Full opinion text
FINDINGS OF FACT AND CONCLUSIONS OF LAW EDWIN M. STANLEY, Chief Judge. The plaintiff, Jefferson Standard Life Insurance Company, seeks by these actions to recover of the defendant, United States of America, Federal income taxes allegedly overpaid with respect to the years 1958 and 1959. In its answers, the defendant, in addition to denying liability to the plaintiff, asserts counterclaims with respect to additional income taxes assessed against the plaintiff for the years 1958 and 1959. The plaintiff, by replies timely filed, denies liability for the deficiency assessments asserted in the counterclaims. The cases were tried by the Court without a jury. At the conclusion of the trial, the parties stipulated that, because of the numerous and complicated issues involved, and in the interest of obtaining a decision at the earliest possible date, it would be agreeable for the Court to dispense with its customary practice of writing opinions in non-jury cases, and confine its decision to findings of fact and conclusions of law. The Court, after giving due consideration to the pleadings and the evidence, including exhibits and stipulations, the requests and briefs submitted by the parties, and oral arguments of counsel, now makes and files herein its Findings of Fact and Conclusions of Law, separately stated: FINDINGS OF FACT I General Findings 1. The facts herein found are applicable with respect to the taxable years 1958 and 1959, except as otherwise stated or indicated. 2. Jefferson Life Insurance Company (hereinafter referred to as “Jefferson”), and Pilot Life Insurance Company (hereinafter referred to as “Pilot”), are domestic stock life insurance companies duly incorporated and existing under the laws of the State of North Carolina, and engaged in business as life insurance companies as defined in § 801(a) of the Internal Revenue Code of 1954, as amended (hereinafter referred to as “the Code”). The principal office of Jefferson is located at Jefferson Square in the City of Greensboro, Guilford County, North Carolina, and the principal office of Pilot is located at Sedgefield, Guilford County, North Carolina. 3. Jefferson owns all the outstanding capital stock of Pilot, and Jefferson and Pilot duly elected to file consolidated income tax returns for the years 1958 and 1959. 4. Jefferson duly and timely executed and filed with the District Director of Internal Revenue for the District of North Carolina Federal income tax returns (the same being consolidated returns applicable to Jefferson and its subsidiary, Pilot, as permitted by law), for the taxable (and calendar) year 1958, and for the taxable (and calendar) year 1959. 5. As provided by law, Jefferson’s subsidiary, Pilot, duly consented to and authorized the filing of said consolidated income tax returns, and pursuant to applicable laws and regulations, Jefferson, both on its own behalf and as the duly authorized agent of its subsidiary, Pilot, was entitled to file in its sole name said consolidated income tax returns for the years 1958 and 1959, and to file in its sole name the claims for refund hereinafter mentioned. 6. Jefferson, both on its own behalf and as the duly authorized agent of its said subsidiary, Pilot, is entitled, in its sole name, to institute and prosecute these actions, and to receive the amounts of refund, if any, which the Court may adjudge to be due Jefferson in these actions. 7. Jefferson’s tax return for the year 1958 reported a tax liability for said taxable year in the amount of $7,213,-029.00, and this tax was duly and timely paid to the District Director of Internal Revenue for the District of North Carolina. 8. Jefferson’s tax return for the year 1959 reported a tax liability for said taxable year in the amount of $7,280,350.00. However, of said reported amount, $292,-906.00 represented Jefferson’s liability for the transitional tax for the year 1957, arising under the provisions of § 818(e) of the Code. Thus, the amount of tax shown to be due by Jefferson’s return for the year 1959, exclusive of said 1957 transitional tax, was $6,987,444.00. Under the mentioned statute, Jefferson is allowed to pay its 1957 transitional tax in ten equal annual installments. Accordingly, with respect to the year 1959, Jefferson duly and timely paid to the District Director of Internal Revenue for the District of North Carolina the amount of $6,987,444.00, plus $29,291.00 representing one-tenth of said 1957 transitional tax, or an aggregate amount of $7,016,735.00. 9. At all times referred to herein, the District Director of Internal Revenue for the District of North Carolina was the agent of the defendant duly authorized by law to accept and collect, on behalf of the defendant, payments of the aforementioned income taxes made by Jefferson and, consequently, payment of said income taxes to the said District Director of Internal Revenue for the District of North Carolina constituted a payment of said taxes to the defendant. 10. Jefferson duly filed, pursuant to the provisions of § 6511 and § 7422(a) of the Code, and within the time required by law, with the defendant, through its authorized agent, the District Director of Internal Revenue for the District of North Carolina, claims for refund for certain amounts paid to the defendant on account of Jefferson’s income tax returns for the years 1958 and 1959, and for lawful interest thereon, and for such additional refund or other relief to which it might be lawfully entitled, and alleged by Jefferson to have been erroneously and illegally assessed against, and collected from, Jefferson by the defendant. These actions, based upon said claims for refund, were timely instituted. 11. By orders duly entered, the Court granted motions of the defendant to amend its answers by adding counterclaims with respect to additional income taxes asserted and assessed against Jefferson for the years 1958 and 1959. The amendments were timely filed and served upon Jefferson. Jefferson, by replies to the amended answers, and the counterclaims therein set forth, which replies were timely filed and served upon the defendant, denied liability for said adjustments to its income tax liabilities, and for the deficiency assessments made by the defendant and referred to in its counterclaims, to the extent and for the reasons set forth in its replies. II The Applicable Rate of Tax 12. Both Jefferson and Pilot are life insurance companies subject to the tax imposed under § 802 of the Code. 13. The form 1120 L, corporate income tax return provided by the Internal Revenue Service for use by life insurance companies subject to the tax imposed by § 802 of the Code for 1958 and 1959, specified a tax of 30 percent on amounts not over $25,000.00 and 52 percent on amounts in excess of $25,000.00. Said form further specified, in the event a consolidated return was filed, a tax of 32 percent on amounts not over $25,-000.00 and 54 percent on amounts in excess of $25,000.00. Jefferson computed and paid tax at the latter rates on its consolidated returns for 1958 and 1959. 14. The form 1120, corporate income tax return for corporations subject to the tax imposed under § 15 or § 204 of the Internal Revenue Code of 1939, with respect to such returns for each of the years 1942 through 1953, contained the question: “Is this a consolidated return ?” Said form further contained, in the computation of the tax for such corporations, a parenthetical reference to a higher tax rate in the case of consolidated returns. 