48 T.C. 118">*119 The respondent determined deficiencies in petitioner's income tax for the years and in the amounts as follows:

The issues for determination are as follows:

(1) Whether petitioner may retroactively adjust its beginning 1958 group accident and health claim 1967 U.S. Tax Ct. LEXIS 111">*113 reserves and individual hospital and medical claim reserves for alleged overstatements therein.

(2) Whether the construction fees received by petitioner during the years 1958 through 1961 were reportable as gain from operations pursuant to section 809(c)(3) of the Internal Revenue Code of 1954¹ or as investment income pursuant to section 804(b) of the Code.

(3) Whether the option fee, standby fees, and bond commitment fees received by petitioner during the years 1959 through 1961 were reportable as gain from operations pursuant to section 809(c)(3) or as investment income pursuant to section 804(b).

(4) Whether the gain from the sale of short-term U.S. Treasury bills received by petitioner during 1961 was reportable as gain from operations pursuant to section 809(c)(3) or as investment income pursuant to section 804(b).

(5) Whether amounts left on deposit with petitioner under settlement option provisions, as well as premiums received by petitioner on certain guaranteed renewable accident and health policies, constitute "premiums * * * attributable to nonparticipating contracts * * * issued 1967 U.S. Tax Ct. LEXIS 111">*114 or renewed for periods of 5 years or more," as required by section 809(d)(5) of the Code.

48 T.C. 118">*120 Additional issues raised by the pleadings have been disposed of by agreement of the parties.

GENERAL FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

Petitioner, a corporation duly organized and existing under the laws of the State of California, is a mutual life insurance company transacting the business of life insurance, annuities, and health and accident insurance. Its principal office is at Los Angeles, Calif. Petitioner is authorized to transact business in all States, except New York, and in the District of Columbia and Puerto Rico. Its returns for the calendar years 1958 through 1961 were timely filed with the district director of internal revenue at Los Angeles, Calif.

FINDINGS OF FACT

In accordance with the laws and regulations of the various States in which it operates, petitioner annually prepares and submits to the insurance departments of those States a detailed report of its financial status. This report is referred to as an annual statement and consists of numerous schedules which reflect 1967 U.S. Tax Ct. LEXIS 111">*115 various aspects of the company's financial condition as of December 31 of each year. Petitioner relies on much of the information contained in its annual statement when preparing its income tax return.

Petitioner, after obtaining an extension of time, filed its income tax return for the calendar year 1958 in March 1960. On that return, petitioner claimed a deduction for death benefits of $ 78,168,093.16 in computing its gain from operations. That figure represented the total benefits paid or accrued under section 809(d)(1) of the Code. Of that amount, $ 31,672,514.42 represented total accident and health benefits paid or accrued during the year, as reflected on Schedule H of petitioner's annual statement for 1958. Also included in the $ 78 million deduction, and in addition to the $ 31 million accident and health category, was the amount of $ 667,448.38 which, like the $ 31 million category, was intended by petitioner to reflect accident and health benefits paid or accrued during 1958. The $ 667,000 amount represented the total downward adjustment made by petitioner to certain of its beginning accident and health claim reserves for the calendar year 1958. ² The result of this 1967 U.S. Tax Ct. LEXIS 111">*116 adjustment was to reduce certain of petitioner's beginning accident and health claim reserves so that they equaled the 48 T.C. 118">*121 "total losses incurred" ³ in 1958 on such claim reserves, as reflected in Schedule O of its annual statement. The adjustment, which was disallowed by respondent, applied to two of the five accident and health claim reserves set forth in Schedule O, namely, the group accident and health claim reserves and the hospital and medical claim reserves. ^{41967 U.S. Tax Ct. LEXIS 111">*119} The chart below reflects the adjustment made by petitioner to each of those two categories indicating the reduction to beginning reserves of the several components in each category:

The National Association of Insurance Commissioners prescribes no standards for establishing group accident and health claim reserves. These reserves must be established on a company by company basis, with each insurance company exercising its best actuarial judgment. In establishing beginning reserves for the first two components in its 48 T.C. 118">*122 group accident and health claim category, i.e., "disability income" and "basic medical expense," petitioner ordinarily relied on reserve estimates obtained by the application of three methods of projecting past company experience. Comparison of the beginning 1958 reserve estimates obtained by application of those three methods, as computed on January 30, 1958, with the beginning reserves actually used by petitioner, are set forth below:

