Sophisticated tax structuring is generally involved in the investment activities of foreign private and sovereign investors in U.S. private equity and real estate investments that generate effectively connected income to a U.S. trade or business (ECI). The focus of this structuring generally accomplishes several important tax and non-tax objectives:
Avoidance of the need to file a U.S. income tax return and falling under the scrutiny and jurisdiction of the IRS.
Recharacterization of income that would be otherwise subject to taxation at the top corporate rates into interest and dividend income that is subject to lower tax rates under applicable tax treaties with the U.S.
Minimization of corporate taxation on the “blocker” corporation structure frequently used as part of this planning.
The focus of this article is on the use of a U.S. blocker corporation and its cousin the leveraged blocker corporation. In an era where specialization is the norm, professionals tend to operate in the realm of their own comfort zone and professional specialization, i.e., their existing “bag of tricks”. As a result, professionals tend to be unfamiliar within other “silos” of technical solutions outside of their own silo. Such is the case of the use of the private placement group variable deferred annuity contract (GAC) in tax structuring for ECI and FIRPTA.
The GAC has largely been the domain of large life insurers such as Prudential, John Hancock and Principal Financial who make the GAC available exclusively to the insurer’s wholly owned investment advisory subsidiaries. Investment advisors not owned by a life insurer have not had access to the GAC. In the last decade specialty life insurers who have a focus on customized life insurance and annuity products and without an “ax to grind” on the investment side of the equation, have emerged providing a platform for third party investment advisors for use of the GAC.
This article addresses a number of questions regarding the private placement group variable deferred annuity (GAC) contract as a conduit for U.S. real estate investment for foreign institutional investors versus the use of a standard or leveraged blocker corporation.
What is Effectively Connected Income (ECI)?
A foreign person or corporation is taxed on all of the income effectively connected with the conduct of a U.S. business and trade at the same tax rates and same basic principal as any other U.S. citizen or resident under IRC Sec 871(b). Gauging the existence of a U.S. business is complex. The facts and circumstances are evaluated in each case. The primary test is whether there is “considerable, continuous and regular” business activity.
A number of alternative investments present the issue of ECI treatment for the foreign institutional investors. Many real estate partnerships and private equity partnerships result in taxation at ordinary rates. Treaty provisions generally do not provide any reduced rates for ECI. Withholding provisions under IRC Sec 1446 provide for withholding by the funds’ general partner.
Real estate income such as rental income is generally treated as fixed and determinable and periodic income (FADP) subject to a 30 percent withholding tax without the benefit of any deductions. IRC Sec 871(d) allows the foreign investor to treat real estate income as ECI allowing the foreign investor to enjoy the benefit of deductions against gross income.
What is FIRPTA?
FIRPTA introduced a federal withholding system which requires the buyer of the property to deduct and withhold ten-percent of the gross sales price and remit to the federal government within twenty days of the sale. The rules for FIRPTA are found in IRC Sec 897.
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 Effectively Connected Income (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. Corporate taxation at the state level can also apply.
The Standard Blocker Corporation Arrangement
The standard blocker corporation arrangement focuses more on the need to avoid filing a U.S. tax return and avoid the jurisdiction of the IRS than tax savings. The standard blocker corporation is a low cost arrangement. The standard arrangement involves the creation of a corporation in a jurisdiction that has no corporate taxation such as the Cayman Islands. The blocker corporation invests directly into the private equity real estate fund.
The blocker corporation (rather the foreign investor) is responsible for filing a U.S. tax return and is subject to any withholding taxes under FIRPTA at 35 percent. Additionally, the blocker corporation could be subject to the Branch Profits tax bringing the effective tax rate to 54 percent.
The investor might avoid the branch profits tax by creating the blocker corporation in a jurisdiction that has a tax treaty with the U.S. However, the corporation would most likely subject the corporation to taxation in the foreign jurisdiction potentially offsetting any of the benefit of the U.S. blocker corporation.
The Leveraged Blocker Corporation
In the leveraged blocker corporation, the foreign investor invests in a Delaware corporation. The corporation is capitalized with a mix of equity and debt. The common ratio of debt-to-equity is 3:1. It is not uncommon for a fund manager to structure the leveraged blocker corporation as a series partnership or series LLC. A separate leveraged blocker exists for each investment or series within the partnership. Otherwise, absent the series partnership or LLC structure, the foreign investor would invest in a separate U.S. corporation for each investment within the fund.