15. The form 1120 L, corporate income tax return for life insurance companies subject to the tax imposed under § 201 of the Internal Revenue Code of 1939, with respect to returns for each of the years 1942 through 1953, contained the question: “Is this a consolidated return?” However, said form contained no reference, in the computation of tax for life insurance companies, to a higher tax rate, or to an additional tax in the case of consolidated returns. 16. The form 1120, corporation income tax return for corporations subject to the tax imposed under § 11(c) or § 831 of the Internal Revenue Code of 1954, with respect to returns for each of the years 1954 through 1957, contained the question: “Is this a consolidated return?” Said form further contained, in the computation of the tax for such corporations, a parenthetical reference to a higher tax rate in the case of consolidated returns. 17. The form 1120 L, corporate income tax return for life insurance companies subject to the tax imposed under § 802 of the Internal Revenue Code of 1954, with respect to the returns for each of the years 1954 through 1957, contained the question: “Is this a consolidated return ?” However, said form contained no reference, in the computation of the tax for life insurance companies, to a higher rate or an additional tax in the case of consolidated returns. 18. The form 1120, corporate income tax return for corporations subject to the tax imposed under § 11(c) or § 831 of the Internal Revenue Code of 1954, with respect to returns for the years 1958 and 1959, in the computation of tax for such corporations, contains a parenthetical reference to a higher tax rate in the case of consolidated returns. These returns also contain the question: “Is this a consolidated return?” 19. The form 1120 L,. corporate income tax return for life insurance companies subject to the tax imposed under § 802 of the Internal Revenue Code of 1954, with respect to returns for the years 1958 and 1959, in the computation of the tax for such life insurance companies, contains a parenthetical reference to a higher tax rate in the case of a consolidated return. This form also contains the question: “Is this a consolidated return?” Ill Determination of Consolidated Taxable Income 20. Jefferson acquired 100 percent of the outstanding stock of Pilot by purchase prior to 1958, and at a time when Pilot’s net worth was equal to the purchase price paid by Jefferson for said stock. 21. In each of the years 1958 and 1959, Pilot paid dividends in the amount of $1,250,000.00 to Jefferson out of current earnings and profits of the year. 22. Pilot was solvent at all times during 1958 and 1959. 23. For the years 1958 and 1959, Jefferson and Pilot elected to file consolidated Federal income tax returns. In both returns, Pilot and Jefferson were treated as parts of a single entity. The computations of taxable investment income (Phase I) and gain from operations (Phase II), made in determining the income tax of life insurance companies, were made by consolidating the figures for the two companies on an item-by-item basis, eliminating from all computations the intercompany dividends and the intercompany investments. 24. The dividends distributed by Pilot to Jefferson during 1958 and 1959 did not reduce Pilot’s assets to a point where they were inadequate to satisfy its liabilities to creditors and the requirements for reserves for its policies required under the law. 25. At all times during 1958 and 1959, the assets of Jefferson were adequate to satisfy its liabilities to creditors and the requirements for reserves for its policies without taking into account either Jefferson’s investment in the stock of Pilot or the amount received as dividends from Pilot. 26. In 1958 and 1959, Jefferson, for purposes of Phase I (consolidated taxable investment income), computed a consolidated investment yield figure and a consolidated policy and other contract liability requirements figure. The investment yields of the two separate companies were combined and the intercompany dividend paid by Pilot to Jefferson was entirely eliminated to arrive at a consolidated investment yield. In determining a consolidated policy and other contract liability requirements, the assets of the two separate companies were combined with the investment in the stock of Pilot held by Jefferson eliminated to arrive at consolidated assets. A current earnings rate was obtained by dividing the consolidated investment yield by the consolidated assets. Earnings rates for the preceding years were determined in the same manner, and an adjusted reserves rate was computed from these earnings rates. The life insurance reserves of the two companies were combined to arrive at consolidated life insurance reserves. The adjusted life insurance reserves were computed by using the consolidated life insurance reserves, the average rate of interest assumed on the consolidated life insurance reserves, and the adjusted reserves rate determined by using consolidated investment yields and consolidated assets. The consolidated policy and other contract liability requirements were determined by multiplying the adjusted life insurance reserves by the adjusted reserves rate and by combining the interest paid by the two companies. Further, in 1959, the applicable portions of pension plan reserves of the two companies were combined to arrive at consolidated pension reserves, and the consolidated pension reserves were multiplied by the current earnings rate. A policyholders’ share percentage was determined on the basis of the consolidated policy and other contract liability requirements and consolidated investment yield. This policyholders’ share percentage was applied to the items of consolidated investment yield to determine a policyholders’ share of consolidated investment yield and a company’s share of consolidated investment yield. Only one $25,000.00 small business deduction was taken into account in each of the years 1958 and 1959. 27. For 1958 and 1959, Jefferson, for purposes of Phase II (consolidated gain from operations) computed a consolidated required interest figure and a consolidated investment yield figure. The investment yields of the two separate companies were combined and the inter-company dividend paid by Pilot to Jefferson was entirely eliminated to arrive at a consolidated investment yield. In determining a consolidated required interest figure, the life insurance reserves of the two companies were combined and required interest was computed on the combined life insurance reserves of the two companies. A percentage of investment yield set aside for policyholders was determined on the basis of the consolidated required interest and the consolidated investment yield. This percentage was applied to the items of consolidated investment yield to determine a share of consolidated investment yield set aside for policyholders and a company’s share of consolidated investment yield. In computing the increase in reserves which is required by § 810(b) and allowed as a deduction by § 809(b) (2) of the Code, Jefferson, for 1958 and 1959, reduced the consolidated increase in reserves by the share of the consolidated investment yield set aside for policyholders under § 809(a) (1) of the Code. Only one $25,000.00 small business deduction was taken into account in each of the years 1958 and 1959. 