (1970) (identifying items not to be included in return premiums, and stating that "premiums or other consideration returned to another life insurance company in respect of reinsurance ceded" are not encompassed by this limitation). 40. Colonial American, 109 S. Ct. at 2416 (describing effect of section 809(c)(1)). 41. Id. at 2416 n.8 (explaining Treas. Reg (a)(1)(ii) as applied to I.R.C. 809(c)(1)). 42. Id. at 2416 (quoting I.R.C. 809(c)(1) (1970)). 43. See id at 2411 (characterizing issue in case). 44. I.R.C. 263 (1990). The purpose of capitalization "is to 'mak[e] a meaningful allocation of the cost entailed in the use :.. of the asset to the periods to which it contributes [income]'." Colonial American, 109 S. Ct. at 2414 (quoting Massey Motors, Inc. v. United States, 364 U.S. 92, 104 (1960)); see Commissioner v. Idaho Power Co., 418 U.S. 1 (1974) (construing section 263 as requiring capitalization of construction-related expenses). 45. See Colonial American, 51 T.C.M. at 1126 (discussing Tax Commissioner's determination that ceding commissions from indemnity reinsurance transactions cannot be amortized), rev'd, 843 F.2d 201 (5th Cir. 1988), aft'd, 109 S. Ct (1989). The regulation provides that "any expenditure which results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year may not be deductible, or may be deductible only in part, for the taxable year in which incurred." Treas. Reg. 1A61-1(a)(2) (1987) (quoted in Colonial American, 109 S. Ct. at 2415) (emphasis added).

8 1274 THE AMERICAN UNIVERSITY LAW REvIEw[Vol. 39:1267 for the indemnity reinsurance ceding commission as if it were payment for an asset whose cost cannot be amortized. 46 This alternative treatment is appropriate for amounts expended to acquire a capital asset whose useful life cannot be determined. 47 If an indemnity reinsurance ceding commission is viewed as being payment for a capital asset, then such payment cannot be deducted under section 809(d)(12) because the cost of acquiring a capital asset is not an "ordinary and necessary" business expense. 48 Furthermore, deducting one's cost to acquire a capital asset violates regular accrual accounting rules. 49 Thus, if an indemnity reinsurance ceding commission is viewed as being payment for a capital asset, then such payment cannot be deducted under section 818(a). 50 The Commissioner of Internal Revenue Service traditionally required reinsurers to capitalize amounts paid as "up-front" ceding commissions, and challenged any taxpayer who took a current deduction for the ceding- commission on an indemnity reinsurance contract. 5 ' The Tax Court, on the other hand, had consistently held that a reinsurer could currently deduct an indemnity reinsurance ceding commission. 52 Prior to the Court's decision in ColonialAmeican, the circuits were split on this issue. 55 Therefore, the treatment of the ceding commission and the outcome of the case depended entirely on where the taxpayer was required to docket its appeal. 46. Colonial American, 51 T.C.M. at Id. at See supra notes and accompanying text (discussing incorporation of section 162(a) "ordinary and necessary" business expenses into section 809(d)(12) deductions from gross premiums). 49. See Treas. Reg (a)(2) (discussing accrual method of accounting). 50. Id. 51. See Rev. Rul , C.B. 102, (disallowing deduction for "up-front" ceding commission, but allowing deduction for annual ceding commission under Rev. Rul ); Gen. Couns. Mem. 38,833 (Apr. 6, 1982) (discussing Rev. Rul ); Gen. Couns. Mem. 37,395 (Jan. 27, 1978) (discussing Rev. Rul ); see also Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435, 1437 (7th Cir. 1988) (stating Commissioner's position), cert. granted, vacated, remanded for further consideration in light of Colonial American, 109 S. Ct (1989); Modem Am. Life Ins. Co. v. Commissioner, 830 F.2d 110, 111 (8th Cir. 1987) (stating Commissioner's position). But cf Anchor Nat'l Life Ins. Co. v, Commissioner, 93 T.C. 382 (1989) (post-colonial American) (stating Commissioner, in effect, allowed deduction of ceding commission). 52. E.g., Beneficial Life Ins. Co. v. Commissioner, 79 T.C. 627 (1982) (allowing deduction); Merit Life Ins. Co. v. Commissioner, 52 T.C.M. (CCH) 658 (1987) (allowing deduction), aft'd, 853 F.2d 1435, 1438 (7th Cir. 1988), cert. granted, vacated, remanded for further consideration in light of Colonial American, 109 S. Ct (1989). 53. Compare Colonial Am. Life Ins. Co. v. Commissioner, 843 F.2d 201 (5th Cir. 1988) (disallowing current deduction), aff'd, 109 S. Ct (1989); Prairie States Life Ins. Co. v. United States, 828 F.2d 1222 (8th Cir. 1987) (disallowing same); Modem Am. Life Ins. Co. v. Commissioner, 830 F.2d 110 (8th Cir. 1987) (disallowing same) with Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435 (7th Cir. 1988), cert. granted, vacated, remandedforfurther consideration in light of Colonial American, 109 S. Ct (1989) (finding ceding commission currently deductible).

