JOHN HANCOCK FINANCIAL SER╜VICES, INC. and John Hancock Life Insurance Company (Formerly John Hancock Mutual Life Insurance Company), Plaintiffs, v. The UNITED STATES, Defendant., United States Court of Federal Claims., 57 Fed.Cl. 643, No. 01-543T., July 15, 2003

JOHN HANCOCK FINANCIAL SER╜VICES, INC. and John Hancock Life Insurance Company (Formerly John Hancock Mutual Life Insurance Company), Plaintiffs, v. The UNITED STATES, Defendant.

United States Court of Federal Claims.

57 Fed.Cl. 643

No. 01-543T.

July 15, 2003.

Matthew J. Zinn, Steptoe & Johnson LLP, Washington, D.C., with whom were J. Walk╜er Johnson, Steptoe & Johnson LLP, Wash╜ington, D.C., and Theodore R. Groom, Groom Law Group, Washington, D.C., of counsel, for plaintiffs.

Sheryl B. Flum, Tax Division, United States Department of Justice, Washington, D.C., with whom were, Eileen J. O'Connor, Assistant Attorney General, and Mildred L. Seidman, for defendant.

OPINION

MARGOLIS, Senior Judge.

Plaintiff John Hancock Life Insurance Company, formerly John Hancock Mutual Life Insurance Company ("John Hancock"), ¹ claims that it is entitled to refunds of $982,736 and $3,886,617 from the Internal Revenue Service for tax years 1988 and 1989, respectively. John Hancock asserts that, for those tax years, it is entitled to exclude in╜come attributable to the Government's disal╜lowance of additions to its policyholder divi╜dend deductions associated with a negative recomputed differential earnings amount cal╜culated for tax year 1986, using a formula prescribed by section 809 of the Internal Revenue Code ("section 809"). 26 U.S.C. ╖ 809. Specifically, John Hancock argues that the Government's disallowance of addi╜tions to its policyholder dividend deduction relating to the negative recomputed differen╜tial earnings amount calculated for tax year 1986 resulted in corresponding increases in income for tax years 1988 and 1989. John Hancock contends that, under the tax benefit rule, it is entitled to exclude those increases in income because the same data used to calculate its recomputed earnings differential amount for tax year 1986, from which it obtained no tax benefit, were also used as a basis for imputing taxable income to John Hancock for tax years 1988 and 1989. Be╜fore the Court are the parties' cross-motions for summary judgment.

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^1. ═ John Hancock Financial Services, Inc., co-plaintiff in this action, is the common parent and agent for John Hancock Life Insurance Company. For simplicity, the plaintiffs will be collec╜tively referred to as "John Hancock" in this opinion.

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FACTS

John Hancock was, during all relevant pe╜riods, a mutual life insurance company. There are generally two business forms of life insurance companies: stock life insurance companies and mutual life insurance compa╜nies. Stock life insurance companies are or╜ganized as corporations and are owned by stockholders. Mutual life insurance compa╜nies, on the other hand, have no stockhold╜ers; rather, the companies are basically owned by the policyholders. CUNA Mut. Life Ins. Co. v. United States , 169 F.3d 737, 738 (Fed.Cir.1999).

Each year, life insurance companies cus╜tomarily disburse rebates, referred to as "policyholder dividends," ² to their policy╜holders. Under section 808 of the Internal Revenue Code ("section 808"), life insurance companies are generally permitted to deduct policyholder dividends paid or accrued dur╜ing the taxable year. ³ "Stockholder divi╜dends," on the other hand, represent earn╜ings distributions by stock life insurance companies to their stockholders and, accord╜ingly, are not deductible. CUNA , 169 F.3d at 738.

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^2. ═ A "policyholder dividend" is "any dividend or similar distribution to policyholders in their ca╜pacity as such." 26 U.S.C. ╖ 808(a). Policy╜holder dividends include "(1) any amount paid or credited (including as an increase in benefits) where the amount is not fixed in the contract but depends on the experience of the company or the discretion of the management, (2) excess interest, (3) premium adjustments, and (4) experience-rated refunds." 26 U.S.C. ╖ 808(b).

^3. ═ "Except as limited by paragraph (2), the deduc╜tion for policyholder dividends for any taxable year shall be an amount equal to the policyholder dividends paid or accrued during the taxable year." 26 U.S.C. ╖ 808(c)(1).

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As mutual life insurance companies are owned by their policyholders, rather than a distinct ownership class of "stockholders," a problem arises with regard to the tax treat╜ment of policyholder dividends disbursed by mutual companies. Id . The policyholder dividends paid by mutual companies may include a distribution of earnings, the amount of which is unknown because the policyholder dividends are processed as a single transac╜tion and deducted from income pursuant to section 808. Id . Thus, absent any adjust╜ments to their policyholder dividends, mutual life insurance companies may have a tax advantage over stock life insurance compa╜nies in being able to deduct payments to their owners that are, in substance, distribu╜tions of earnings. Id.