28. Jefferson’s method of consolidation used on its tax returns results in a consolidated policyholders’ share for purposes of Phase I which will not be equal to the sum of separate policyholders' shares of Jefferson and Pilot. For example, based upon the figures contained in the Revenue Agent’s report for 1958, a consolidated policyholders’ share for Phase I computed in accordance with Jefferson’s method of computation would be $20,335,417.00, • and separate policyholders’ shares of Jefferson and Pilot, computed in accordance with the defendant’s method, would be $15,665,587.00 for Jefferson and $4,671,952.00 for Pilot, or a total of $20,337,539.00, or $2,122.00 more than the policyholders’ share under the method employed by Jefferson. Based upon the figures contained in the Revenue Agent’s report for 1959, a consolidated policyholders’ share for Phase I computed in accordance with Jefferson’s method of computation would be $22,056,815.00, and separate policyholders’ shares of Jefferson and Pilot, computed in accordance with the defendant’s method, would be $16,888,052.00 for Jefferson and $5,156,668.00 for Pilot, or a total of $22,044,720.00, or $12,095.00 less than the policyholders’ share under the method employed by Jefferson. 29. Upon audit of Jefferson’s consolidated income tax returns for 1958 and 1959, the Commissioner of Internal Revenue disapproved Jefferson’s method of computing its taxable income. The method employed by the Commissioner in the Revenue Agent’s report was as follows: (a) The Commissioner in determining the taxable investment income of Jefferson for purposes of Phase I investment income, first and prior to any consolidation, separately computed each company’s policy and other contract liability requirements. This amount for each company was arrived at in accordance with the provisions covering the determination of policy and other contract liability requirements of separate companies. For purposes of these separate computations, the dividends received by Jefferson from Pilot were included in the gross investment yield of Jefferson and the value of the Pilot stock held by Jefferson was included as an asset of Jefferson. The policyholders’ share exclusion for Jefferson was calculated by dividing its investment yield by assets and applying the earnings rates so obtained to its adjusted reserves. The policyholders’ share of Pilot was obtained in the same manner. The ratio of the policy and other contract liability requirements of each company to its gross investment yield was then applied to each and every item of investment income to determine the policyholders’ share of each item of its investment income. (b) When the time came (Schedule C of the tax returns) to allocate (on the basis of the ratio as determined in (a) above) each and every item of investment yield between the company and the policyholders, the dividend received portion of consolidated investment yield was first reduced by 100 percent of the Pilot dividends prior to allocation. Having thereby eliminated 100 percent of the Pilot dividends' in the course of consolidation, that portion of the policyholders’ exclusion of dividends received was reduced by the amount attributable to the Pilot dividends. (c) Similarly, in determining taxable income for purposes of Phase II, gains from operations, separate figures for gross investment income and investment yield were computed for each company. In the computation of the exclusion of the share of investment yield set aside for policyholders of Jefferson under § 809(a) of the Code, the Pilot dividends and the value of Pilot stock were included. Each company’s separately determined “required interest” was divided by its investment yield to obtain each company’s policyholder exclusion percentage. The allocation of each item of investment yield and the treatment of the Pilot dividend was handled in the same manner as described in (b) above. 30. At the trial of these actions, the defendant presented another method of computing consolidated taxable investment income. This method also utilized separately computed policy and other contract liability requirements and investment yields determined without eliminating either the intercompany dividends paid by Pilot to Jefferson or the investment in the stock of Pilot held by Jefferson. A policyholders’ share percentage was determined for each company on the basis of the separately determined policy and other contract liability requirements and investment yields. This policyholders’ share percentage for each company was applied to the individual items of investment yield for each company to determine a policyholders’ share to be excluded for that company. The intercompany dividends paid by Pilot to Jefferson were not eliminated from the separately determined investment yield of Jefferson. Consolidated investment yield was determined by combining the individual items of investment yields of the two companies and without excluding the intercompany dividends paid by Pilot to Jefferson. The policyholders’ share of consolidated investment yield was determined by combining the separately determined policyholders’ shares of investment yield. This policyholders’ share of consolidated investment yield was subtracted from the consolidated investment yield that included the intercompany dividends to arrive at a company’s share of consolidated investment yield. This company’s share was then reduced by eliminating a portion of the intercompany dividends equal to the percentage which the separately determined Jefferson company’s share was of the separately determined Jefferson investment yield. One $25,000.00 small business deduction was taken into account in each of the years 1958 and 1959. The consolidated taxable investment income computed under this method was the same as consolidated taxable investment income computed in the Revenue Agent’s Report. 31. At the trial of these actions, the Government also presented another method of computation of consolidated gain from operations. This method likewise utilized separately determined required interests and investment yields. The separate investment yields were determined as if each company was filing a separate return without excluding the intercompany dividends paid by Pilot to Jefferson. A percentage for share of items, investment yield set aside for policyholders was determined for each company on the basis of the separately determined required interests and investment yields. This percentage for each company was applied to the individual items of investment yield for each company to determine a share set aside for policyholders to be excluded for that company. The intercompany dividends paid by Pilot to Jefferson were not eliminated from the separately determined investment yield of Jefferson. Consolidated investment yield was determined by combining the individual items of investment yield of the two companies and without eliminating the intercompany dividends paid by Pilot to Jefferson. The share of consolidated investment yield set aside for policyholders was determined by combining the individual items of share of investment yield of the separate companies set aside for policyholders. This share of consolidated investment yield set aside for policyholders was subtracted from the consolidated investment yield that included the intercompany dividends to arrive at a company’s share of consolidated investment yield. This company’s share was then reduced by eliminating a portion of the intercompany dividends equal to the percentage which the separately determined Jefferson company’s share was of the separately determined investment yield. This portion of the intercompany dividends was the only portion that was eliminated from consolidated gain from operation. Only one $25,000.00 small business deduction was taken into account in each of the years 1958 and 1959. 