9 1990] COLONIAL AM. LIFE INS. Co. V. COMMISSIONER 1275 C. Use of Analogies Both the Tax Court and the circuit courts used analogies to bolster their reading of the statutory provisions governing the tax treatment of indemnity reinsurance ceding commissions.- 4 Prior to the Supreme Court's decision in Colonial American, the Tax Court consistently held that a ceding commission on an indemnity reinsurance contract is analogous to the commission that a primary insurer pays a salesperson on a newly issued insurance policy. 55 The Tax Court thus allowed an indemnity reinsurer to currently deduct its ceding commission payments. 56 Some circuit courts, on the other hand, implicitly adopted the Tax Commissioner's analogy and found that indemnity reinsurance ceding commissions are intangible assets analogous to the ceding commissions paid on assumption reinsurance transactions. 57 Under this approach, the courts required an indemnity reinsurer to treat its ceding commission payments as the cost to acquire a capital asset that could be amortized over the life of the reinsured policies. 58 The agent's commission analogy embraced by the Tax Court was the approach most favorable to the taxpayer. 59 The seminal case establishing the Tax Court's position that indemnity reinsurance 54. See generally 2A N. SINGER, SUTHERLAND ON STATUTORY CONSTRUCTrION, (4th ed. 1986) (discussing statutory extension using analogy and implication). In addition to resorting to analogies to interpret statutes, courts use analogies to extend the scope of a particular statute. Id. 55. See infra notes and accompanying text (discussing Tax Court reliance on insurance salesperson analogy). 56. See, e.g., Beneficial Life Ins. Co. v. Commissioner, 79 T.C. 627 (1982) (permitting deductibility); Merit Life Ins. Co. v. Commissioner, 52 T.C.M. (CCH) 658 (1986) (following Beneficial Life and permitting deductibility), aft'd, 853 F.2d 1435 (7th Cir. 1988), cert. granted, vacated, remanded for further consideration in light of Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct (1989); Individual Life Assurance Co. v. Commissioner, 51 T.C.M. (CCH) 1028 (1986) (permitting deductibility); Modem Security Life Ins. Co. v. Commissioner, 51 T.C.M. (CCH) 188 (1985) (following Beneficial Life and permitting deductibility). 57. See Colonial Am. Life Ins. Co. v. Commissioner, 843 F.2d 201, (5th Cir. 1988) (construing indemnity reinsurance as asset with useful life greater than one year and equating tax treatment of assumption reinsurance ceding commission with treatment of indemnity reinsurance ceding commission), aff'd, 109 S. Ct (1989); Prairie States Life Ins. Co. v. Commissioner, 828 F.2d 1222, 1229, 1232 (8th Cir. 1987) (recognizing indemnity reinsurance as asset with useful life greater than one year and stating that Treas. Reg (d)(2)(ii), which "by its terms applies only to assumption reinsurance," and Treas. Reg (a)(7)(ii), in which "the definition of assumption reinsurance... specifically excludes indemnity reinsurance... [do] not prescribe a different tax treatment for [indemnity reinsurance] transactions"); Modem Am. Life Ins. Co. v. Commissioner, 830 F.2d 110, 111 (8th Cir. 1987) (defining indemnity reinsurance as asset with useful life greater than one year). But see Merit Life Ins. Co. v. Commissioner, 853 F. 2d 1435, (7th Cir. 1988) (rejecting Commissioner's assertion and stating that Internal Revenue Code treats indemnity reinsurance as "issuance of insurance"), cert. granted, vacated, remandedforfurther consideration in light of Colonial American, 109 S. Ct (1989). 58. See infra notes and accompanying text (discussing Commissioner's position). 59. See, e.g., Colonial Am. Life Ins. Co. v. Commissioner, 51 T.C.M. (CCH) 1123, 1126 (1986) (relying on Beneficial Life which treated indemnity reinsurance transaction as purchase

10 1276 THE AMERICAN UNIVERSITY LAW REvIEw[Vol. 39:1267 ceding commissions are deductible is Beneficial Life Insurance Co. v. Commissioner. 60 The Tax Court in Beneficial Life recognized that, while certain provisions of the Internal Revenue Code and related Treasury Regulations treated assumption reinsurance as an asset sale, those same provisions expressly do not apply to indemnity reinsurance transactions. 61 It concluded that an indemnity reinsurance transaction should not be treated as the purchase of a capital asset, but rather as the purchase of insurance from the reinsurer. 62 The ceding company, in other words, insured the risks associated with the insurance policies covered by the contract. 63 The Tax Court reasoned that an indemnity reinsurance transaction, being in effect the sale of insurance by a reinsurer, is analogous to a primary insurer's sale of life insurance, 64 and, therefore, the ceding commission paid by the reinsurer is analogous to the primary insurer's underwriting expenses. 65 Indeed, the Tax Court stated that the ceding commission was analogous to the commission a primary insurer pays a sales agent who sells a life insurance policy. 66 Because a life insurance company can deduct sales commissions and other underwriting expenses from gross income, 67 the Tax Court found that indemnity reinsurance ceding commissions are deductible in the year incurred. 