This is a suit for refund of some $535,946.24 federal income taxes and interest alleged to have been erroneously assessed to and collected from plaintiff for the calendar years 1958 through 1968. Plaintiff (the taxpayer) is a mutual life insurance company incorporated under the laws of the State of Maine and having its principal office at Portland. It is subject to taxation under Sections 801-820 of the Internal Revenue Code of 1954, as amended (the Code), 26 U.S.C. §§ 801-820 (1970), which sections were added to the Code by the Life Insurance Company Income Tax Act of 1959, 73 Stat. 112 (the 1959 Act). 1" It is stipulated that the taxpayer has complied with procedures governing exhaustion of its administrative remedies and that it has properly invoked the jurisdiction of this Court under 28 U.S.C. § 1346(a) (1970). By its amended complaint, the taxpayer has presented in six counts six distinct and separate challenges to determinations affecting the taxpayer's federal income tax liability made by the Commissioner of Internal Revenue. In addition, the United States has raised as a counterclaim a seventh issue as grounds for an offsetting adjustment against any recovery by the taxpayer. All seven issues presented arise under the 1959 Act.
The action has been tried to the Court, without a jury, and has been fully briefed and argued by counsel. The following opinion contains the Court's findings of fact and conclusions of law as required by Fed. R. Civ. P. 52(a).
INTRODUCTION: THE TAXING FORMULA
A description of the purposes and framework of the 1959 Act is needed at the outset to set the context of the issues presented by this action.
The purpose of the 1959 Act was to come to grips with certain difficulties inherent in the income taxation of life insurance companies. The two principal difficulties identified by Congress were (1) the need to determine what portion of a company's investment income is properly allocable to reserves which the company must hold for the purpose of meeting the company's future obligations to policyholders, and what portion is properly considered income taxable to the company and (2) the problem of calculating underwriting income on a yearly, as opposed to a long-term basis. See S. Rep. No. 291, 86th Cong., 1st Sess., 1959 U.S. Code & Ad. News 1577-82. The first step in Congress' approach to these difficulties was to decide that a life insurance company's taxable income would be calculated in three distinct parts or "phases." Id. at 1576. In Phase I the taxable portion of the company's investment income -- its "taxable investment income" -- is computed. Sections 804-806. In Phase II the company's gain (or loss) from operations -- its "underwriting gain" -- is computed. Sections 809-812. In Phase III the company's taxable income owing to certain distributions to stockholders is computed. Section 815. 2" Once each of these amounts has been computed, the company's taxable income is then computed under Section 802(b) to equal the sum of (1) the lesser of Phase I or Phase II income; (2) 50% of the excess, if any, of Phase II income over Phase I income; and (3) Phase III taxable income, if any. The sum thus calculated -- the company's "life insurance company taxable income" -- is then taxed at the normal corporate rate. Sections 802(a), 11.
The issues presented in the instant case directly concern only Phase I of the overall computation, that is, the computation of the company's taxable investment income. The purpose of Phase I, simply stated, is to divide the company's investment income into two parts, that portion which is allocable to reserves held to meet the company's obligations to policyholders, which is not taxed; and that portion which is available to the company for other purposes, which is taxed. The Phase I computation proceeds as follows:
(1) For the taxable year in question, the company calculates its "gross investment income" by adding together interest, dividends, rents, royalties and other income derived from investments or any trade or business other than the insurance business. Section 804(b). From this amount the company deducts items allowed as deductions, such as investment and investment-related expenses. Section 804(c). The result is the company's "investment yield" for that taxable year. Idem.
(2) The company then calculates its "assets," Section 805 (b)(4), as of the beginning and end of the taxable year and computes the mean thereof.
(3) The company then calculates its "current earnings rate" by dividing its investment yield by the mean of its assets. Section 805(b)(2). It also calculates its "average earnings rate" by computing the average of its current earnings rates for the present and last four taxable years. Section 805(b) (3). The lower of the current and the average earnings rates is the company's "adjusted reserves rate." Section 805(b)(1).
(4) The company then calculates its "adjusted life insurance reserves." Section 805(c). To do this:
(a) The company first calculates the mean of its "life insurance reserves," as defined by Section 801(b), as of the beginning and end of the taxable year. Section 805(c)(1)(A).
(b) The company then calculates the weighted average of the interest rates which it has assumed for the purpose of calculating its life insurance reserves. Section 805(c)(2). This figure, which may be termed the company's "average rate of assumed interest," is then deducted from the adjusted reserves rate.
(c) The company then determines its "adjusted life insurance reserves" by reducing its life insurance reserves by 10% for each 1% by which the adjusted reserves rate exceeds the average rate of assumed interest. Section 805(c)(1).
(5) The company then multiplies its adjusted life insurance reserves by its adjusted reserves rate. The result, with certain adjustments not at issue here, is the company's "policy and other contract liability requirements" (policy liability requirements) for the taxable year. Section 805(a)(1).
(6) The company then divides its policy liability requirements by its investment yield. The result is the percentage of investment income which the company may allocate to reserves held for the purpose of meeting its obligations to policyholders. Section 804(a)(1). The remaining portion of the investment yield, less certain deductions not at issue here, represents the company's taxable investment income. Sections 802(b)(1), 804(a)(2).
This process is well illustrated by the following example drawn from the Senate Finance Committee's report on the 1959 Act, S. Rep. No. 291, supra, 1959 U.S. Code Cong. & Ad. News 1593-94:
Assume the following with respect to a life insurance company:
Assets $1,000,000Reserves $900,000Investment yield (or net investment income before small business deduc- tion under the House bill) $40,000Company's current earnings rate/-- percent 4Company's average earnings rate (for the current and 4 prior years)/-- percent 3.75Company's assumed rate/--do 2.5