32. In both 1958 and 1959, Jefferson’s gain from operations exceeded its taxable investment income, so that there was consolidated taxable income under both Phase I and Phase II. 33. The duties of the officers of Pilot are separate and distinct from the duties of the officers of Jefferson. 34. The officers of Jefferson do not exercise day-to-day operational control over Pilot’s officers. 35. Jefferson sells only life insurance, while Pilot is known as a multiple line company in that it sells accident and health policies, both to individuals and to groups, in addition to selling life insurance. 36. The agents of Jefferson and Pilot work out of different agency offices. 37. No joint advertising is conducted which couples Jefferson and Pilot. 38. Under generally accepted accounting principles, a consolidated financial statement would not normally be prepared for Jefferson and Pilot. However, a consolidated income tax return is a form of financial statement that might be used for special purposes. 39. Jefferson does not prepare for distribution or publication any consolidated financial statements, and annual reports for stockholders for Jefferson and Pilot are separately prepared. 40. Generally accepted accounting principles of consolidation require the elimination of intercompany dividends in the preparation of consolidated statements of income, and such principles apply in the case of consolidated statements of life insurance companies as well as in the case of consolidated statements of ordinary business corporations. 41. Generally accepted accounting principles of consolidation further require, in the preparation of consolidated financial statements, the elimination of intercompany investments in the stock of a subsidiary, and such principles apply in the case of consolidated statements of life insurance companies as well as in the case of consolidated statements of ordinary business corporations. 42. The Commissioner does not dispute the right of Jefferson to file a consolidated tax return, but maintains that prior to consolidation separate computations must be made for each company to determine its policyholders’ share exclusions. 43. A substantial portion of the investment income earned by a life insurance company is necessary to provide assets which, together with premium collections, will permit the company to meet its future obligations to policyholders. 44. In a typical life insurance company, approximately 80 to 85 percent of the liabilities represent liabilities to policyholders. 45. Approximately 75 to 80 percent of the assets of Jefferson and Pilot in 1958 represented obligations to policyholders. 46. From an accounting standpoint, the reserves required of an insurance company to meet obligations to its policyholders are considered as liabilities. 47. Jefferson reflects its policyholder reserves as liabilities, both for the purpose of its Annual Statement and its Report to Stockholders. 48. Contracts of insurance to individual policyholders run only to the issuing company, just as the liabilities of any individual company in an affiliated group run only to the individual company. 49. .Since insurance companies have an obligation to properly protect their policyholders, sound accounting principles require the separate computation of the amounts which stand to protect the policyholders’ share of each company before these interests may be consolidated. 50. The overriding concern of the State Insurance Commissioners is the protection of the policyholders, and the maintenance of sufficient reserves for the policyholders by individual companies. In examining Jefferson, no distinction is made by the Insurance Commissioner between the dividends Jefferson receives from Pilot as opposed to other-sources of income. All such dividends are considered as available to meet Jefferson policyholder obligations. Further, 'in determining the adequacy of Jefferson’s reserves, the Pilot shares of stock are not excluded. 51. The Annual Statements of Jefferson filed with the Insurance Commissioner reflect the Pilot dividends and the Pilot stock held by Jefferson. 52. As of December 31, 1959, the carrying value of Pilot stock was increased by Jefferson in the amount of $7,500,-000.00. An amount equal to this increase, plus additional funds, was used to increase the reserves for Jefferson’s policyholders for all years subsequent to December 31, 1959. 53. Under generally accepted accounting principles, the liabilities of an affiliated group of life insurance companies as a result of their obligation to policyholders, are computed and shown on a consolidated financial statement on the basis of the benefits to be paid under the policy contracts, the premiums collected and anticipated (net of underwriting expenses), and the assumptions made as to rate of return on investments and mortality among policyholders. Such liabilities, and the changes in such liabilities from year to year, are determined without regard to either the source of the amount of investment income received or earned by the companies during the year. Such liabilities are consolidated by adding together such liabilities for the separate insurance companies in the affiliated group. 54. The terms “policyholders’ share of investment yield,” “share of investment yield set aside for policyholders,” and “policyholders’ share,” which are frequently used to describe figures used in the computations under the Life Insurance Income Tax Act of 1959, are different from the reserves which are required to be maintained by law for the protection of policyholders, and are different from increases in said reserves. Said quoted terms refer only to income tax concepts used in measuring the amount of certain income exclusions that are made in the computation of Federal income tax. 55. Since the dividends paid by Pilot to Jefferson in 1958 and 1959 were paid from current earnings and profits, and Pilot had taxable investment income included in consolidated taxable investment income and investment yield included in consolidated gain from operations in both 1958 and 1959 in amounts in excess of the amount of the intercompany dividends, use of any portion of the inter-company dividends in such years to satisfy a portion of a policy or other contract liability requirements figure computed under Phase I for Jefferson, or to satisfy a portion of a required interest figure computed under Phase II for Jefferson, would satisfy such portions from income of Pilot that was subject to income tax in the same year. . 56. Neither the method of computation used by the defendant in the revenue agent’s reports for 1958 and 1959, nor the method of computation used by the defendant in its illustrative exhibits presented at the trial of the cases, eliminated completely the intercompany dividends for purposes of either the Phase I or Phase II computations. Such inter-company dividends were not eliminated under such methods to the extent that they were used to satisfy policy and other contract liability requirements for purposes of Phase I, or to satisfy the required interest for purposes of Phase II. 57. Under generally accepted accounting principles of consolidation, in the case of a consolidated financial statement of two life insurance companies for a year in which an intercompany dividend is paid, no reduction is made in the sum of the net increases in policy reserves of the two companies by reason of elimination of the intercompany dividend. 