68 of insurance by initial insurer from reinsurer and finding for taxpayer on basis of agent's commission analogy), rev'd, 843 F.2d 201 (5th Cir. 1988), aff'd, 109 S. Ct (1989) T.C. 627 (1982). 61. Beneficial Life Ins. Co. v. Commissioner, 79 T.C. 627, (1982) (citing Treas. Reg (a)(1)(iii)). The phrase "reinsurance ceded," as used in I.R.C. 809(c)(1), encompasses indemnity reinsurance and does not include assumption reinsurance. Id. at 646 n Id at Id at See id at ; see also Cologne Life Reinsurance Co. v. Commissioner, 80 T.C. 859, 862 (1983) (dicta) (citing Beneficial Li, 79 T.C. at ), aff'd by summary order, 732 F.2d 141 (2d Cir. 1984) (unpublished opinion). 65. Beneficial Life Ins. Co. v. Commissioner, 79 T.C. 627, (1982). 66. Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2412 (1989). 67. Id. (holding agent's commissions deductible under 26 U.S.C. 809(d)(12) (1970)). This provision has been reenacted several times since It currently resides at 26 U.S.C. 805(a)(8) (1990). Life insurance company gross income is defined at I.R.C. 803 (1990). Prior to 1984, life insurance company gross income was defined at I.R.C. 809(c) (1970) (denoting such income as "gross premium income"). See supra note 31 (providing authority for deductibility of agent's sales commissions). 68. Beneficial Life Ins. Co. v. Commissioner, 79 T.C. 627 (1982); see also Merit Life Ins. Co. v. Commissioner, 52 T.C.M. (CCH) 658 (1986) (following Beneficial Life and permitting deductibility), aff'd, 853 F.2d 1435 (7th Cir. 1988), cert. granted, vacated, remanded for further consideration in light of Colonial American, 109 S. Ct (1989); Individual Life Assurance Co. v. Commissioner, 51 T.C.M. (CCH) 1028 (1986) (permitting deductibility); Modem Security Life Ins. Co. v. Commissioner, 51 T.C.M. (CCH) 188 (1985) (following Beneficial Life and permitting deductibility). But see Anchor Nat'l Life Ins. Co. v. Commissioner, 93 T.C. 382 (1989) (following Colonial American and disallowing current deduction). While not explicitly applying the sales agent analogy, both the Seventh and Ninth circuits followed the Tax Court's decision in Beneficial Life to conclude that ceding commissions from

11 1990] COLONIAL AM. LIFE INS. Co. v. COMMISSIONER 1277 While controlling in the Tax Court, the sales agent analogy was not adopted by the Fifth and Eighth Circuit Courts. 6 9 These courts adopted, instead, the assumption reinsurance analogy endorsed by the Commissioner of Internal Revenue. 70 The Commissioner reasoned that an indemnity reinsurance agreement is an intangible asset with a useful life greater than one year, and therefore, the tax consequences of indemnity and assumption reinsurance transactions are identical. 7 1 The law requires that any such intangible asset indemnity reinsurance transactions are currently deductible. See Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435, 1445 (7th Cir. 1988) (reading I.R.C. section 809(c)(1) as providing for current deduction of indemnity reinsurance ceding commissions), cert. granted, vacated, remandedforfurther consideration in light of Colonial American, 109 S. Ct (1989); Oxford Life Ins. Co. v. Commissioner, 790 F.2d 1370, 1376 (9th Cir. 1986) (distinguishing between assumption reinsurers, who cannot deduct ceding commissions, and indemnity reinsurers, who can deduct such payments). 69. See Colonial Am. Life Ins. Co. v. Commissioner, 843 F.2d 201, 205 (5th Cir. 1988) (requiring reinsurer to capitalize ceding commission), aft'd, 109 S. Ct (1989); Prairie States Life Ins. Co. v. Commissioner, 828 F.2d 1222, (8th Cir. 1987) (requiring same); Modem Am. Life Ins. Co. v. Commissioner, 830 F.2d 110, 111 (8th Cir. 1987) (requiring same). But see Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435, 1445 (7th Cir. 1988) (deciding case on other grounds, but stating that court agreed with petitioner's contention that ceding commissions are analogous to direct insurer's currently deductible underwriting expenses), cert. granted, vacated, remandedforfurther consideration in light of Colonial American, 109 S. Ct (1989); Oxford Life Ins. Co. v. Commissioner, 790 F.2d 1370, 1376 (9th Cir. 1986) (holding that assumption reinsurers must capitalize ceding commissions but distinguishing indemnity reinsurers who can deduct such payments). See also Vukasovich, Inc. v. Commissioner, 790 F.2d 1409, 1413 (9th Cir. 1986) (explaining that "general rule of special deference to the Tax Court is inappropriate although its judgments in its field of expertise are always accorded a presumption that they correctly apply the law") (quoted in Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435, 1438 (7th Cir. 1988), cert. granted, vacated, remanded for further consideration in light of Colonial American, 109 S. Ct (1989)). 70. See supra note 51 and accompanying text (discussing Commissioner's position). 