In establishing its "disability income" and "basic medical expense" reserves for 1958, petitioner did not rely exclusively on the results calculated by any one of those three methods. Instead, using the results obtained thereby as a guide only, petitioner determined the beginning reserves by exercising actuarial judgment, taking into consideration circumstances that it thought required establishing greater reserves than were called for by application of most of the projections obtained by those three methods. In establishing its beginning 1958 reserves for the third component in the group accident and health claim category, i.e., "major medical expense," petitioner did not attempt to project reserves from its past experience since it had only entered this field of insurance in 1956 and, as of December 31, 1957, lacked adequate company data from which it could accurately project beginning 1958 reserves. After conversations with other actuaries relative to the size of the reserves needed for this component, which conversations indicated that the reserves 1967 U.S. Tax Ct. LEXIS 111">*121 should be between 25 and 100 percent of premiums, petitioner's actuary determined that reserves for this component should be 65 percent of premiums paid.

In establishing the beginning 1958 reserves for the two components in its hospital and medical claim category, i.e., "comprehensive hospital and medical expense" and "polio," petitioner estimated the total amount it thought would be payable to policyholders during the entire benefit period, reduced that amount by the total benefits paid as of December 31, 1957, and established the balance as the reserves.

Due to numerous factors occurring subsequent to January 1, 1958, which affected the amount of claims arising from the "group accident 48 T.C. 118">*123 and health" and "hospital and medical" claim categories, the liabilities incurred by petitioner for those two categories, as measured by petitioner's "total losses incurred," were less than the beginning 1958 reserves. For the two reserve categories in question, the following chart shows the percentage excess of total beginning reserves over "total losses incurred" for each of the following years:

The 1967 U.S. Tax Ct. LEXIS 111">*122 beginning 1958 reserves in question were determined by petitioner's actuaries who, at the time they established such reserves, considered them to be reasonable estimates based upon all information available. No mathematical error was made in their computation. All of petitioner's 1958 accident and health claim reserves, including the two categories in question, were certified by an independent actuary to be "satisfactory and adequate."

As reported by the Senate Finance Committee, the bill which became the Life Insurance Company Income Tax Act of 1959 contained a section 811(b)(3) which provided that where an insurance company established a beginning 1958 reserve for "dividends to shareholders" which was larger than the amount of dividends actually paid out during that year, the company could use the actual rather than the erroneously projected amount in computing its taxable income for 1958. During Senate debate on the bill, it was pointed out that a similar problem existed with respect to other beginning 1958 reserves which, if not permitted to be retroactively adjusted so as to accurately reflect actual payments, would cause a misstatement of the taxpayers' income tax liability 1967 U.S. Tax Ct. LEXIS 111">*123 for 1958. ⁵ While the legislation was pending in the Senate, the Treasury Department was requested by the chairman of the Senate Finance Committee to render its opinion on a proposed amendment to delete section 811(b)(3) from the bill. In responding to the letter from the Senate Finance Committee, the Treasury Department indicated it had no objection to the adoption of such an amendment. The Life Insurance Company Income Tax Act of 1959, as enacted, did not contain section 811(b)(3) or any other provision which would permit an insurance company to retroactively adjust any beginning 1958 reserves.

48 T.C. 118">*124 OPINION

The issue involved herein, most simply stated, is whether the Life Insurance Company Income Tax Act of 1959 ⁶ (hereinafter referred to as the 1959 Act) permits petitioner, a mutual life insurance company, to retroactively adjust its beginning 1958 reserves for certain of 1967 U.S. Tax Ct. LEXIS 111">*124 its claim categories associated with the accident and health aspect of its insurance business. Disposition of this issue, because of the complex statutory provisions involved, requires a discussion of the relevant provisions of the 1959 Act in the context of the facts as found above.

