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UNITED STATES CODE — TITLE 26 (INTERNAL REVENUE CODE)
SUBTITLE A — INCOME TAXES | CHAPTER 1 — NORMAL TAXES AND SURTAXES
SUBCHAPTER L — INSURANCE COMPANY TAX | PART I — LIFE INSURANCE COMPANIES
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SECTION 817: Treatment of variable contracts.

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(h) DIVERSIFICATION REQUIREMENTS FOR VARIABLE CONTRACTS.—

    (1) IN GENERAL.—For purposes of subchapter L, section 7702, and section 72, 
        a variable contract (other than a pension plan contract) which is based 
        on a segregated asset account shall NOT be treated as a life insurance, 
        endowment, or annuity contract for any period (and any subsequent period) 
        for which the investments made by such account are not adequately 
        diversified in accordance with regulations prescribed by the Secretary.

    (2) SAFE HARBOR FOR VARIABLE CONTRACTS.—A segregated asset account shall be 
        treated as meeting the requirements of paragraph (1) for any quarter 
        of a taxable year if such account meets the diversification requirements 
        prescribed by Treasury Regulations.

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TREASURY REGULATION § 1.817-5 (DIVERSIFICATION REQUIREMENTS):

    (b) TESTING THRESHOLDS.—A segregated asset account is adequately diversified 
        at the end of a calendar quarter (or within 30 days thereafter) only if:
            1. No single investment constitutes more than 55% of total asset value.
            2. No two investments constitute more than 70% of total asset value.
            3. No three investments constitute more than 80% of total asset value.
            4. No four investments constitute more than 90% of total asset value.

    (f) LOOK-THROUGH RULE FOR INSURANCE-DEDICATED FUNDS (IDFs).—
        If a segregated account invests in a regulated investment company (RIC), 
        real estate investment trust (REIT), partnership, or trust, the policy 
        may "look through" to the underlying assets of the entity to satisfy 
        the diversification tests of paragraph (b), provided:
            (i) All beneficial interests in the entity are held by one or more 
                segregated asset accounts of one or more insurance companies; and
            (ii) Public access to the entity is restricted (non-registered / IDF).

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CATASTROPHIC CONSEQUENCE OF §817(h) FAILURE:
Under Treas. Reg. §1.817-5(a), if a separate account fails diversification testing 
at the end of any quarter, the ENTIRE account loses qualification for ALL 
policyholders invested in that account, triggering immediate ordinary income tax 
on all inside buildup.
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