50 T.C. 285">*285 Respondent determined deficiencies in income tax against petitioner as follows:

Respondent has conceded an issue relating to interest on policy and contract funds. Petitioner has conceded that it is not entitled to deduct from gross investment income in determining investment yield during the years in question, 80 percent of the interest paid on the mortgage, 50 T.C. 285">*286 and that the respondent did not err in determining earnings rates pursuant to the provisions of section 805(b), I.R.C. 1954, by increasing investment yield by 80 percent of the interest paid by petitioner on the indebtedness to which its real estate was subject during the years 1956-61.

The remaining issues, all to be determined under section 805(b)(4), are (1) whether petitioner in establishing the "fair market value" of its home office property as an asset may exclude the mortgage encumbrances on the improved real estate which was acquired "subject to the mortgage"; whether petitioner, in determining the mean of its assets under section1968 U.S. Tax Ct. LEXIS 128">*131 805(b)(4), must include (2) "net premiums deferred and uncollected"; (3) "premiums due and unpaid"; (4) "loading" applicable to gross premiums deferred and uncollected; (5) agents' debit balances; and (6) accounts receivable from reinsurance assumed.

FINDINGS OF FACT

Substantially all of the facts have been stipulated. Those facts which have been stipulated are hereby found and are recited in pertinent parts. From the testimony of the only witness and the exhibits received in evidence we make such findings of fact as might hereinafter appear which are not stipulated facts.

Petitioner is a life insurance company duly organized under the insurance laws of the State of Texas and, at all times material, was engaged in business as a life insurance company as defined in section 801(a), I.R.C. 1954. Petitioner's principal place of business is now and was at the date of filing of its petition in its home office building at 205 East 10th Street, Amarillo, Tex. It is the wholly owned subsidiary of the Southwestern Investment Co.

As a life insurance company petitioner writes life and other types of insurance permitted to be written by life companies and carries on an investment business. 1968 U.S. Tax Ct. LEXIS 128">*132 It conducts two broad categories of business, i.e., underwriting and investments.

Petitioner keeps a cash receipts and disbursements ledger, as required by the insurance laws, and an accrual ledger. It has prepared all of its Federal income tax returns and all of its National Association of Insurance Commissioners (NAIC) convention forms ¹ on the basis of an accrual method of accounting and a year ending December 31 of each year.

Petitioner filed its Federal income tax returns for the taxable years ending December 31, 1958, to December 31, 1961, inclusive, with the district director of internal revenue at Dallas, Tex. Each year petitioner was required to and did file a duplicate of its NAIC annual 50 T.C. 285">*287 statement for that year with its Federal income tax return. This statement is prepared on a hybrid system on which petitioner must report its1968 U.S. Tax Ct. LEXIS 128">*133 cash receipts and disbursements which are then converted to an accrual basis, and is for use for examination and audit by State insurance departments and has nothing to do directly with income tax.

Petitioner owns its home office building subject to a mortgage indebtedness. It acquired such real estate by deed on January 6, 1956, subject to an outstanding mortgage indebtedness of $ 700,000. The principal amount outstanding of the mortgage indebtedness to which the property was subject at the end of the respective years was as follows:

At all times material the fair market value of petitioner's home office real estate, free and clear of any mortgage indebtedness, was $ 912,500.

Petitioner leases the entire building to the Southwestern Investment Co., its parent company, which operates the building, paying for all repairs, utilities, and janitorial services. Southwestern Investment Co. subleases 20 percent of it to petitioner. At all times material 80 percent of the entire rental value of petitioner's home office real estate was held1968 U.S. Tax Ct. LEXIS 128">*134 and used by petitioner as an investment and the remaining 20 percent was used by petitioner in its insurance business.

There is a practice in the life insurance industry that life companies generally attempt to avoid liability for any indebtedness on their real estate. They acquire their real estate subject to indebtedness. They do not borrow money to invest; they invest their assets. Pursuant to this practice petitioner bought its home office property subject to the mortgage and was not liable on the note secured by the mortgage.

Standard Improvement Co. is liable for the note secured by the mortgage. It is a dormant corporation created and used for this purpose. It was set up with small capital, borrowing the money to build the building, and then conveying the property to petitioner subject to the indebtedness. The life insurance company which made the mortgage loan was aware of the character of Standard Improvement Co. and required a lease on the entire building by Southwestern Investment Co. to make its loan safe. Petitioner was required to and did make all payments of principal and interest on the indebtedness when due. By making the principal payments on the mortgage1968 U.S. Tax Ct. LEXIS 128">*135 petitioner's equity in the building was increased.

50 T.C. 285">*288 Petitioner, on its income tax returns for the years in issue, valued its real estate (home office) for purposes of section 805(b)(4) as of the end of the respective years, as follows (cost less the outstanding encumbrance and depreciation allowances):

In its NAIC annual statements petitioner shows its real estate as an asset. It is required in these statements to reduce the book value of its real estate (determined in the accepted sense) by the principal balance of the mortgage indebtedness to which it is subject because petitioner does not owe the debt.