58. The method of consolidation used by Jefferson for purposes of Phase I and Phase II computations on the consolidated returns for 1958 and 1959 reflected consolidated taxable investment income and consolidated gain from operations, and such method reached the same results as would have been reached if Jefferson and Pilot had merged prior to 1958 and had operated in 1958 and 1959 as a single life insurance company. IV Branch Office Managers Supplemental Retirement Plan 59. On or about January 1, 1956, Jefferson, as an employer, established a Branch Office Managers Supplemental Plan, which is in evidence as Plaintiff’s Exhibit 8. This Plan was in effect in the taxable years 1958 and 1959. 60. A purpose of the Branch Officers Supplemental Retirement Plan was to provide supplemental pension benefits to the managers to augment the benefits they could receive as a member of the Pension Plan for agents. 61. The Plan covered Jefferson’s branch office managers who were in charge of regional sales offices throughout the country. 62. Each manager was automatically included in the Plan, and no consent was necessary. 63. Upon the adoption of the Plan, all branch officers were notified by letter of the provisions and application of the Plan, and persons subsequently becoming branch office managers were so notified when ■ appointed as branch office managers. 64. Under the Plan, Jefferson was to make contributions to the Plan based upon the employee’s salary. However, such contributions were not to be set apart or treated as separate funds, but were to constitute a part of the general corporate funds of the Company. 65. With respect to Jefferson’s contributions, Section 5 of the Plan provided as follows: “5. COMPANY’S CONTRIBUTION. Each year the Company will contribute to the Plan an amount equal to 4% of the Manager’s compensation for each Manager who has not attained age fifty-five (55) during such year, and an amount equal to 5% of such compensation for each Manager who has attained age fifty-five or over during such year.” 66. With respect to eligibility, Section 3 of the Plan provided as follows: “3. ELIGIBILITY FOR MEMBERSHIP. All Branch Office Managers of the Jefferson Standard Life Insurance Company (hereinafter sometimes referred to as Manager) shall be eligible for membership in this Retirement Plan.” 67. With respect to change or termination, Section 11 of the Plan provided as follows: “11. CHANGE OR TERMINATION OF PLAN. “(a) The Company hopes and expects to continue the Retirement Plan indefinitely but must necessarily reserve the right to change or discontinue it at any time, provided, however, no such change or discontinuance shall affect the right of any Manager to receive, upon attaining age sixty-five and if otherwise eligible hereunder, any benefits accrued to his account under this Plan prior to the effective date of such change or termination. “(b) If at any time during the first ten years following the effective date ' of the Plan, the Plan shall be terminated and the full current cost of the Plan shall not have been paid, thereafter the Company’s contributions which may be used for the benefit of any one of the twenty-five highest paid Managers on the effective date of this Plan whose benefits upon retirement exceed Fifteen Hundred ($1,500) Dollars per year, shall not exceed the greater of either (1) $20,-000 or (2) an amount computed by multiplying the smaller of (i) $10,000 or (ii) 20% of such Manager’s compensation during the -last five years of service, by the number of years since the effective date of the Plan. Any excess reserves arising upon the application of the foregoing provision shall be used and applied for the benefit of other participating Managers and retired participating Managers on the basis of the liabilities under the Plan on account of each of them.” 68. With respect to annuity benefits, Section 6 of the Plan provided as follows: “6. ANNUITY BENEFITS. The amount contributed by the Company each year will be used by it to provide a deferred life annuity for the Manager, with the first payment from said annuity to be made on the first day of the second month following the Manager’s sixty-fifth birthday. The monthly annuity provided for by this paragraph shall be calculated on the basis of the net 1937 Male Standard Annuity Table with 3% interest.” 69. Section 12(a) of the Plan provided as follows: “(a) Membership in the Plan shall not affect the right of the Company to terminate any Branch Office Manager’s contract. The Company’s authority and control over its Managers and the terms of their employment shall be as absolute and unconditional as though this Retirement Plan had never been adopted, and no provision hereof, or action taken hereunder, shall be construed as giving to any member of the Plan the right to permanent employment with the Company.” 70. With respect to forfeiture of benefits, Section 8 of the Plan provided as follows: “8. FORFEITURE OF BENEFITS. If a Branch Office Manager’s service as Branch Office Manager is discontinued prior to his sixty-fifth birthday, but if he remains a member of the Jefferson Standard Life Insurance Company Agents’ Retirement Plan in accordance with its terms, the amount of annuity earned by such Manager as provided hereunder up to the date of such discontinuances of service as Branch Office Manager shall be paid to him beginning at age sixty-five. If at any time while under age sixty-five the Branch Office Manager ceases for any reason to be a member of the Jefferson Standard Life Insurance Company Agents’ Retirement Plan, or if after retirement or termination of employment the Manager shall die or shall become an employee of another life insurance company or shall act or contract to act as life insurance underwriter, agent or sales representative for any other company engaged in the business of selling life insurance, then all unpaid annuity payments and benefits provided herein shall be forfeited.” 71. Regardless of the number of years an employee belonged to the Plan, and the amounts contributed by Jefferson to the Plan, the employee had no right to any cash value in the Plan. 72. No actual annuity contracts of any sort were issued to Branch Office Managers upon their inclusion in the Plan, and their annuity contracts consisted of the adoption of the Plan by Jefferson, the notification to Branch Office Managers of their rights under the Plan, and annual reports made to them by Jefferson. 73. Jefferson, as a part of its insurance business, issued life annuity contracts. 74. Ordinarily, once a life annuity is issued, Jefferson cannot, of its own accord, cancel the benefits. 75. Ordinarily, under life annuities issued by Jefferson, a policyholder has a right to any guaranteed cash surrender in the contract. 