71. See Colonial Am. Life Ins. Co. v. Commissioner, 843 F.2d 201, (5th Cir. 1988) (construing indemnity reinsurance as asset with useful life greater than one year and equating tax treatment of assumption reinsurance ceding commission with treatment of indemnity reinsurance ceding commission), aff'd, 109 S. Ct (1989); Prairie States Life Ins. Co. v. Commissioner, 828 F.2d 1222, 1229, 1232 (8th Cir. 1987) (recognizing indemnity reinsurance as asset with useful life greater than one year and stating that Treas. Reg (d)(2)(ii), which "by its terms applies only to assumption reinsurance," and Treas. Reg (a)(7)(ii), in which "the definition of assumption reinsurance... specifically excludes indemnity reinsurance... [do] not prescribe a different tax treatment for [indemnity reinsurance] transactions"); Modem Am. Life Ins. Co. v. Commissioner, 830 F.2d 110, 111 (8th Cir. 1987) (defining indemnity reinsurance as asset with useful life greater than one year). But see Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435, (7th Cir. 1988) (rejecting Commissioner's assertion and stating that Internal Revenue Code treats indemnity reinsurance as "issuance of insurance"), cert. granted, vacated, remanded for further consideration in light of Colonial American, 109 S. Ct (1989). See generally BARRON's LAw DicTIoNARY 238 (2d ed. 1984) (defining intangible asset as "an asset that has no physical being, apart from a writing which evidences its existence. For instance, the debt of another which is evidenced by a promissory note is an intangible asset. The intangible assets of a business include going concern value and good will." [emphasis in original]); BARRON'S LAw DICToNARY 129 (2d ed. 1984) (defining "useful life" as "the reasonable estimate of the term of an asset's usefulness to the taxpayer in his business"). The I.R.S. Commissioner acknowledged that the differences between indemnity and assumption reinsurance are important to the underlying policy holders and to the contracting parties, the ceding company and the reinsurer, but argued that these differences do not warrant different tax consequences to the reinsurer who pays a ceding commission. Merit Life

12 1278 THE AMERICAN UNIVERSITY LAW REviEW[Vol. 39:1267 be capitalized and amortized over its useful life, rather than taken as an expense in the current year. 72 Under the Commissioner's analysis, an indemnity reinsurer's ceding commission payment must be capitalized and is not fully deductible in the year paid. 73 The Court of Appeals for the Seventh Circuit rejected the asset acquisition theory promulgated in the Fifth and Eighth Circuits. In Merit Life Insurance Co. v. Commissioner, 74 the Seventh Circuit held that a reinsurer can currently deduct the ceding commission paid to enter into an indemnity reinsurance transaction. 75 The court based its decision on the language of the relevant statutory and regulatory provisions. 76 In Merit Life the Commissioner asserted -that the ceding commission deduction provided for in section 809(c)(1) of the Internal Revenue Code applies only to the ceding company and not to the reinsurer. 77 The court responded by stating that there is no provision in the regulations to support the Commissioner's position. 78 The court pointed out that a ceding company receives ceding commissions rather than paying them. 79 A reinsurer, on the other hand, pays ceding commissions. 8 0 Thus, the Court reasoned that, by their very nature, indemnity reinsurance ceding commissions are income, and not deductions to a ceding company. 8 ' The court concluded that the ceding commission deduction provided for in section Ins. Co. v. Commissioner, 853 F.2d 1435, 1438 (7th Cir. 1988), cert. granted, vacated, remanded for further consideration in light of Colonial American, 109 S. Ct (1989). 72. See, e.g., Commissioner v. Idaho Power Co., 418 U.S. 1, 12 (1974) (requiring capitalization); United States v. Mississippi Chem. Corp., 405 U.S. 298, 309 (1972) (requiring same); Commissioner v. Lincoln Savings and Loan Ass'n, 403 U.S. 345, 354 (1971) (requiring same). See I.R.C. 263 (1990) (denying deduction for capital expenditures); see generally 1 B. BITrEa, FEDERAL INCOME TAXATiON OF INCOME, EsTATEs AND GxFrs t 20.4 (2d ed. 1989) (discussing capital expenditures and capitalization). Cf. I.R.C. 195 (1989) (requiring capitalization of business start-up expenditures, and allowing amortization only if taxpayer makes timely election). 73. See supra note 72 (providing cases). But cf Rev. Rul , C.B. 102, (permitting current deduction for annual ceding commission, but denying current deduction for "up-front" payment) F.2d 1435 (7th Cir. 1988), cert. denied, vacated, remanded for further consideration in light of Colonial American, 109 S. Ct (1989). 75. Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435, 1445 (7th Cir. 1988). (pointing out that primary insurer also acquires asset, broadly defined, but that law permits deductibility of cost of such asset, and deciding issue without applying agent's commission analogy), cert. granted, vacated, remanded for further consideration in light of Colonial American, 109 S. Ct (1989). 76. Id at , 1445 (discussing I.R.C. 809(c)(1) (1970), 809(d)(1 1) (1970), and Treas. Reg (a) (as amended in 1966), (a) (as amended in 1969), and (a) (as amended in 1976)). 77. Id at Id 79. Id 80. Id 81. Id.

