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Differential Earnings
(Section 809)
PDF Version
The National Alliance of Life Companies (NALC) is a national
trade association of more than 250 life and health insurance companies which do
business in all 50 states and the District of Columbia. Smaller insurance
companies suffer under the current system of taxation, specifically, the
following tax provision.
Equity income is imputed to mutual insurers. Section 809
imposes a formula for identifying the portion of policyholder dividends which
allegedly represents the equity return, based on observed differences in the
earnings rates between stock and mutual companies. Congress adopted a
mathematical formula that imputes additional income to mutual companies based on
a comparison of the current one-year average mutual company earnings rate for
the previous three years. However, this calculation is based on the earnings
rates of a handful of large mutual insurers, with much greater capital and
earning power than the smaller to mid-size mutual insurers possess.
The formula under Section 809 operates in two stages: In the
first year, mutual companies calculate a differential earnings amount and, in
the second year, they calculate a recomputed differential earnings amount. The
differential earnings amount is computed by multiplying the "life insurance
company’s average equity base for the taxable year" by the differential
earnings rate (DER) for that year.
The General Accounting Office (GAO) stated in a 1989 study
that Section 809 imposes a tax that is regressive both year to year and company
by company. When mutual companies do well in a particular year, the average
mutual earnings rate is high and the differential earnings rate and resulting
taxes are low. When the segment does poorly, the differential taxes are high.
When a company does better than the average mutual in a tax year, the
differential taxes for that company are a smaller proportion of the total taxes.
If the company does worse than average, these taxes are a larger proportion of
the total taxes. This results from the way the differential earnings rate, is
calculated and applied to all firms, regardless of earnings experience.
In its Final Report to Congress on Life Insurance Company
Taxation, The Treasury stated that "different tax rules, such as Section
809, should apply to different forms of business organizations only to the
extent necessary to measure accurately and tax equally their net income."
Treasury determined that Section 809 is not necessary because "equity
returns (of mutual companies) to participating policyholders bear an appropriate
tax at the corporate level." Accordingly, Treasury recommended that Section
809 be repealed.
In a 1989 study, the GAO reached a similar conclusion as
stated above and also recommended the repeal of Section 809. Indeed, the
economist who developed the economic theory on which Section 809 is based, Dr.
Henry Aaron of the Brookings Institution, has since concluded that his analysis
was incorrect and that Section 809 overtaxes mutual companies.
Finally, smaller to mid-size mutual companies are forced to
maintain a higher level of capitalization for rating agency purposes in order to
compete with the larger companies. As a result, the smaller companies are
penalized by the addition taxation of the surplus, which is charged to earnings
and taxed as ordinary earnings. The actual impact on the small to mid-size
mutual companies has punitive. In the past few years, the number mutual insurers
has been shrinking due to demutualizations and the formation of Mutual Holding
Companies. Further, as a result of this activity, the DER has been minimal or
nonexistent in recent years.
We believe that Section 809 is bad tax policy. Therefore, we
ask that Section 809 be repealed.
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