76. With respect to reserves, Section 10(b) of the Plan provided as follows: “(b) The Company shall maintain a reserve for its obligation under all benefits guaranteed under this Plan. Each year the Pension Committee shall determine the amount of the Company’s contributions required to meet the reserve under the Plan, and upon approval by the Company contributions shall be made accordingly. All contributions made by the Company shall be added to such reserve, which reserve shall not thereafter be decreased, except by payment of benefits under the Plan, until all payments required under the Plan have been made.” 77. Jefferson established a reserve for the Branch Office Managers Supplemental Retirement Plan computed on the basis of the 1937 Standard Annuity Mortality Table, with interest at the rate of three percent. This table is one of the tables specified in Section 58-201.1 of the General Statutes of North Carolina, and is one of the bases for annuity reserves approved by the Commissioner of Insurance of North Carolina. Jefferson used this table in computing reserves for annuity contracts issued by it, and it is widely used throughout the United States by other companies in computing reserves for annuity contracts. 78. The amount of the reserve set aside for the Branch Office Managers Supplemental Retirement Plan at the beginning of the year 1958 was $150,488.00, the amount of the reserve at the end of the year 1958 was $232,516.00, and the amount of the reserve at the end of 1959 was $309,752.00. These reserves were computed on recognized mortality tables and assumed rates of interest, and were included in Jefferson’s regular reserve funds. 79. Jefferson maintained a separate valuation record sheet for each member of the Plan, showing information needed in connection with the administration of the Plan with respect to that member. The separate valuation record sheet also contained a determination of Jefferson’s reserve liability with respect to the annuity provided under the Plan for that member. 80. Jefferson submitted the Plan to the Internal Revenue Service for a ruling as to whether it qualified under Section 401 of the Code. The Internal Revenue Service ruled that the Plan did not meet the requirements of Section 401 of the Code, citing the fact that the Plan discriminated in favor of the managerial category. This fact did not in any way affect Jefferson’s determination as to the amount of the reserve under the Plan. 81. During 1958 and 1959 there were approximately 65 to 70 managers covered under the Plan. The entire cost of the Plan was contributed by Jefferson. 82. Over a dozen of the branch office managers covered by the Plan in 1958 and 1959 were later retired and each of them received benefits under the Plan. Some of the branch office managers who had been covered under the Plan prior to 1958 and 1959 retired in those years and received benefits under the Plan. 83. One of the purposes for which the Insurance Commissioner examined Jefferson’s reserves was to determine if they were inadequate or excessive, and on the proper tables. The Insurance Commissioner requires a reserve if there is any doubt whatever that the company may be liable. 84. The Insurance Commissioner would reduce, or recommend that a reserve be reduced or excluded, when such reserves were twice included as liabilities. 85. For purposes of the annual statements filed with the State Insurance Commissioner and the Federal income tax returns filed for the years pertinent herein, the contribution of Jefferson to the Plan was carried as an income item, the actual payments made to retired managers during the year were shown as annuity benefit payments; the amount of the insurance in reserve was shown as a deduction for increase in reserves in the summary of operations; and the cost of the Plan to Jefferson was shown as a general business expense. 86. If a branch office manager ceased to be a manager, but continued as an agent and member of the Agents’ Pension Plan, all credits set aside for his benefit under the Branch Office Managers Plan remained to his credit and were payable to him, beginning at age 65. 87. The Commissioner treated the Plan as a deferred compensation Plan, allowing in full all deductions based on actual benefits paid to employees, eliminating the contributions both as a deduction and as an income item, and eliminating amounts designated as funding for the Plan from life insurance reserves, for purpose of computing policy and other contract liability requirements, required interest and increases in life reserves. V Computations for Annual Statement 88. The National Association of Insurance Commissioners (hereinafter referred to as N.A.I.C.), is a national organization composed of the officials of the various states who are charged with the supervision of insurance affairs. It was organized in 1871. Soon after its organization, the N.A.I.C. adopted a uniform Annual Statement blank, and the Annual Statement forms that have been filed by insurance companies since that time have been forms approved by the N.A.I.C. 89. Jefferson and Pilot were each required by the laws of the State of North Carolina and of the other states in which they did business, to complete and file the Annual Statement form approved by the N.A.I.C. 90. Both the Annual Statement form and the' instructions for its completion were prepared and approved by the N.A.I.C. 91. State Insurance Departments require each company to prepare its own Annual Statement separately and submit it to the Insurance Department. It is required to be filed on an individual basis because it is essentially for the purposes of supervision by the supervising regulatory authority. The primary concern of the regulatory authorities is the protection of the policyholders. 92. Jefferson and Pilot were required to compile the Annual Statement form, and to comply with it and the instructions regarding its completion, and each did so with respect to its Annual Statements for the years 1958 and 1959. 93. Both Jefferson and Pilot were examined in 1961 for the three-year period 1958 through 1960, pursuant to the procedures of the N.A.I.C., by a team of examiners from the insurance departments of various states, including North Carolina. In no respect was the treatment on the Annual Statements for 1958 and 1959 of matters relevant to issues in these cases disapproved or changed by the examination reports resulting from the 1961 examinations. 94. The N.A.I.C. maintains a committee on forms, the purpose of which is to study the form with a view to appropriate revisions from time to time. VI Unearned, Investment Income 95. Upon audit of Jefferson’s income tax returns for 1958 and 1959, the Commissioner required that certain amounts of interest and rent actually received by Jefferson, but as yet unearned, should be included in investment income. 96. The Commissioner also required that interest which was not collected when due under the terms of policy loan contracts, but added by Jefferson to the principal of the loan, be included in investment income. 97. The amounts involved herein consist of the following items: JEFFERSON STANDARD LIFE INSURANCE COMPANY Description 1957 1958 1959 a. Rents received for rental of premises in years subsequent to year of receipt $ 20,450 $ 25,713 $ 24,536 b. Interest received on bonds, mortgage loans, and collateral notes for use of money in years subsequent to year of receipt ' $146,835 $149,537 $181,821 c. Interest received on premium notes, policy loans, and liens and interest added to policy loan accounts in advance of receipt for use of money in subsequent years $725,459 $780,360 $840,793 PILOT LIFE INSURANCE COMPANY Description 1957 1958 1959 a. Interest received on bonds, mortgage loans, and collateral notes for use of money in years subsequent to year of receipt $ 47,109 $ 48,529 $ 52,078 b. Interest received on premium notes, policy loans, and liens and interest added to policy loan accounts in advance of receipt for use of money in subsequent years $ 308 $ 151 $ 126 98. The interest on policy loans arises when an insured borrows money from the company in connection with a specific life insurance policy and assigns to the company all profits and proceeds then due, or which may thereafter become due, as the sole security for the repayment of the loan and the interest thereon. 