As an undergraduate at West Point, I was a Spanish and Portuguese major. My Brazilian “thing” had already started a decade earlier as a ten year old growing up in the Panama Canal Zone seeing Pele play for his Brazilian team Santos along with hearing Sergio Mendes and Brasil 66. To this day I submit that the band’s lead singer Lani Hall (aka Mrs. Herb Albert) is one of the best female and most unheralded singers. As a challenge, compare her Bacharach’s “Look of Love’ rendition to Dionne Warwick’s rendition. She sang brilliantly in Spanish and Portuguese without speaking either language.
Brazil is one of the BRIC (Brazil, Russian, India and China) countries and is enjoying a considerable economic boom. Brazil will be on center stage as it hosts the World Cup this summer and Summer Olympics in 2016. Unless you live in South Florida, New York City or other small regions like Framingham, Mass, and Danbury, Ct, you would not know about any Brazilians living in the U.S. unless you watch MMA. Suddenly, Brazilians have discovered that there is a place with beaches and sunshine kind of like Rio called Miami.
A lot of that money is finding its way for investment in the U.S. in hard asset investments such as real estate. When you come from Latin America, you know that while things may be economically and politically stable today, it may not be that way tomorrow. As a practical matter if you are a wealthy South American, it is easy to move around the U.S. as another face in the crowd without a target on your back.
Taxation of Brazilian High Net worth Investors.
The Brazilian tax code imposes taxation on individuals on worldwide income. The top marginal tax rate is 27.5 percent. Brazilian residents are taxable on their worldwide income on a monthly cash basis. Brazil like most South American countries is not a party to an income tax treaty with the U.S. Real estate income and gains are taxed in the jurisdiction where the real estate is located.
Taxation of U.S Real Estate Investments for Brazilian Investors
IRC Sec 871(d) gives a non-resident alien the right to treat U.S. real estate investment as effectively connected income (ECI) with respect to a trade or business in the United States. Without this election, real estate income and gains would be subject to the 30 percent withholding tax under IRC Sec 871(a) without the benefit of any tax deductions. IRC Sec 882(d) provides a similar deduction for foreign corporations with investments in U.S. real estate.
When a foreign person engages in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered to be ECI. This applies whether or not there is any connection between the income, and the trade or business being carried on in the United States, during the tax year. Taxes are withheld at a 35 percent rate. The foreign taxpayer is taxed according to the graduated rate structure. State taxation would also apply when applicable
Private Placement Variable Deferred Annuities (PPVA)
The PPVA is a private placement variable deferred annuity contract issued by an offshore life insurer that has not made an IRC Sec. 953(d) election to be treated as a U.S. taxpayer. However, the PPVA contract is U.S. tax qualified. The offshore life insurer is a controlled foreign corporation for U.S. tax purposes.
The PPVA contract is institutionally priced and transparent allowing for complete customization of the investment menu to include multiple real estate investments. The policy may be issued on either a group or individual policy form.
Under insurance law, separate account investments are expressly authorized on a non-guaranteed or variable basis. The separate account assets belong to and are titled in the name of the insurance company.
For FIRPTA tax analysis, this point is the critical point. The life insurer is a non-domestic life insurer and is the legal and beneficial owner of the investment in U.S. real property with respect to the FIRPTA withholding. Pursuant to the sale of U.S. real property that is subject to FIRPTA, the withholding agent, the investment manager of an insurance dedicated fund (IDF) within the annuity, withholds and then applies for a refund.
The life insurer is a non-IRC Sec 953(d) electing company that is a Controlled Foreign Corporation (CFC) for U.S. tax purposes. The life insurer receives a reserves deduction eliminating its income on the sale of its interest in U.S. real property and is entitled to a reduction and refund as a result of the sales proceeds withheld for FIRPTA.
U.S. Tax Qualification for Annuities
Annuity policies must satisfy the federal tax requirements for investment diversification and investor control. The life insurer is treated as a foreign investors.