Enactment of the 1959 Act, retroactive to January 1, 1958, constituted the first major change in the method of taxing life insurance companies since 1921. Under the pre-1958 taxing scheme, only net investment income was taxed. ^{71967 U.S. Tax Ct. LEXIS 111">*125} With passage of the 1959 Act, there was established a 3-phase taxing formula ⁸ which, for the first time, included gain from underwriting operations in the computation of taxable income of life insurance companies. The following discussion of the pertinent provisions of the 1959 Act is limited to the tax year in question, 1958, and does not reflect subsequent statutory amendments.

The first phase of the 3-phase taxing scheme is used to determine "taxable investment income," ⁹ and is obtained by splitting the company's net investment income into "the policyholder's share," which is nontaxable, and "the company's share," which is taxable and constitutes the phase 1 tax base.

Phase 2 is used to determine gain or loss from operations as computed under section 809 and includes gross receipts from all sources less related expenses. Thus, gross receipts include not only the investment income under phase 1 but, in 1967 U.S. Tax Ct. LEXIS 111">*126 addition, premiums and other receipts. Pursuant to section 809(d), deductions are allowed against these gross receipts both for the amounts paid as claims and benefits to policyholders and their beneficiaries, and for investment expenses and expenses of operating an insurance business. The deductions also include increases in life insurance and other reserves which the company maintains in order to meet future obligations. When the various deductions are subtracted from gross receipts, the remaining amount constitutes gain (or loss) from operations.

48 T.C. 118">*125 If the section 809 calculation results in a gain from operations, taxable investment income, as computed under phase 1, is subtracted from the gain since taxable investment income is already included in the insurance company's tax base. The amount remaining constitutes underwriting gain since it consists essentially of mortality and loading savings. ¹⁰ One-half of the underwriting gain is then added to the taxable investment income obtained under phase 1 to reach the combined tax base under phases 1 and 2. ^{111967 U.S. Tax Ct. LEXIS 111">*128} Where, however, there are underwriting losses, i.e., where either the gain from operations is less than taxable investment 1967 U.S. Tax Ct. LEXIS 111">*127 income or where there is actually a loss from operations, the total tax base under phases 1 and 2 is the gain (or loss) from operations. ¹² Expressed differently, the total tax base equals the taxable investment income minus 100 percent of underwriting loss, underwriting loss being equal to the gain (or loss) from operations less taxable investment income.

As indicated in describing phase 2, supra, only one-half of the underwriting gain is taxed currently because of the difficulty of determining, on an annual basis, the true income of life insurance companies. Where, however, the company distributes dividends to stockholders which exceed investment income and that half of underwriting gain previously taxed, it is evident that the company itself has determined that such dividends constitute income no longer needed for policyholders' contracts. Phase 3 therefore provides, as set forth in section 815, that after December 31, 1958, income distributed by life insurance companies to stockholders in excess of the amounts already taxed on a current basis is to be included in the regular income tax base of the insurance company. ^{131967 U.S. Tax Ct. LEXIS 111">*129}

In preparing its income tax return for the calendar year 1958, petitioner, in computing its gain from operations under phase 2 of the 1959 Act, claimed a deduction for death benefits in the amount of $ 78,168,093.16, pursuant to section 809(d)(1). Of that amount, $ 31,672,514.42 represented the total accident and health benefits paid or accrued during 1958 as reflected in Schedule H of petitioner's 1958 48 T.C. 118">*126 annual statement. Also included in the $ 78 million death benefits deduction, and in addition to the $ 31 million accident and health category, was the amount of $ 667,448.38 which, like the $ 31 million category, was intended by petitioner to reflect accident and health benefits paid or accrued in 1958 but, unlike the $ 31 million amount, was nowhere reflected in petitioner's 1958 annual statement as accident and health benefits paid or accrued.

In computing gain from operations under phase 2 of the 1959 Act, section 809(c)(2) provides, in substance, that a net decrease in reserves, as computed under section 810(a), ^{141967 U.S. Tax Ct. LEXIS 111">*131} is treated as an income item whereas section 809(d)(2) provides, in substance, that a net increase 1967 U.S. Tax Ct. LEXIS 111">*130 in reserves, as computed under section 810(b), ¹⁵ is treated as a deduction item. Since the net change in reserves as computed under section 810 (a) and (b) is the difference between the beginning and ending reserves, and since the 1959 Act was made retroactive to January 1, 1958, if for any reason any of the petitioner's beginning 1958 reserves were erroneously overstated and the respective ending 1958 reserves were correct, the result would be an understatement of the increase in such reserves (or an overstatement of the decrease in such reserves where ending reserves were less than beginning reserves), resulting, in either case, in an overstatement in the gain from operations (or an understatement in the loss from operations where a loss was reported).