In an attempt to level the playing field with respect to the income tax treatment of the two business forms of life insurance com╜panies, in 1984 Congress revised the Internal Revenue Code to set forth new rules requir╜ing mutual life insurance companies to re╜duce their policyholder dividend deduction distinguishing between stock and mutual company policyholder dividend deductions. Id . Under the new tax rules, stock life insur╜ance companies simply deduct policyholder dividends from income, but mutual compa╜nies must perform series of complex calcula╜tions, set forth in section 809, that are de╜signed to impute that portion of a mutual company's policyholder dividends that consti╜tute a distribution of earnings. Id. The mu╜tual company's policyholder dividend deduc╜tion is then reduced by the amount estimated to be a distribution of earnings, analogous to a stock company's stockholder dividends. ⁴ Id .

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^4. "In the case of a mutual life insurance compa╜ny, the deduction for policyholder dividends for any taxable year shall be reduced by the amount determined under section 809." 26 U.S.C. ╖ 808(c)(2).

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Section 809 imputes income to mutual life insurance companies based on a rolling three-year average of reported earnings of major stock life insurance companies. Id .; Indianapolis Life Ins. Co. v. United States, 115 F.3d 430, 431 (7th Cir.1997). Section 809 requires mutual life insurance companies to reduce their deductions to reflect an imputed distribution of earnings (differential earnings amount) to their policyholders. ⁵ The rate of imputed stock company return (the imputed earnings rate) is compared with a mutual company rate of return after the payment of policyholder dividends (the average mutual earnings rate), to derive a "differential earn╜ings rate." CUNA 169 F.3d at 738; 26 U.S.C. ╖ 809(c)(1), (d), (e). The differential earnings rate is then multiplied by the par╜ticular mutual company's "average equity base," and the resulting "differential earn╜ings amount" is then used to reduce the company's policyholder dividend deduction for the taxable year. Id .; 26 U.S.C. ╖ 809(a)(1), (3).

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^5. "In the case of any mutual life insurance com╜pany, the amount of the deduction allowed under section 808 [policyholder dividend deduction] shall be reduced (but not below zero) by the differential earnings amount." 26 U.S.C. ╖ 809(a)(1).

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The problem with this methodology arises because data needed to calculate the reduc╜tion in mutual companies' policyholder divi╜dends is not available for the current tax year. Thus, Congress devised a two-step process. For the current year, certain prior-year data is used to calculate a rough esti╜mate of the mutual companies. Then, when current data becomes available, a "recomput╜ed differential earnings rate" and a "recom╜puted differential earnings amount" are cal╜culated. CUNA, 169 F.3d at 739; 26 U.S.C. ╖ 809(f)(1), (2), (3). If the differential earn╜ings amount exceeds the recomputed differ╜ential earnings amount, the excess is allowed as a "life insurance deduction" in the follow╜ing year. If the differential earnings amount is less than the recomputed differential earn╜ings amount, the difference is imputed as income for the following taxable year. CUNA , 169 F.3d at 739; 26 U.S.C. ╖ 809(f)(1), (2), (3).

In 1986, cyclical fluctuations in earnings rates created an anomaly in the section 809 calculations where the average mutual earn╜ings rate exceeded the imputed earnings rate. The "excess" of the mutual rate over the stock rate resulted in a negative recom╜puted differential earnings rate and differen╜tial earnings amount. The question arose whether this negative recomputed differen╜tial earnings rate could serve to increase the policyholder deduction, rather than reduce it. This question was answered in the negative in CUNA where the Federal Circuit held that the recomputed differential earnings rate could never be less than zero. CUNA, 169 F.3d at 742.

John Hancock's action is based on the same essential facts as those in CUNA, but is seeking recovery based on a different theory. In CUNA, the plaintiff argued that it should be able to increase its 1987 deduction based on the negative recomputed differential earn╜ings rate calculation for 1986. However, while conceding that it cannot increase its 1987 policyholder deduction based on the negative recomputed differential earnings rate, John Hancock argues that, under the "tax benefit rule," it should be able to ex╜clude income for tax years 1988 and 1989 to the extent that the tax benefit that was disal╜lowed for 1986 was used as the basis for imputing income in 1988 and 1989.