Petitioner regards the fair market value of its home office real estate, less the encumbrance, as the value of that property for its investment purposes because, in order to pay off the mortgage indebtedness in full, petitioner would be required to pay off this indebtedness with funds obtained from liquidating other investment assets.

In life insurance, premiums are the agreed price for assuming and carrying the risk. The part of the premium intended to meet the cost of insurance, 1968 U.S. Tax Ct. LEXIS 128">*136 both current and future, and carry it from period to period, is called the net premium. In addition to this amount, policyholders also pay what is known as loading, which is a sum added to the net premium for estimated administration, management and operating expenses, as well as for contingencies, and, in some cases, profits. Loading when added to the net premium constitutes what is known as the gross premium. "Premiums deferred and uncollected" are premiums not yet due to be paid under the terms of the policies, and will not become due prior to the end of the year. No premium collected but not recorded would be shown in the deferred and uncollected accounts. "Premiums due and unpaid" are premiums which relate only to accident and health insurance and are due to be paid before the end of the year under the terms of the policies but which have not been paid. There is no obligation, legal or otherwise, on insured to pay to the insurer either premiums deferred and uncollected or premiums due and unpaid. If the policyholder does not pay the premium in conformity with the provisions of the policy, the policy is canceled after the grace period and appropriate adjustments are made1968 U.S. Tax Ct. LEXIS 128">*137 to reserves.

The net premiums deferred and uncollected, the premiums due and unpaid, the loading, and the total thereof with reference to petitioner's outstanding policies as of the end of the various years indicated were: 50 T.C. 285">*289

The yearend reserve on each life insurance policy is computed on the assumption that the entire premium for the current policy year has been collected a year in advance. As an offset the portion of the current policy year net premium which has not been collected is set up as an asset. The reserve liability is overstated and such net premiums are set up as an asset to offset the excessive reserve and to avoid distortion.

1968 U.S. Tax Ct. LEXIS 128">*138 Assuming a policy anniversary date of December 1, petitioner's accounting would be as set forth below with respect to a $ 1,000 wholelife policy issued at age 35 with a gross annual premium on a quarterly basis of $ 22.48 and a first year net premium of $ 4.73, a first year mortality reserve of $ 2 and a first year loading of 78.95 percent or $ 17.75:

1968 U.S. Tax Ct. LEXIS 128">*140

1968 U.S. Tax Ct. LEXIS 128">*142 The NAIC annual statement treats deferred and uncollected premiums on a net basis. Item 17, on the assets page of the balance sheet, calls for the statement of "Life insurance premiums and annuity considerations deferred and uncollected" on a net premium basis. Exhibit 13, which gives the detail of the assets, sets forth deferred and uncollected premiums on a net basis. It provides for a memorandum account to show the amount of loading excluded from the deferred and uncollected premiums. Item 16 of the liabilities page of the balance sheet calls for a statement of the "'Cost of collection' on premiums and annuity considerations deferred and uncollected in excess of total loading thereon." As required by the NAIC annual statement, petitioner's annual statements showed net premiums deferred and uncollected as an asset. Also in conformity with the form, petitioner's annual statement did not show loading as an asset.

Exhibit 13 of the NAIC annual statement provides for the disclosure of three kinds of assets -- ledger assets, nonledger assets, and nonadmitted assets. Ledger assets are cash or assets that have been acquired with cash to the extent of that cash investment. Nonledger1968 U.S. Tax Ct. LEXIS 128">*143 assets have not resulted in the receipt of money. Petitioner, for example, in its NAIC annual statement for 1961, showed as nonledger assets the excess of the value of its stock portfolio over cost, net premiums 50 T.C. 285">*292 deferred and uncollected, premiums due and unpaid, and interest due and accrued. Nonadmitted assets are assets that life insurance companies are not permitted to carry as ledger or nonledger assets, e.g., furniture, paper profits on stocks, and agents' debit balances.

In the summary of operations contained in the NAIC annual statements, line 1.1, "Premiums and annuity considerations," includes deferred and uncollected premiums on a gross basis. It (line 1.1) provides for the inclusion of deferred and uncollected premiums at gross to be added to gross premiums collected during the year less deferred and uncollected premiums at gross as of the end of the previous year. Line 17, which is the "Increase in aggregate reserve for policies and contracts with life contingencies," removes from income the net portion of the deferred and uncollected premiums. Line 25 provides for the deduction of the increase in loading on deferred and uncollected premiums and also for 1968 U.S. Tax Ct. LEXIS 128">*144 the deduction of cost of collection of premiums in excess of loading on deferred and uncollected premiums.

Net premiums deferred and uncollected, the loading thereon and premiums due and unpaid cannot be collected as a matter of right, they cannot be invested, and they are productive of no income. They are bookkeeping items to offset the distortion of an overstatement of reserves.

Petitioner pays no investment expenses out of loading. Loading relates only to the writing of insurance and the conduct of the business of underwriting insurance. It is expected to cover agents' commissions and insurance operating expenses and to provide, if possible, an underwriting profit. Petitioner can make no use in its investment business of either premiums deferred and uncollected or due and unpaid. When an insured does not pay a premium when due, petitioner through its agents and a home office policy service section makes a strenuous effort to cause the insured to maintain his policy in force.