Petitioner's income tax return for 1958 was filed on March 14, 1960, subsequent to the enactment of the 1959 Act. Petitioner computed its phase 2 gain from operations by considering, among other things, the net increase or decrease in the various claim reserve categories of its insurance business. In preparing its 1958 return, petitioner realized that an overstatement in any of its beginning reserves would result in an increase in its gain from operations. In exercising actuarial hindsight, petitioner determined that the beginning 1958 reserves in question were overstated and should be adjusted downward to equal the "total losses incurred" attributable to these claim categories. ¹⁶ In making those adjustments, petitioner attempted 1967 U.S. Tax Ct. LEXIS 111">*132 to restate the beginning 1958 reserves in question so as to reflect as nearly as possible its actual experience.

48 T.C. 118">*127 The effect of the adjustments was to increase the section 809(d)(1) death benefits deduction, resulting in a corresponding reduction in petitioner's phase 2 gain from operations. In refusing to allow the downward adjustment to the beginning 1958 reserves in question, the Commissioner stated the following at page 5 of his deficiency notice dated December 24, 1964:

It is determined that you overstated death benefits etc. deduction for the year 1958 in the amount of $ 667,448.28 [sic] by improperly decreasing the accident and health claims reserve as of December 31, 1957 in the amount of $ 667,448.28 [sic]. Therefore, the deduction for Death Benefits etc. under Section 809(d) is decreased by this amount.

Petitioner contends that because of special circumstances existing at the end of 1957, it overestimated the beginning 1967 U.S. Tax Ct. LEXIS 111">*133 1958 reserves in question, causing a corresponding increase in its 1958 taxable income. Petitioner argues from this that if the alleged overstatements are not corrected for 1958, its income tax liability will not only be erroneous for that year but, because of the nature of the tax computation required under the 1959 Act, it will never be corrected in any later year. Assuming, arguendo, that the 1959 Act would have such an irreparable effect on petitioner's tax liability, petitioner's argument, as stated, is a plea for equitable relief. Such an argument cannot be considered by this Court since we lack equity jurisdiction. Commissioner v. Gooch Co., 320 U.S. 418">320 U.S. 418 (1943); Lorain Avenue Clinic, 31 T.C. 141">31 T.C. 141 (1958); Edward P. Clay, 46 T.C. 505">46 T.C. 505 (1966).

Petitioner contends, however, that it was the intention of Congress in passing the 1959 Act to permit aggrieved taxpayers to correct any distortion of income caused by overstatements in beginning 1958 reserves. Petitioner's support for this position rests upon its interpretation of a statement made by Senator Carl Curtis during Senate debate on the bill which became the 1959 Act and a letter received by the Senate Finance Committee from 1967 U.S. Tax Ct. LEXIS 111">*134 the Treasury Department. A brief history of the subject legislation will place petitioner's contention in proper perspective.

The Life Insurance Company Income Tax Act of 1959, retroactive to January 1, 1958, was introduced in the House of Representatives on February 9, 1959. ¹⁷ As drafted, the bill contained no provision which would have allowed an insurance company to retroactively adjust any of its beginning 1958 reserves. The Senate Finance Committee amended the House version of the bill by adding a section numbered 811(b)(3) which provided that in computing the deduction for "Dividends to Policyholders" under section 811, an insurance company could report the amount "actually paid" as dividends during 1958, thereby permitting a company to retroactively adjust its beginning 48 T.C. 118">*128 1958 reserves for dividends. ¹⁸ However, while the legislation was pending in the Senate, the Treasury Department was requested by the then chairman of the Senate Finance Committee, Harry Flood Byrd, to render its opinion on a proposed amendment to delete section 811(b) (3) from the bill. The Treasury Department's opinion, as stated in a letter dated May 19, 1959, and signed by the then Assistant to the 1967 U.S. Tax Ct. LEXIS 111">*135 Secretary, David A. Lindsay, read as follows:

This is in reference to your request for our opinion on a proposed amendment to H.R. 4245, the pending life insurance company income-tax bill, dealing with the special rule under section 811(a)(3) [sic], which provides a special rule for the 1958 reserve for dividends to policyholders.