DISCUSSION

The tax benefit rule is a "judicially devel╜oped principle that allays some of the inflexi╜bilities of the annual accounting system." Hillsboro Nat'l Bank v. Commissioner, 460 U.S. 370, 377, 103 S.Ct. 1134, 75 L.Ed.2d 130 (1983). The tax benefit rule is partially codi╜fied in section 111 of the Internal Revenue Code, which states in relevant part: "Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not re╜duce the amount of tax imposed by [Chapter 1-Normal Taxes and Surtaxes]." 26 U.S.C. ╖ 111.

The United States Supreme Court ob╜served that "[a]n annual accounting system is a practical necessity if the federal income tax is to produce revenue ascertainable and pay╜able at regular intervals .... Nevertheless, strict adherence to an annual accounting sys╜tem would create transactional inequities." Hillsboro Nat'l Bank, 460 U.S. at 377, 103 S.Ct. 1134. Thus, "the basic purpose of the tax benefit rule is to achieve rough transac╜tional parity in tax ... and to protect the Government and the taxpayer from the adverse effects of reporting a transaction on the basis of assumptions that an event in a subsequent year proves to have been errone╜ous." Id . at 383, 103 S.Ct. 1134.

However, courts must apply the tax benefit rule on a case-by-case basis. Id. at 385, 103 S.Ct. 1134. Where "the events giving rise to the tax benefit question are governed by provisions of the [Internal Revenue] Code, there may be an inherent tension between the tax benefit rule and these provisions." American Mut. Life Ins. Co. v. United States, 267 F.3d 1344, 1350 (Fed.Cir.2001) ("American Mutual II"). When such ten╜sion exists, "there is no blanket rule that the tax benefit rule prevails over the particular provisions of the Code at issue." Id. Specifi╜cally, in determining whether to apply the tax benefit rule to transactions at issue in the instant case, this Court "must undertake an examination of the particular provisions of the Code that govern these transactions to determine whether the deductions taken by the taxpayers were actually inconsistent with later events and whether specific nonrecogni╜tion provisions prevail over the principle of the tax benefit rule." Hillsboro, 460 U.S. at 390-91, 103 S.Ct. 1134.

John Hancock argues that this Court should apply the tax benefit rule to the trans╜actions at issue because Congress' intended purpose in enacting section 809 was to tax the equity returns of stock and mutual life insurance companies comparably so that, re╜gardless of organizational form, each compa╜ny would bear an equivalent tax burden. John Hancock points out that, in enacting section 809, Congress' primary goal was "to provide a mechanism for competitive balance between stock and mutual [life insurance] companies which will be dynamic enough to adjust to changes in the industry over time." Staffs of the Joint Committee on Taxation and Senate Committee on Finance, Major Issues in the Taxation of Life Insurance Products, Policyholders, and Companies, 10-11 (Jt. Comm. Print 1983).

Additionally, John Hancock asserts that the U.S. Treasury Department has com╜mented that "[t]he tax system should seek to provide a level playing field" for stock and mutual life insurance companies. (Pl.'s App. at B-33). The Treasury Department also observed that time mismatching problems may arise in the application of section 809 because the recomputed differential earnings rate for a given tax year is calculated "by comparing the average of stock earning rates for the three years preceding the taxable year with the mutual earnings rate for the current taxable year." (Pl.'s App. at B-35). The Treasury Department further opined that [t]his mismatching of years increases the likelihood that the differential earnings rate under section 809 will be inappropriate. Id .

John Hancock also cites Allstate Insur╜ance Co. v. United States, 936 F.2d 1271 (Fed.Cir.1991), and California & Hawaiian Sugar Refining Corp. v. United States, 159 Ct.Cl. 561, 311 F.2d 235 (1962), as being analogous to the facts in the instant case. In Allstate, the Federal Circuit applied the tax benefit rule to permit the plaintiff insurance company to exclude subrogation recoveries from income where it had received no tax benefit from the associated prior-period loss╜es. Allstate, 936 F.2d at 1275-76. In Cali╜fornia & Hawaiian Sugar, the Court of Claims held that where the plaintiff had, in a prior period, deducted certain business taxes that were subsequently found to be unconsti╜tutional and, therefore, were refunded to the plaintiff, the refunds were excludable from income because they constituted return of capital, not income. California & Hawaiian Sugar , 311 F.2d at 247. Neither Allstate nor California & Hawaiian Sugar involve exclu╜sion of income associated with previously dis╜allowed deductions, such as the facts in the instant case. None of the cases cited by John Hancock support its conclusion that a deduction claimed, but disallowed, may nev╜ertheless be considered a "deduction" under the tax benefit rule.