13 1990] COLONIAL AM. LIFE INS. Co. v. COMMISSIONER (c)(1) must apply to the reinsurer because the ceding company cannot possibly utilize it.82 The court held further that the provision that mandates capitalization and amortization for assumption reinsurance ceding commissions does not affect indemnity reinsurance ceding commissions. 8 3 The court in Merit Life acknowledged that the distinction between indemnity and assumption reinsurance drawn by the statute and regulations results in a direct matching of income and expenses in only one of the transactions-that of assumption reinsurance. 8 4 The court found that, even though there is a mismatching of income and expenses when an indemnity reinsurer is allowed a current deduction for its ceding commission payment, the Code and the regulations nevertheless provide for such a deduction. 8 5 The court thus allowed a current deduction for indemnity reinsurance ceding commissions. 8 6 To resolve the uncertainty caused by the conflict between the Seventh Circuit and the Fifth and Eighth Circuits, the United States Supreme Court granted certiorari to hear Colonial American Life Insurance Co. v. Commissioner. 87 II. COLONIAL AMERICAN LIFE INSURANCE Co. v. COMMISSIONER The Court in Colonial American held that indemnity reinsurance ceding commissions must be capitalized and amortized over the productive life of the reinsured policies. 8 " The majority began its analysis by considering the character of indemnity reinsurance ceding commissions. 8 9 Only then did it examine the language of the applicable statutory provisions See id 83. Id, Treasury Regulation section (d)(2)(ii)(B) provides that, in the case of assumption reinsurance transactions, "a reinsurer shall... [t]reat any [ceding commission] paid... as a deferred expense that may be amortized over the reasonably estimated life.., of the contracts reinsured." Treas. Reg (d)(2)(ii)(B) (as amended in 1976). Treasury Regulation section (a)(7)(ii), in the course of defining the phrase "assumption reinsurance," states that "[s]uch term does not include indemnity reinsurance or reinsurance ceded.. " Treas. Reg (a)(7)(ii) (as amended in 1969). 84. See Merit Life Ins. Co. v. Commissioner, 853 F.2d 1435, (7th Cir. 1988) (differentiating between indemnity reinsurance and assumption reinsurance), cert. granted, vacated, remanded for further consideration in light of Colonial American, 109 S. Ct (1989). 85. See id (discussing I.R.C. 809(c)(1), 809(d)(7), and Treas. Regs (a) (as amended in 1966), (a) (as amended in 1969), (a) (as amended in 1976)). 86. Id at S. Ct. 527 (1988); see Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2412 & n.3 (1989) (listing conflicting circuit court cases). 88. See Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408,2414 (1989) (noting general tax treatment of assets with income-producing life greater than one year). 89. Id. at See id, at (analyzing 809(c)(1), 809(d)(12) and 818(a) as possible authority for current period deduction); see also infra text accompanying notes (discussing Court's application of I.R.C. 809(c)(1) and its legislative history).

14 1280 THE AMERICAN UNIVERSITY LAW REviEW[VoI. 39:1267 A. Facts and Procedural History Colonial American Life Insurance Company reinsured life insurance policies that other companies issued. 91 During both 1975 and 1976, Colonial American entered into two reinsurance transactions with another insurance company. 92 The company paid ceding commissions, as well as paying a finder's fee with respect to the 1975 reinsurance transactions. 93 Colonial American deducted the finder's fee and ceding commissions on its tax returns for 1975 and 1976, treating these expenditures as "other deductions" under Internal Revenue Code section 809(d)(12). 94 The Commissioner of Internal Revenue challenged Colonial American's treatment of its ceding commission payments and issued a statutory notice of deficiency against the company. 95 The Com- 91. Colonial Am. Life Ins. Co. v. Commissioner, 51 T.C.M. (CCH) 1123, 1124 (1986), rev'd, 843 F.2d 201 (5th Cir. 1988), aft'd, 109 S. Ct (1989). In addition, Colonial American Life Insurance Company sold life, accident, and health insurance directly to consumers in Louisiana and several other states. Id 92. Id at The risks reinsured in each of the transactions arose from the same block of life insurance policies. See Colonial Am. Life Ins. Co. v. Commissioner, 843 F.2d 201, 203 (5th Cir. 1988) (providing percentage breakdown of policies reinsured), aft'd, 109 S. Ct (1989). In addition, the transactions consisted of one conventional coinsurance agreement and one modified coinsurance agreement. Colonial Am. Life Ins. Co. v. Commissioner, 51 T.C.M. (CCH) 1124, (1986), rev'd, 843 F.2d 201 (5th Cir. 1988), aff'd, 109 S. Ct (1989). Colonial American and the ceding company agreed to apply the rules governing conventional coinsurance agreements to the modified coinsurance contracts as provided in I.R.C. 820 (1970) and the accompanying regulations. Id at Thus, each of the contracts was, for federal income tax purposes, equivalent to a conventional coinsurance agreement. Colonial Am. Life Ins. Co. v. Commissioner, 843 F.2d 201,204 (5th Cir. 1988) (stating that although ceding company retained reserves under modified coinsurance agreement, such reserves are treated as though transferred to reinsurer because of parties' election to have section 820 govern agreements), aff'd, 109 S. Ct (1989). Cf. supra note 27 (explaining that modified coinsurance transaction could give rise to double taxation if taxpayer failed to elect conventional coinsurance treatment). 93. Colonial Am. Life Ins. Co. v. Commissioner, 51 T.C.M. (CCH) 1123, 1125 (1986), rev'd, 843 F.2d 201 (5th Cir. 1988), aff'd, 109 S. Ct (1989). Colonial American and the ceding company exchanged relatively little cash each year with respect to the combined reinsurance transactions. Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2411 n.2 (1989). Specifically, the Court listed the amounts transferred for 1975 and See 51 T.C.M. (CCH) at In 1975, pursuant to the conventional coinsurance agreement, total reserves transferred were $675,762, less a ceding commission of $60,000, for a net amount owed the reinsurer of $615,762. Id The modified coinsurance agreement provided for a ceding commission of $620,000 with no reserves transferred, for a net amount due the ceding company of $620,000. Id Thus, only the difference of $4,238 was actually transferred to the ceding company. Id In 1976, reserves transferred under the conventional coinsurance agreement totaled $851,398, minus a ceding commission of $72,000, for a net amount owed to the reinsurer of $779,398. Id Under the modified coinsurance agreement, the ceding commission was $780,000 and no reserves were transferred. Id The difference and amount actually transferred was only $602. Id. 94. Colonial Am. Life Ins. Co. v. Commissioner, 843 F.2d 201, (5th Cir. 1988), aff'd, 109 S. Ct (1989). 95. See Colonial Am. Life Ins. Co. v. Commissioner, 51 T.C.M. (CCH) 1123, 1125 (1986) (challenging ceding commissions as non-deductible), rev'd, 843 F.2d 201 (5th Cir. 1988), af'd, 109 S. Ct (1989).