This special rule was originally included in H.R. 4245 for the relief of certain companies which had overstated their reserve for policyholder dividends at the end of 1957, due to technical errors, caused, in certain cases, for example, by the introduction of new data-processing equipment.

It is further understood that the introduction of this special relief rule will work unintended hardship on certain other companies. Accordingly, it has been suggested that an amendment be adopted to take care of this situation by eliminating section 811(a)(3) [sic], thus leaving the adjustment for the error in the starting policy dividend reserve to administrative action.

The Department would have no objection to such an amendment. [105 Cong. Rec. 8435.]

During 1967 U.S. Tax Ct. LEXIS 111">*136 Senate debate on the bill, Senator Carl Curtis took occasion to make the following remarks:

In addition to the foregoing, I should like to invite attention to a relatively minor matter of somewhat technical nature on which I fear the language and intent of the bill might be misconstrued if some appropriate explanation were not made. The point is this: Most appropriately, section 811(b)(3) of the bill, which was added by the committee, makes it perfectly clear that where through inadvertent error, a life insurance company's reserve and policyholders dividends at the beginning of 1958 were overstated, the error is to be corrected in computing the company's taxable income for 1958 by referring to the dividends actually paid by the company during 1958.

The point I wish to make clear is that there are a good many other types of beginning 1958 reserves which enter into computation of the taxpayers' 1958 taxable income. Any error in any of those opening reserves will result in an erroneous computation of taxable income, if not corrected. Such errors should be corrected in making the tax computations, whether the errors were protaxpayer or progovernment. If such errors are not corrected, 1967 U.S. Tax Ct. LEXIS 111">*137 the result is an inaccurate and erroneous computation of tax, which, because of the nature of the tax computation, will never be corrected. I think it quite clear that, even without any special provision in the bill itself, a taxpayer or the Internal Revenue Service, as the case may be, has ample authority under other law to correct any error in any opening reserves, in computing taxable income under this bill. Since I understand that to be the law, I am not offering any amendment to the bill on this point, but thought it well to make the record on it completely clear. [105 Cong. Rec. 8430.]

48 T.C. 118">*129 On May 19, 1959, the Senate voted to print a version of the House bill which contained neither section 811(b)(3) nor any similar provision. No further reference was made to that section by either House of Congress and the bill as enacted contained no such provision.

Petitioner contends that the foregoing statements "make it apparent that both Congress and the Treasury Department intended that a life insurance company would be allowed to correct its beginning 1958 reserves for error and that such adjustments should be handled administratively rather than by special legislation."

By their very 1967 U.S. Tax Ct. LEXIS 111">*138 nature, reserves are mere estimates whose accuracy is dependent upon the judgment and experience of the person establishing them. Congress explicitly recognized this fact when it defined "life insurance reserves" under the 1959 Act in terms of "computed or estimated "amounts. ¹⁹ We think that Congress thereby intended to treat life insurance reserves like any other reserves which, in the absence of legislative exception, may not be retroactively adjusted for purposes of correcting errors of judgment in the original estimate. Petitioner contends that there were a number of special circumstances which caused it to overstate the reserves in question. Assuming, arguendo, that this were the fact, we fail to perceive its importance since petitioner's actuary testified that he established the reserves in question based upon all available information and, further, that there was no mathematical error in their computation. We think petitioner reads too much into that part of the legislative history relied upon. The Treasury's letter specifically recognized that the proposed amendment, sec. 811(b)(3), was intended to permit adjustment to insurance reserves which were overstated "due to technical 1967 U.S. Tax Ct. LEXIS 111">*139 errors." Similarly, Senator Curtis' remarks indicated that the amendment permitted retroactive adjustment only to those reserves which had been overstated "through inadvertent error." In rejecting petitioner's legislative interpretation, we conclude that neither the legislative history relied upon nor any other law or regulation brought to our attention would permit an insurance company to retroactively adjust an insurance reserve which, at the time it was established, was based upon all available information and contained no mathematical error.