Three U.S. Courts of Appeals cases have upheld the Government's disallowance of in╜creased policyholder dividends associated with negative recomputed differential earn╜ings rates: CUNA ; Indianapolis Life; and American Mut. Life Ins. Co. v. United States, 43 F.3d 1172 (8th Cir.1994) (" Ameri╜can Mutual I ") . John Hancock asserts that it does not dispute these holdings. It contends that its action for application of the tax benefit rule in this case begins with the uncontested assumption that recomputed dif╜ferential earnings rate can never be less than zero, and that any such negative excess is a disallowed deduction. The Court agrees with the Government, however, that applica╜tion of the tax benefit rule to allow John Hancock to exclude income associated with such disallowed "deductions" would consti╜tute an "end run" around now well-settled law that disallows recognition of any deduc╜tion based on any negative recomputed dif╜ferential earnings rates calculated under sec╜tion 809.

The courts in CUNA , Indianapolis Life, and American Mutual I all based their hold╜ings on their statutory construction of section 809. John Hancock argues that the holdings did not reach the issue of whether timing mechanisms of section 809 result in transac╜tional inequities subject to the tax benefit rule. In CUNA, however, it was held "that ╖ 809(c)(1) unambiguously precludes the use of a 'negative excess' amount to increase the policyholder dividend deduction." CUNA , 169 F.3d at 742. Thus, such a statutorily disallowed "negative excess" cannot form the basis for the calculations urged by John Han╜cock to support its claim for exclusions from income under the tax benefit rule. The Court agrees that this conclusion may result in transactional inequities; however, the remedy John Hancock proposes would cir╜cumvent the operation of section 809. As Judge Easterbrook observed in Indianapolis Life, "the Internal Revenue Code does not always follow logic." Indianapolis Life, 115 F.3d at 434.

Moreover, American Mutual II sup ports the proposition that, where deductions are applied to the extent allowed by the statute in the period in which they are tak╜en, they are not deductions that "did not reduce the amount of tax imposed" for pur╜poses of the tax benefit rule and, therefore, cannot be used to exclude income in the current year under the tax benefit rule. 26 U.S.C. ╖ 111. American Mutual II involved deductions associated with increases in a mutual life insurance company's reserves, which were required under state law to ensure that adequate funds would be available to pay claims. American Mutual II, 267 F.3d at 1346. Generally, increases in re╜serves were deductible from income, and de╜creases were added to income. Id . The plaintiff in American Mutual II increased its reserves during a series of years. Id . at 1347. Against this backdrop was the compa╜ny's tax assessment based on underwriting income and investment income. Id. At that time, underwriting income was taxable only to the extent that it exceeded investment income. Id The reserve increases operated as deductions to reduce investment income, but the net effect of the deductions on in╜come was only a fraction of the deduction amounts themselves. Id . The plaintiff ar╜gued that, under the tax benefit rule, it was entitled to exclude income from future re╜serve decreases to the extent that it was not able to obtain the full tax benefit from the previous reserve increases. Id. The court found that any inconsistent tax treatment was attributable to changes in the tax code during the intervening period. Id. at 1350. Additionally, the court found that the plain╜tiff "took the full value of the tax deduction available for reserves under then-applicable law." Id . at 1351.

Similarly, in the instant case, John Hancock calculated and fully applied its poli╜cyholder dividend deduction to the maximum extent allowed by law. As in American Mu╜tual II, John Hancock was able to take full lawful value of recomputed differential earn╜ings amounts claimed for 1986. John Han╜cock may not use recomputed differential earnings amounts not lawfully allowable as tax deductions as the basis for excluding future income. Thus, the disallowed nega╜tive excess recomputed differential earnings amount calculated for 1986 is not an "amount deducted in [a] prior taxable year" under 26 U.S.C.╖ 111.

Additionally, the Court agrees with the Government that the recomputed differential earnings amounts calculated in tax years subsequent to 1986, even though impacted by the 1986 calculations, cannot be considered "recoveries" during those tax years for pur╜poses of the tax benefit rule. While the U.S. Supreme Court has recognized that "a 'recovery' will not always be necessary to in╜voke the tax benefit rule," there must be a subsequent "event." Hillsboro Nat'l Bank, 460 U.S. at 381, 383, 103 S.Ct. 1134. In the instant case, no "events" occurred subse╜quent to tax year 1986 that could trigger application of the tax benefit rule, only an imputation of income calculated in accor╜dance with section 809, the same statute used to calculate policyholder dividend deductions allowable for 1986. The Court finds that application of the tax benefit rule as John Hancock suggests would directly conflict with the plain language of the governing statute and, therefore, John Hancock's argu╜ment must fail.

CONCLUSION

For the foregoing reasons, John Hancock's motion for summary judgment is DENIED, and defendant's cross-motion for summary judgment is GRANTED. The Clerk shall enter judgment for the defendant. Costs for the defendant.

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