99. The advance receipt of interest arose because of the practice of Jefferson and Pilot of collecting a full year’s interest on policy loan accounts on their anniversary dates, or by reason of the fact that interest in default was added to the principal of a borrower’s loan pursuant to the terms of his contract. 100. The net amount included in gross investment income for the year 1958 by reason of this item was $64,-129.00 (consisting of $62,866.00 as to Jefferson, and $1,263.00 as to Pilot) and for the year 1959 was $95,064.00 (consisting of $91,540.00 as to Jefferson, and $3,524.00 as to Pilot). 101. Plaintiff’s Exhibit 10 illustrates the manner in which unearned policy loan interest was handled on the records of Jefferson in making the computations necessary for the annual statement, both with respect to interest paid in cash on the anniversary date and with respect to interest unpaid but added to the policyholders’ loan account on the anniversary date. Based on a situation where the policy anniversary date was July 1, and a policy loan was made on July 1, 1957, for $1,000.00, and the interest was $56.60, Jefferson deducted the interest of $56.60 in advance from the loan, paying to the policyholder the balance of $943.40. At the end of the year (December 31, 1957), Jefferson made an adjustment on its records reflecting one-half of $56.60 as earned in 1957, and set up the balance as a deferred item to be taken into income in 1958. If the policy loan interest of the same amount was in default, and added on the outstanding loan to the policy loan account, then, as of the end of the year, one-half of the $56.60 was considered as interest earned in that year and the balance was deferred until 1958. 102. The typical policy loan certificate under which interest payments herein referred to arise, provides that “interest shall be payable annually in advance,” and “any interest not paid when due shall be added to the principal of the loan and bear interest at the same rate.” 103. Both in the case of interest paid in advance by a borrower and interest charged to a policy loan account in advance of receipt, in the event the loan balance was reduced or paid in full during the period to which the interest paid in advance or the unearned interest related, the resulting excess amount of interest was paid to, or credited to the account of, the borrower, or, if the borrower was a deceased policyholder, to the beneficiary under the policy. However, no evidence was presented by Jefferson that it attempted to estimate in advance the refunds to be made, and no evidence was presented of the actual amounts refunded. 104. The record does not disclose the specific reason giving rise to the advance receipt of rents. Presumably, the greater portion is attributable to receipt of a full year’s rental in advance, with a portion of the amount attributable to the subsequent calendar year. 105. For the years 1957, 1958, and 1959, Jefferson and Pilot prepared and filed with the State Insurance Commissioner annual statements on forms approved by N.A.I.C. On these annual statements, the portions of rent received in a year for rental of premises during such year were treated as earned income, and the portions of interest received during the year for the use of money during such year, and the portion of interest added to policy loan accounts for the use of money during such year, were treated as earned income, and the remainders of the amounts of .rents or interest received during the year, or added to policy loan accounts during the year, exclusive of amounts of earned income of prior-years, were deferred as unearned income and reported as income in the subsequent year when earned. These items were required to be computed and reported on such Annual Statements in this manner. 106. Jefferson treated unearned investment income on its 1958 and 1959 tax returns in the same manner as Jefferson and Pilot treated such items on the Annual Statements approved by N.A.I.C. 107. The issue herein is simply whether the amounts of rent and interest actually received or credited must be included in investment income in the year received or credited, or may they be deferred for tax purposes. VII Charitable Contributions 108. Jefferson paid charitable contributions amounting to $59,817.59 in 1958 and $68,443.66 in 1959. Pilot paid charitable contributions amounting to $16,-183.34 in 1958 and $16,991.67 in 1959. 109. Jefferson allocated a portion of its contributions to investment expense by applying to the total contributions the ratio of the number of employees in investment functions to total employees. Pilot allocated a portion of its contributions to investment expense by applying to total contributions the ratio of salaries of employees engaged in investment functions to total salaries. These allocations have been accepted for many years by the State insurance departments for purposes of the Annual Statements. 110. A portion of charitable contributions was claimed for Federal tax purposes as an underwriting expense, and a portion as an investment expense. The defendant disallowed only the deduction for charitable contributions as an investment expense, but would permit their deduction in full in the computation of underwriting income. 111. The charitable nature or amount of the contributions is not in issue, nor is the method of allocation used for Annual Statement purposes in dispute. 112. Charitable contributions allocated to investment expense by Jefferson amounted to $20,936.00 for 1958 and $23,955.00 for 1959. Charitable contributions allocated to investment expense by Pilot amounted to $3,275.00 for 1958 and $3,571.00 for 1959. 113. Life insurance companies, including Jefferson and Piot, were required for purposes of the Annual Statement approved by the N.A.I.C., to allocate charitable contributions between investment expense and underwriting expense on a reasonable basis. 114. Of the total amount of charitable contributions paid by Jefferson in 1958, over 93 per cent was paid to organizations in North Carolina and 49 per cent was paid to organizations in the Greensboro area. In 1959, over 95 per cent was paid to organizations in North Carolina and 54 per cent was paid to organizations in the Greensboro area. During 1958 and 1959, Jefferson employed approximately 550 people in Greensboro. 115. Of the total amount of charitable contributions paid by Pilot in 1958, over 94 per cent was paid to organizations in North Carolina, and over 63 per cent was paid to organizations in the Greensboro-High Point area. In 1959, over 93 per cent was paid to organizations in North Carolina and over 67 per cent was paid to organizations in the Greensboro-High Point area. During 1958 and 1959, Pilot employed approximately 500 people in the Greensboro area. 116. The computations of the portion of charitable contributions treated as investment expense in 1958 and 1959 by Jefferson and Pilot were made in a manner consistent with the manner required for the purposes of the Annual Statement approved by N.A.I.C. VIII Increase in Loading on Deferred and Uncollected Premiums 117. It is a common practice in the life insurance industry to permit policyholders to pay premiums in semi-annual, quarterly, or monthly installments. However, additional charge or interest-type factor is added to the amount of the annual premium when an installment method of paying the premium is elected. Jefferson and Pilot follow this practice. 