However, even if we could interpret the foregoing statements as imparting a congressional intention to allow an insurance company to retroactively adjust beginning 1958 reserves where its actual experience showed the reserves to be overstated, we would be required to hold against petitioner for another reason. In attempting to justify the downward adjustments made to its beginning 1958 group accident and health claim reserves and individual hospital and medical claim reserves, 48 T.C. 118">*130 petitioner's contentions, as discussed supra, are necessarily based upon the assumption that its beginning 1958 reserves were overstated. The validity 1967 U.S. Tax Ct. LEXIS 111">*140 of this assumption, because of its critical importance to those contentions, warrants careful consideration.

Petitioner adjusted only two of the five categories of beginning 1958 accident and health claim reserves shown in Schedule O of its 1958 annual statement: "Group Accident and Health," $ 580,785.46, and "Hospital and Medical Expense," $ 86,662.92, for a total downward adjustment of $ 667,448.38. Petitioner supports the downward adjustment to these claim reserves on the ground that they were erroneously estimated, or overstated. In support of the alleged overstatements, petitioner relies upon a test used by the insurance commissioner of California for determining adequacy of reserves. Under that test, as employed by petitioner, beginning reserves are reduced by the "total losses incurred" for the particular year under consideration. ²⁰ The difference, when divided by "total losses incurred," yields a figure designated by petitioner as "percentage excess of beginning reserves over total losses incurred" and is intended to reflect, as a percentage, the extent of overstatement of beginning reserves. Application of the test to the two claim categories in question shows that the 1967 U.S. Tax Ct. LEXIS 111">*141 beginning 1958 reserves were overstated by 13.41 percent, an amount several times larger than that obtained when the test was applied to the same claim categories for the years 1957, 1959, 1960, and 1961. However, before we may accept the percentage deviation arrived at by this test, an examination of the underlying components used in calculating that figure is required.

The accuracy of the result obtained from the application of the foregoing test is dependent upon only two components, one, the amount of beginning reserves under consideration and two, the "total losses incurred" on the claim categories to which those reserves relate. Whereas the amount representing beginning reserves consists of the actual amount used in establishing those reserves, the amount designated "total losses incurred" is, by definition, based in part on an estimate. ²¹ Thus, if the estimated component of "total losses incurred" is inaccurate, the percent of error of beginning reserves will likewise be inaccurate. Although the uncontradicted testimony at trial revealed that petitioner could have determined on the date of the filing of the 1967 U.S. Tax Ct. LEXIS 111">*142 return here involved, the exact liability incurred with respect to the claim categories in question, petitioner chose not to do so, but instead relied on its estimate of incurred liability in computing the alleged amount of overstatement, $ 667,448.38, as well as the percentage deviation figure of 13.41 percent. Inasmuch as petitioner has never determined the true liability for the claim categories in question, there is 48 T.C. 118">*131 no assurance that the amounts actually paid on those categories were in fact more or less than the beginning 1958 reserves prior to adjustment thereof. Lacking such assurance, we cannot conclude that the reserves in question were either overstated or understated.

Petitioner attempts to mitigate this fact by arguing that the period of group accident and health claim payments is a very short one inasmuch as the term of the policy is for 1 year renewable. Thus, petitioner argues, the claims incurred as of December 31 of any given year are largely paid out as of December 31 of the following year. In support of this argument, petitioner points out that the total dollar amount of the estimated component of "total losses incurred" for the claim categories 1967 U.S. Tax Ct. LEXIS 111">*143 in question was only $ 90,024, or 1.59 percent of the total beginning reserves in question. While this fact constitutes some evidence which might tend to support the accuracy of the estimated component of petitioner's "total losses incurred" figures for the year in question, petitioner has still failed to prove the actual liability incurred, and having failed in this respect, there is no showing in the record that the beginning 1958 reserves in question were actually overstated. Thus, even if we were of the view that Congress had expressed an intent to permit retroactive adjustment to beginning 1958 reserves, which we are not, we would still be required to hold against petitioner for failure to prove any overstatement in such reserves.