15 1990] COLONIAL AM. LIFE INS. Co. V. COMMISSIONER 1281 missioner determined that Colonial American's 1975 and 1976 ceding commissions were amounts paid for an "intangible asset with an indeterminate useful life" that must be capitalized and could not be amortized. 96 Alternatively, the Commissioner determined that the ceding commission expenditures were amounts paid to acquire capital assets, and that such costs must be amortized over the estimated useful lives of the assets so acquired. 97 The Commissioner disallowed Colonial American's ceding commission deductions, capitalized the expenditures, and allowed no amortization of the capitalized cost. 98 Furthermore, the Commissioner disallowed Colonial American's finder's fee deduction on the grounds that such payment was properly included in the cost of the asset acquired in Colonial American challenged the Commissioner's determinations in the Tax Court. 100 The court considered only the issue of ceding commission deductibility and found, on the strength of Beneficial Life Insurance Co. v. Commissioner,1 0 ' that ceding commissions on indemnity reinsurance contracts are fully deductible in the year paid.102 Upon review, the United States Court of Appeals for the Fifth Circuit reversed the Tax Court's determination.' 0 3 The Fifth Circuit stated that it would apply general tax principles because the relevant statutory provisions do not make a clear distinction between assumption and indemnity reinsurance transactions. 0 4 The 96. See ColonialAmerican, 51 T.C.M. (CCH) at The amount of the deficiency as the Commissioner determined it was equal to "the excess amounts of the required reserves over the cash received by [Colonial American]." Id This amount equals the ceding commissions paid. See id (discussing Commissioner's treatment of excess amounts paid). This amount is then multiplied by the tax rate to determine the tax deficiency. Id 97. Id. Treasury Regulation (a)(2) (as amended in 1967) provides that "any expenditure which results in the creation of an asset having a useful life which extends substantially beyond the dose of the taxable year may not be deductible, or may be deductible only in part, for the taxable year in which incurred." Treas. Reg (a)(2) (as amended in 1967) (emphasis added). 98. Id 99. See id. (recharacterizing finder's fee as asset) See Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2412 (1989) (reviewing procedural history) T.C. 627 (1982) Colonial Am. Life Ins. Co. v. Commissioner, 51 T.C.M. (CCH) 1123, , rev'd, 843 F.2d 201 (5th Cir. 1988), aff'd, 109 S. Ct (1989). The Commissioner had conceded that the court's resolution of the ceding commission issue would determine the finder's fee deductibility issue. Id. at Hence, the court did not separately consider the issue of finder's fee deductibility. See id. (disallowing current deduction for finder's fee without discussing merits). Prior to 1984, a modified coinsurance agreement was treated as a conventional coinsurance agreement for federal income tax purposes if the taxpayer elected to do so under I.R.C See supra note 27 (discussing reasons Congress enacted 820) Colonial Am. ife Ins. Co. v. Commissioner, 843 F.2d 201,205 (5th Cir. 1988), aff'd, 109 S. Ct (1989) Id at 204.

16 1282 THE AMERICAN UNIVERSITY LAW REVIEW[Vol. 39:1267 general principle the court applied was that a company must capitalize and amortize amounts expended to acquire an economic interest providing economic benefits for a period greater than one year.105 Thus, the court endorsed the assumption reinsurance analogy and held that Colonial American must capitalize and amortize the ceding commissions, and the related finder's fee, over the productive lives of the underlying policies Character of analogies B. Supreme Court Opinion In Colonial American Life Insurance Co. v. Commissioner the Supreme Court affirmed the decision of the Fifth Circuit Justice Kennedy, writing for the majority, opined that the Internal Revenue Code provisions governing the tax treatment of life insurance companies do not explicitly allow a current deduction for indemnity reinsurance ceding commissions.1 08 The Court then reviewed the battle of analogies raging in the courts below The Court examined Colonial American's proposition that indemnity reinsurance ceding commissions are currently deductible just as agent's commissions on the sale of primary insurance are deductible. 110 The Court stated that the parallels between indemnity reinsurance ceding commissions and agent's commissions are "chiefly nominal.""' Moreover, the Court said that even if it accepted the agent's commissions analogy, it would prove only that Congress had made an exception to the general rule when it decided that a primary insurer may deduct agent's commissions in the year paid. 1 2 The Court explicitly refused, however, to extend Congress' exception for agent's commissions to other capital expendi Id at 204 (citing Commissioner v. Idaho Power Co., 418 U.S. 1, 12 (1974)); see supra note 72 (listing other cases that establish principle) See ColonialAmerican, 843 F.2d at (concluding assumption and indemnity reinsurance must be treated equally for tax purposes) S. Ct (1989), aff'g 843 F.2d 201 (5th Cir. 1988) Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2412 (1989). The tax provisions governing life insurance companies for the relevant periods are codified at I.R.C (1970 and Supp. V 1975) I d at See id. at (discussing proposed agent's commission analogy). Colonial American adopted the analogy that the Tax Court favored. See supra notes and accompanying text (discussing Beneficial Life Ins. Co. v. Commissioner, 79 T.C. 627 (1982) and the agent's commission analogy) Id at Id at 2414; see supra text accompanying notes (discussing general rule); supra text accompanying notes (discussing basis for agent's commission analogy); see also supra note 72 (listing cases that stand for general rule).