Agents' debit balances are the result of advances to agents against anticipated future commissions. The practice of making advances to life insurance agents and charging the advances against the agents' 1968 U.S. Tax Ct. LEXIS 128">*145 anticipated commissions is widely recognized and established in the life insurance industry. Agents' debit balances represent an ordinary and necessary advance and outlay in carrying on petitioner's insurance business. Petitioner has the right to demand payment of the unpaid balance of advances to agents at the time of their discontinuation of representation of petitioner. It has been the policy of petitioner to obtain judgment against those agents with a substantial balance for advances where no arrangement has been made for, or there was refusal of, repayment and it appears that the agent might possibly have sufficient assets in the future to repay the balance of advances.

50 T.C. 285">*293 After annual chargeoffs for worthlessness, the agents' debit balances at December 31 of the indicated years were as set forth below opposite such year:

Agents' debit balances charged off at the close of the indicated years are set forth below opposite such years:

In its annual statements1968 U.S. Tax Ct. LEXIS 128">*146 for 1953 through 1955 petitioner did not show any agents' debit balances as assets. Its 1956 statement showed debit and credit balances but made no extension to nonadmitted assets. Its 1957 and 1958 statements showed agents' debit balances as nonadmitted assets in the respective amounts of $ 139,457.40 and $ 150,405.29. In no subsequent statements has it shown agents' debit balances as nonadmitted assets. With the advent of the Life Insurance Company Income Tax Act of 1959 petitioner commenced charging off agents' advances as they were made, maintaining only a memorandum account with respect thereto. Petitioner adopted this practice because it did not want to show agents' debit balances as nonadmitted assets because it was of the opinion that they had no real asset value and could not be used for credit purposes or otherwise.

Petitioner normally reinsures its risks with other companies and does not act as a reinsurer. However, it bought some policies from a local company and as a consequence assumed some reinsurance. The amount of accounts receivable from reinsurance assumed as of the end of the taxable year indicated was: 1959 -- $ 752.50, 1960 -- $ 300.

Petitioner had to 1968 U.S. Tax Ct. LEXIS 128">*147 set up a reserve for any liability involved in the reinsurance. The receivables are an accrual item.

OPINION

A tax is imposed on life insurance companies for the years 1958 and thereafter under the provisions of subchapter L, part I, section 801 et seq., I.R.C. 1954, as amended by the Life Insurance Company Income Tax Act of 1959. ² In general the law provides a three-phase tax base for life insurance companies; the first is on a portion of its investment income; the second is on one-half of the excess of its underwriting 50 T.C. 285">*294 (operating) income over its investment income; and the third is on the amount subtracted from the policyholder's surplus account for the taxable years. The various issues in this case are involved in determining petitioner's taxable investment income which is defined in section 804(a)(2) to be the sum of the life insurance company's share of all items of investment yield, reduced by certain items, plus, after 1961, the excess of long-term capital gains over net short-term capital losses. Under section 804(a)(1) the policyholder's shares of each item of investment yield of any life insurance company shall not be included in taxable investment income. 1968 U.S. Tax Ct. LEXIS 128">*148 The policyholder's share of any such item shall be that percentage obtained by dividing the policy and other contract liability requirements by the investment yield. Investment yield is defined in section 804(c) as gross investment income less certain deductions, and gross investment income is defined in section 804(b) as the sum of the gross income from (A) interest, dividends, rents, and royalties; (B) the entering into of any lease, mortgage, or other instrument or agreement from which the life insurance company derives interest, rents, or royalties; or (C) the alteration or termination thereof; and short-term capital gain and trade or business income.

The "policy and other contract liability requirements" used in determining the policyholder's shares of items of investment yield required to be excluded from the company's taxable investment income under section 804(a)(1) is defined in section 805(a) as including the adjusted1968 U.S. Tax Ct. LEXIS 128">*149 life insurance reserves, multiplied by the adjusted reserves rate. The adjusted reserves rate is the average earnings rate, or, if lower, the current earnings rate. The current earnings rate, with which we are primarily concerned here, is determined under section 805(b) (2), by dividing the taxpayer's investment yield for the taxable year by the mean of the taxpayer's assets at the beginning and end of the taxable year. Fortunately, the issues remaining for our decision involve only the determination of whether certain items are to be included in taxpayer's "assets" for the years involved and, if so, the values thereof to be included.

Under section 805(b)(4) the term "assets" is defined as meaning --

all assets of the company (including nonadmitted assets), other than real and personal property (excluding money) used by it in carrying on an insurance trade or business. For purposes of this paragraph, the amount attributable to --

(A) real property and stock shall be the fair market value thereof, and

(B) any other asset shall be the adjusted basis (determined without regard to fair market value on December 31, 1958) of such asset for purposes of determining gain on sale or1968 U.S. Tax Ct. LEXIS 128">*150 other disposition.