FINDINGS OF FACT

During the tax years 1958 through 1961, petitioner made mortgage loans for the construction of new buildings (hereinafter construction loans) and loans on existing buildings (hereinafter regular loans). With respect to its regular loans, petitioner charged the borrower a "loan service fee" or "lender's fee," and with respect to its construction loans, petitioner charged the borrower a "construction fee." These 1967 U.S. Tax Ct. LEXIS 111">*144 fees were in addition to the normal interest rate charged on such loans. In petitioner's experience, although construction loans involve an element of risk, they are no more hazardous than regular loans and at any given time and place the interest rate on a construction loan is likely to be the same as that on a regular loan. The construction fee constituted a percentage of the principal amount of the loan and varied from 1/2 to 2 percent. Both the loan service fee and the construction fee were arrived at by negotiation, both being influenced by the availability of mortgage money at the time and place the loan was made. On its income tax return for the years in question, petitioner included the total loan service fees in its gross investment income but failed to include any of its construction fees in gross investment income.

48 T.C. 118">*132 Petitioner operates a mortgage loan department whose function is the investment of its funds in regular and construction loans, secured by real estate, as well as the servicing of such loans. In addition to home office personnel, petitioner's mortgage loan department has several field offices located in various parts of the country with salaried employees 1967 U.S. Tax Ct. LEXIS 111">*145 who make loans and provide services in connection with such loans directly to borrowers. Few major life insurance companies operate directly in this manner. Most major life insurance companies purchase mortgage loans from mortgage loan brokers, mortgage loan correspondents, banks, savings and loan associations, and finance companies, or they place their mortgage loans through mortgage loan brokers and correspondents. During the years in question petitioner placed a limited volume of mortgage loans through mortgage loan brokers, referred to by petitioner as preferred brokers.

During the years in question, petitioner's general procedure in making regular loans was essentially as follows: In the initial contact with a prospective borrower, petitioner inquired as to the amount desired and the type of property involved. If the proposal appeared attractive, the loan representative inspected and appraised the property. If the property met expectations, negotiations as to the exact terms of the loan were commenced. Included in those negotiations was the amount of the loan service fee to be charged by petitioner. If agreement was reached, petitioner prepared a loan application embodying 1967 U.S. Tax Ct. LEXIS 111">*146 the agreement and submitted it to the borrower for his signature. Upon receipt of the signed application, the loan representative ordered a credit report and if the proposed loan was in excess of $ 25,000, the application was forwarded to the home office for approval. Where home office approval was obtained, a loan commitment issued and the closing procedure was begun, including the execution of a deed of trust or mortgage, and a promissory note. Applications for loans of $ 25,000 or less on single family dwellings could be approved in the field by authorized employees of petitioner.

Petitioner's general procedure in making construction loans was similar to that employed in making regular loans. However, since there was no existing structure to inspect and appraise, petitioner reviewed the plans and specifications for the building prior to accepting a loan application. This review was undertaken to determine that the size of the rooms and closets were adequate, that the layout was proper, and that the traffic flow of the structure was acceptable. If the loan application was accepted, petitioner executed a construction loan agreement which incorporated the terms of the application, 1967 U.S. Tax Ct. LEXIS 111">*147 including the amount of the construction fee. Concurrent with the execution of the construction agreement, the borrower executed a promissory note and mortgage or deed of trust. When the mortgage 48 T.C. 118">*133 or deed of trust was recorded, petitioner informed the borrower he could begin construction. In the situation where petitioner was not furnished with a survey, its loan man inspected the foundation to verify that its size and location on the lot were as set forth in the plans and specifications. Petitioner then notified the title company to issue a foundation report whereupon the first disbursement of loan funds was made. Thereafter, pursuant to the loan agreement, provision was made for the periodic inspection of the building under construction and the disbursement of funds upon the satisfactory completion of the various stages of construction. However, there was no relationship between the extra services incurred on construction loans and the construction fees charged the borrower. The amount of the fee was the result of negotiations between borrower and lender. The services rendered by petitioner in connection with its construction loans were essentially for petitioner's benefit 1967 U.S. Tax Ct. LEXIS 111">*148 and protection in determining whether to make the loan and, if made, for the subsequent safeguarding of the loan. Petitioner would not enter into a construction loan without reserving the right to perform such services for which a construction fee was always charged the borrower.