17 1990] COLONIAL AM. LIFE INS. Co. v. COMMISSIONER 1283 tures. 113 Likewise, the Court refused to establish a rule that would enable taxpayers to deduct expenditures bearing a greater resemblance to agent's commissions than indemnity reinsurance ceding commissions bear.14 Instead, the Court determined that an indemnity reinsurance ceding commission is a different type of expenditure than a sales commission The Court reasoned that an insurance agent's sales commission, paid by a direct insurer, is an administrative expense, the purpose of which is to compensate the third-party who facilitated the sale. 116 The agent's commission, therefore, is like a salary expense or the other expenses of issuing a new insurance policy. 117 The Court contrasted indemnity reinsurance ceding commissions, which it found to be part of the purchase price for an income producing asset, and not akin to the administrative expenses associated with issuing a new life insurance policy. 1 8 The Court next addressed the proposition that indemnity reinsurance ceding commissions are economically the same as assumption reinsurance ceding commissions." 9 The Court agreed with the Commissioner that Colonial American's payment of ceding commissions in an indemnity reinsurance transaction represented an investment in a future stream of income. 120 The Court declared that the Internal Revenue Code and Supreme Court precedent required capitalization and amortization for the amount spent to acquire such an asset.' 2 1 Consequently, the Court held that Colonial American must capitalize and amortize the ceding commission over the useful life of the asset Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2414 (1989) Id at 2414 n See id at (examining and contrasting ceding commissions and agent's commissions) Id. at ld 118. See id. (stating that payment of ceding commission is not for services but for acquisition of asset) Id- at 2413 (citing Brief for Respondent at 19-20) il at In other words, Colonial American acquired an asset with an income producing life of over one year. Id. at The Court's characterization of the ceding commissions as capital assets served as the foundation for its holding: "Our agreement with [the Commissioner] as to the character of ceding commissions therefore resolves this case, absent some specific statutory provision indicating that ceding commissions for indemnity [re]insurance are an exception to the general rule for which Congress has authorized [a] current deduction." Id at lad at 2414 (citing I.R.C. 263 (1970 & Supp. V 1975); Commissioner v. Idaho Power Co., 418 U.S. 1, 12 (1974); Woodward v. Commissioner, 397 U.S. 572, 575 (1970)) Id at 2418; see id at 2414 (applying general tax treatment to ceding commissions).

18 1284 THE AMERICAN UNIVERSITY LAW REVIEW[Vol. 39: Statutory provisions After concluding on the basis of the characterization issue that indemnity reinsurance ceding commissions are not deductible absent-some specific statutory authorization, the Court proceeded to scrutinize the relevant statutory provisions.' 23 The Court first examined "other deductions" under Internal Revenue Code section 809(d)(12). 124 The Court reasoned that indemnity reinsurance ceding commissions would be deductible under section 809(d)(12) only if they were analogous to sales commissions paid by a primary insurer.' 25 Because the Court had determined that indemnity reinsurance ceding commissions are not analogous to sales commissions, it rejected Colonial American's argument that its indemnity reinsurance ceding commissions were deductible under section 809(d)(12). 126 The Court next examined indemnity reinsurance ceding commission deductibility under Internal Revenue Code section 818(a). 127 Having concluded that Colonial American's ceding commission expenditures gave rise to an asset with a useful life greater than one year, the Court ruled that Colonial American could not deduct such commissions pursuant to section 818(a), reasoning that such a deduction would violate regular accrual accounting rules. 28 The Court strengthened its conclusion with two observations. First, the Court thought it inconceivable that Congress intended to delegate to the NAIC the power to determine such fundamental policy questions as whether an expenditure is a capital outlay or a deductible expense.' 29 Moreover, it maintained that because NAIC rules do not distinguish between indemnity and assumption reinsurance ceding commissions, both would be deductible under Colonial American's argument.' 30 The Court found this stretch too great, given 123. IL at (discussing exceptions to general rule of current deductions) Id at See id (commenting that rejection of agent's commission analogy precludes application of 809(d)(12) exception) Id 127. Id at See id (calling NAIC practices inapposite where inconsistent accrual accounting rules apply). Regular accrual accounting rules require that an asset which has a useful life greater than one year must be capitalized. See Treas. Reg (a)(2) (discussing accrual method of accounting) Colonial American, 109 S. Ct. at 2415; see supra notes and accompanying text (discussing application of NAIC accounting rules under I.R.C. section 818(a)) ColonialAmerican, 109 S. Ct. at 2415; (citing PATTERSON, UNDERWRITING INCOmE, in Reinsurance 539 (R. Stain ed. 1980)).