118. “Deferred premiums” are the fractions of annual premiums, on policies with premiums payable in installments, that become due after December 31 of the calendar year and before the next policy anniversary date. 119. “Uncollected premiums” are annual or installment premiums that, as of December 31 of a calendar year, have become due but which have not been paid. 120. On its Federal income tax returns for 1958 and 1959, in computing gain from operations under Phase II, the taxpayer included in income the gross amount of all premiums, including the gross amount of deferred and uncollected life insurance premiums, and gross amount of accident and health insurance premiums due and unpaid. From these amounts, however, the taxpayer deducted what is referred to as “increase in loading on deferred and uncollected premiums.” It is the correctness of this latter deduction which is at issue herein. 121. Under the requirements of State insurance laws, the holder of a life insurance policy has a 31-day grace period after a premium on his life insurance policy has become due, whether the premium is an annual premium or an installment premium, within which to pay the premium and thus maintain his rights under the policy. 122. The contract premium on an insurance policy is considered to be made up of two parts, a net valuation portion and a loading portion. 123. The gross contractual premium, i. e., the amount actually charged the insured, results from an independent judgment of the company of the amount required to provide all benefits under the policy, to cover all expenses, and to provide a profit. 124. Regardless of the company’s own estimates, State statutes call for reserves to be maintained based upon a “net valuation premium,” i. e., an amount based upon a mortality table and interest rates contained in the statute for the particular policy and its benefits. 125. The difference between the statutory valuation net premium and the gross contractual premium calculated by the company is referred to as the “loading.” 126. “Loading” is the excess of the gross premium provided in a life insurance policy contract over the net valuation premium used in determining the reserves for the policy. A purpose of loading is to pay for expenses incurred in writing and caring for insurance policies and annuity contracts, and as a margin for possible contingencies. 127. The loading element of a premium may thus be zero if and when the net valuation premium, i. e., the amount required under State law to be put into reserves for the policy, equals or exceeds the gross contract premium as computed by the company. . 128. The reserves attributable to policies having deferred and uncollected premiums are computed by Jefferson on the assumption that the entire deferred or uncollected premiums had been paid. Thus, Jefferson credits reserves for its full year’s liability under the policy. 129. The Annual Statements of Jefferson and Pilot submitted to the State Commissioner of Insurance call for the deduction of all actual costs incurred in servicing the policy when such costs are incurred, and such actual costs are deducted accordingly, in addition to the deduction for increases in loading on deferred and uncollected premiums. These actual expenses are deducted as commissions, general expenses, taxes, licenses and fees, etc. 130. Jefferson received deductions in full in computing underwriting income on its Federal income tax returns for 1958 and 1959 for all such expenses paid or incurred in those taxable years. 131. The expenses incident to the writing and servicing of a policy by a life insurance company are greater the first few years of the policy. There is no necessary coincidence in the amount of the actual expenses and the amount referred to as “loading” for any particular year. 132. With respect to the deduction of loading on deferred and uncollected premiums : (a) Such deductions in the first year of a policy would result in an additional deduction over and above the deduction for actual costs incurred with regard to the policy which are deducted in full elsewhere; (b) In the second year of the policy, assuming its terms were not changed and the policyholder continued payments on the same deferred basis, such additional deductions would not be recovered, as the loading at the end of the first year (actually received in the second year) would be equally offset by the deduction for new loading at the end of the second year. The company in the second year would also get a full deduction for actual costs in the second year; (c) The only point at which the additional deduction would be recovered for tax purposes would be in the last year of the policy, or in the event the terms were changed so as to provide for no more deferred payments; (d) In the case of a stable or growing company, such overall deductions would not be recovered for tax purposes by the Government until some indefinite time in the future. 133. Policyholders of Jefferson and Pilot had no legal obligation to pay deferred premiums or uncollected premiums on their policies, and could cancel such policies by not paying any more premiums on them. 134. Jefferson and Pilot each complied with the requirements of the Annual Statement approved by N.A.I.C. in the computations they made with respect to deferred and uncollected premiums for 1958 and 1959. 135. The same computations and the same figures were used for Jefferson and Pilot with respect to loading on deferred and uncollected premiums for purposes of the consolidated income tax returns filed for 1958 and 1959 as were used for purposes of the Annual Statements approved by the N.A.I.C. that were filed by the separate companies. 136. The consolidated increase in loading on deferred and uncollected premiums for 1958 was $81,464.00 (consisting of a decrease of $41,348.00 as to Jefferson and an increase of $122,812.00 as to Pilot). 137. The consolidated increase in loading on deferred and uncollected premiums for 1959 was $49,013.00 (consisting of a decrease of $37,748.00 as to Jefferson and an increase of $86,761.00 as to Pilot). IX Deferred and Uncollected Premiums as Assets; Due and Unpaid Premiums as Assets 138. Following the common practice of the life insurance industry, Jefferson and Pilot sold life insurance policies providing for payment of premiums in installments, resulting in deferred premiums. 139. “Deferred premiums” are those fractions of annual premiums on policies with premiums payable in installments that are payable after December 31 of the calendar year and before the next policy anniversary date. 140. “Uncollected premiums” can be any type of annual, fractional or installment premiums which, as of December 31 of a calendar year, has become due but which has not yet been paid by the policyholders. 141. Jefferson’s and Pilot’s deferred and uncollected premiums directly resulted from the operations of the companies’ insurance trade or busin