The same forms of real estate loan applications were used by petitioner for both its regular loans and its construction loans. The construction fee and the loan service fee, or lender's fee, were customarily set forth in the real estate application submitted by a prospective borrower, which fees were usually withheld from the first moneys disbursed by petitioner. Where a construction loan was placed through one of petitioner's preferred brokers, the borrower was charged both a loan service fee and a construction fee. In this situation, the construction fee was paid to the preferred broker, petitioner retaining the loan service fee.

During the years in question, petitioner investigated a substantial number of requests for construction loans, including a review of the plans and specifications, which, for one reason or another, did not result in the granting of a loan. In such instances, petitioner charged 1967 U.S. Tax Ct. LEXIS 111">*149 no fee to the unsuccessful borrowers.

The total construction fees received by petitioner during the years in question exceeded the expenses attributable to such fees by the following amounts and percentages:

48 T.C. 118">*134 Although petitioner excluded construction fees in reporting its gross investment income during the years in question, it did not exclude any portion of gross investment expenses attributable to its mortgage loan operations. On September 16, 1963, petitioner paid additional tax based on calculations recorded in the revenue agent's report of examination (Form 1907) dated September 17, 1963. These calculations involved the elimination of the construction fees from gross investment income and the elimination from gross investment expenses of those expenses attributable to the income from its mortgage loan construction fees.

During the years in question, petitioner reported the construction fees as gain from operations under section 809(c)(3)1967 U.S. Tax Ct. LEXIS 111">*150 in the calculation of underwriting income. In the deficiency notice dated December 24, 1964, the Commissioner determined that petitioner had improperly included such fees in underwriting income. Based upon this determination, petitioner's income for the years in question was adjusted by decreasing underwriting income in the amount of the construction fees and increasing investment income by the same amount.

OPINION

The question presented by this issue is whether the construction fees received by petitioner during the years in question were reportable as underwriting income pursuant to section 809(c)(3), as petitioner contends, or as investment income under section 804(b)(1), as respondent contends. Section 804(b)(1) provides as follows:

SEC. 804. TAXABLE INVESTMENT INCOME.

(b) Gross Investment Income. -- For purposes of this part, the term "gross investment income" means the sum of the following:

(1) Interest, etc. -- The gross amount of income from --

Simpson, J., dissenting: I agree with the conclusions of the majority concerning the 1967 U.S. Tax Ct. LEXIS 111">*174 first four issues, but I must disagree in part with the conclusions in issue 5. It seems to me that the guaranteed renewable policies issued by the petitioner were not issued for 5 years within the meaning of section 809(d)(5).

The purpose of allowing the 3-percent deduction provided in section 809(d)(5) was to permit insurance companies issuing nonparticipating policies to accumulate additional surplus tax-free. Companies issuing participating policies can charge larger premiums and in this manner retain surplus to protect against unanticipated adverse experience. The additional surplus which can be accumulated by reason of section 809(d)(5) provides similar protection for companies issuing nonparticipating policies.

Although the legislative history fails to explain the reason for the requirement that the policy be issued for 5 years, it seems clear that the accumulation of increased surplus was necessary only when the 48 T.C. 118">*145 insurance company was committed for a 5-year or longer period. If the company is free to adjust its rates at any time when its experience proves to be more unfavorable than expected, there is no need for allowing the tax-free buildup of increased surplus. In the 1967 U.S. Tax Ct. LEXIS 111">*175 case of noncancellable accident and health policies, the company cannot adjust its rates notwithstanding unfavorable experience. However, in the case of the guaranteed renewable policies involved herein, petitioner could alter its rate schedule. It could not increase the rates of an individual policyholder merely because he became an increased risk, but it could increase the rates for the class of policies if it became apparent that the risks for the whole class were greater than expected.

In deciding whether a guaranteed renewable policy is issued for 5 years, I recognize that such a policy may be continued for 5 or more years and that in some respects the company is committed -- it cannot decline to renew the policy at the end of any year and can make only limited changes in its terms. However, since the company is free to adjust its rate schedule, there is no reason to permit the tax-free accumulation of additional surplus to protect against unanticipated risks in connection with these guaranteed renewable policies; and accordingly, I have concluded that these policies are not issued for 5 years within the meaning of section 809(d)(5).