19 1990] COLONIAL AM. LIFE INs. Co. v. COMMISSIONER 1285 the generally accepted view that assumption reinsurance ceding commissions must be capitalized. 13 ' Unlike Colonial American's first two statutory arguments, the Court found its final argument, that ceding commission payments are deductible pursuant to Internal Revenue Code section 809(c)(1), more difficult to dismiss.' 3 2 The Court acknowledged that one could read the statutory language of section 809(c)(1) to authorize a current deduction for indemnity reinsurance ceding commissions.' 3 3 It emphasized, however, that such a reading was only plausible when considered in isolation from the overall statutory structure.' 3 4 When the broader statutory structure was taken into account, the Court found Colonial American's argument untenable.' 3 5 The Court reasoned that ceding commissions cannot be "return premiums" because the reinsurer does not return them to the ceding company.' 3 6 In the Court's view, a more appropriate example of what constitutes "return premiums" are amounts refunded to an individual policy holder or ceding company for overpaid premiums Moreover, the Court reasoned that ceding commissions are not encompassed within the statutory language of section 809(c)(1) that excludes certain items from gross income.' 38 The Court proposed that, because reinsurers do not pay premiums to ceding companies, the term "premiums" in that statutory exclusion refers only to premiums paid by individual policy holders to the ceding company through the reinsurer acting as a middleman.' 3 9 Moreover, while acknowledging that the phrase "other consideration" in the statutory exclusion is open-ended, the Court observed that it can be viewed as referring to expenditures which are analogous to "premi Id. (criticizing petitioner's argument as "too broad" pursuant to NAIC's rules as well as congressional intent) IME at See id. (discussing language of section 809(c)(1) and parallel regulations) See id. at IE 136. Id. at 2417 (explaining that commissions never belong to ceding company until paid by reinsurer) Id. The Court provides an example of a contract provision that may give rise to overpaid premiums. Id Such provision is known as an "experience-rated refund clause, which readjusts the amounts of policy premiums paid over to the ceding company to reflect unanticipated savings." I& Another example is the "premium payments that have been refunded because of an overcharge or the cancellation of a policy." Id. (citing S. REP. No. 291, 86th Cong., 1st Sess. 39, 54 (1959)) Id- (stating that "ceding commissions do not find a snug fit within th[e] phrase... 'premiums and other consideration arising out of reinsurance ceded' ") Id-

20 1286 THE AMERCAN UNIVERSITY LAw REviEw[Vol. 39:1267 urns," which the Court interpreted as not including ceding commission expenditures. 140 The Court pointed out that the purpose of section 809(c) was to define life insurance company gross income, while deductions were treated separately in section 809(d) Moreover, the Court noted that Colonial American's reading of section 809(c)(1) as authorizing a deduction for such a large category of expenditures as ceding commissions "is highly implausible in light of the intricate attention to detail displayed throughout subchapter L" of the Internal Revenue Code. 142 Finally, the Court reiterated its position that ceding commissions are amounts paid to acquire a long-term asset regardless of whether they arise out of indemnity or assumption reinsurance transactions.' 43 As such, the ceding commission payments must be capitalized and amortized over the useful life of the asset so acquired Dissent Justice Stevens, joined by Justices Blackmum and O'Connor, criticized the Court's opinion as internally inconsistent.' 45 Justice Stevens argued that the same general principles on which the Court would require indemnity reinsurance ceding commissions to be capitalized would serve as the basis for concluding that direct sales commissions must also be capitalized. 146 Justice Stevens found the Court's reasoning untenable in light of the fact that the deductibility of agent's sales commissions is firmly established in law. 147 Furthermore, Justice Stevens found no textual authority for the Court's proposition that ceding commissions do not constitute return premiums while experience refunds do.1 48 Finally, Justice Stevens contended that if a ceding commission were characterized as the 140. See Colonial Am. Life Ins. Co. v. Commissioner, 109 S. Ct. 2408, 2447 (1989) (commenting that "[tihe 'other consideration' phrase... can be read in quite a sensible way as tagalong language that refers to analogous expenditures of this kind Id at Id at Subtitle A, Chapter 1, subchapter L of the Internal Revenue Code addresses the income taxation of insurance companies and encompasses I.R.C. section Life insurance company taxation is specifically addressed in Subchapter L, Part I, section See INTERNAL REvENuE CODE XV (U.S. Code Congressional & Administrative News 1990) ColonialAmerican, 109 S. Ct at Id 145. Id at (Stevens, J., dissenting) Id at 2418 (Stevens, J., dissenting) (accusing Court of relying on intuition about policy rather than statutory interpretation) Id at 2418 (Stevens, J., dissenting). See infra notes and accompanying text (explaining dissent's argument that Court's reasoning is untenable in light of statutory and regulatory treatment of sales commissions) Id at 2419 (Stevens, J., dissenting). See supra note 137 (describing experience refunds).