The separate account is not treated as a separate entity from the insurance company for tax purposes. Since the assets and liabilities of the separate account belong to the insurance company, any income, gains, or losses of the separate account belong to the insurance company. Changes in the value of the separate account assets are treated as an increase or decrease in tax reserves under IRC Sec 807(b). The policyholder, i.e. the Brazilian investor, receives a direct pass-through of the investment performance.
The life insurer signs the subscription agreement of the investment option available in the PPVA contract. The life insurer maintains direct ownership over the policy’s investment assets including all of the legal rights associated with ownership. The policyholder (aka the investor) has no ownership in the investment asset owned by the insurer’s separate account and only has the right to participate in the investment gains and losses.
IRC Sec. 817(h) imposes investment diversification requirements for variable life insurance and annuity policies. IRC Sec. 817(h) stipulates that a single investment may not exceed more than 55% of the account value, two investments more than 70%, three investments more than 80%, and four investments more than 90%. Therefore, an investment account must hold at least five different investments. IRC Sec 818(a) provides an exemption from the investment diversification rules for pension annuities.
The tax regulations, Reg. 1.817-5 specify that all of the interests in the same real property project represent a single issue for diversification purposes. The regulations allow a five-year initial period for real estate accounts in order to comply with the diversification requirements. The same regulations provide for a two-year plan of liquidation provision in which the fund may be non-conforming with the investment diversification requirements.
The other significant component for the U.S. tax qualification of an annuity is the Investor Control Doctrine. The Investor Control Doctrine has been developed as a series of rulings and court cases. Under the traditional variable annuity or life contract, the insurer and not the policyholder is considered the owner of the underlying separate account assets.
From a federal estate tax perspective, an annuity issued by a U.S. life insurer is considered U.S. sitused property and is subject to federal estate taxation. This tax treatment is different than the treatment of life insurance on the life of the policyholder which under IRC Sec 2015 is considered non-U.S. sitused property.
Tax Treaties and FIRPTA
Generally, tax treaties and U.S. statutes (including the Internal Revenue Code) are on a theoretical parity. However, under IRC Sec 7852(d) Code provisions adopted subsequent to the IRC Sec 897 should supersede tax treaty provisions.
The benefits of this strategy for foreign institutional or high net worth investors do not rely on treaty benefits or status as a sovereign wealth fund under IRC Sec 892. The policy is U.S. tax qualified and will receive the tax treatment outlines above. When distributions are made to the policyholders no withholding taxation (30%) for fixed and determinable period income under IRC Sec 871 applies to the distribution.
As previously stated above, the properly issued and tax compliant, annuity contract should fall squarely between the exceptions dealing with FIRPTA. The life insurance spate account is the direct owner of U.S. real estate and not the foreign policyholder. Additionally, the sale of U.S. real estate within the PPVA separate account results in no taxation to the policyholder or life insurer.
The annuity structure as outlined above is a “game changer” with respect to tax structuring for foreign inbound investment in U.S. real estate. The cost of the PPVA structure is minimal and under every scenario is significantly more cost efficient than other structures – REIT, leveraged blocker et al. The tradeoffs? First, an investor needs to investment in a fund (can be customized) that has at least five different investments after five years investment period. Second, the fund requires discretionary investment management.
The benefits? The PPVA will provide a tax structure for “all” (with or without the benefit of tax treaty) foreign investors to dramatically curtail and eliminate the impact of FIRPTA and U.S. taxation on U.S. real estate investments. Second, the foreign investor has no need to file a federal tax return for this structure.
Private Placement Variable Deferred annuity contracts have been under-utilized as vehicles for investments in U.S. real or funds that generate taxation as ECI. The PPVA should be given serious consideration for proposed investments that might be subject to FIRPTA or any type of investment withholding. The PPVA can convert taxable real estate and effectively connected income into tax-free income for the non-resident alien.
Once the investor understands what a variable annuity is and how it works, the rest of the story is straight forward in regard to the tax treatment of U.S. real estate investments within the PPVA.