The payout of proceeds from the corporation represents a return of capital, interest and dividends to the foreign investor. The return of capital is paid out income tax-free. Dividends are paid out subject to a 30 percent withholding rate or at a lower rate if available under a treaty.
A typical rate under most treaties is 15 percent for dividend income; however, the rate is zero under the French treaty. Interest payments by the blocker corporation reduce the amount of taxable income to the corporation. Interest payments to the foreign investors are treaty provisions are generally subject to taxation at much lower rates than ECI- 10-15%.
Principal payments on the debt portion of the capitalization are not subject to withholding taxes. Additionally, the blocker corporation should not be taxed on liquidating distributions from the corporation since the corporation is holding cash from the disposal of real estate and not an interest in other real estate within the partnership. Capital gains taxes are not subject to withholding taxation for foreign investors.
From a cost standpoint, the legal costs in the creation and administration of the leveraged blocker corporation are high. The level of complexity is also very high. .An estimate of legal costs in Year 1 would be than $100,000.
Some of the additional tax considerations impacting the utility of the leveraged blocker corporation include the tax rules dealing with thinly capitalized corporations under IRC Sec 385 and interest deduction rules of IRC Sec 163(j). Generally, these rules seek to limit the ability of corporations and investors from converting operating income into interest income that is either not taxed under a treaty or taxed at lower rates under the treaty.
IRC Sec 163(j) defines excess interest means “interest” that exceeds more than 50 percent of a corporation’s’ adjusted taxable income. The second threshold for these rules is a debt-to-equity of 1.5 to 1. Excess interest in a tax year is carried over into future tax years.
Private Placement Group Variable Deferred Annuities (GAC)
The GAC is a private placement group variable deferred annuity (GAC) contract issued by a U.S. life insurance company or an offshore life insurer that has made an IRC Sec 953(d) election to be treated as a U.S. taxpayer. The GAC 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 state 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.
Separate account contract holders have no right to receive in kind distributions, or direct the purchase or sale of separate account assets. Ownership and control of separate account assets legally and contractually rest with the insurer. GAC contracts are taxed as a variable deferred annuity under the appropriate provisions of the Internal Revenue Code (IRC Sec 72).
Over the course of the last thirty years life insurers have issued the GAC typically to wholly owned investment advisory firms and not third party advisors. The list of alternative investments within the GAC includes real estate, oil and gas, co-generation, MLPs, and timber and others. My estimate is that over this period of time, at least $40-50 billion of institutional investments have been structured through the GAC. No one ever knew about this as life insurers issued these policies directly on behalf of their wholly owned investment subsidiaries.
The planning opportunity for foreign institutional investors is the fact that third party life insurers issue the GAC without necessitating a connection to the life insurer. Policies must satisfy the federal tax requirements for investment diversification and investor control. 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).
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.
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 U.S. tax qualification 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.
The policyholder is not taxed on the increase in the contract’s account value. However, if the insurer gives the policyholder a degree of control over investments underlying the contract that is inconsistent with treatment of the insurer’s status as owner of the assets, the tax benefits of the policy will be forfeited. Investor control is determined based upon the facts of a specific situation.
Taxation of Annuity Income for Foreign Investors
IRC Sec. 871 subjects “fixed and determinable” income including annuities to a thirty percent withholding tax. Article 18 of the Model Income Tax Treaty dealing with pensions and annuities overrides the taxes imposed under IRC Sec. 871. Article 18 essentially provides that the annuity is not subject to U.S. income and withholding tax.
The annuity income is only taxed in the foreign jurisdiction. Many foreign jurisdictions provide tax advantages to life insurance and annuity income for individuals. Alternatively, annuity income may be exempt from taxation under treaties as “other income” not specifically defined within the treaty.
IRC Sec. 892 defines the income tax treatment of foreign government entities. IRC Sec 892 provides an income tax exemption to foreign governments that invest in stocks, bonds, and other domestic securities. This income tax exemption does not extend to investment in commercial activities including real estate. However, Reg.1.892-3T(3) defines “other domestic securities “to include annuity contracts. Therefore, annuity income is exempt income for a foreign government entity.
Strategy Example and Comparison
The Leveraged Blocker Corporation
Acme Investment Management is sponsoring a private equity real estate fund in U.S. distressed real estate. The fund is raising $300 million ($100 million each) from a UK, Dutch and French institutional pension plans. Each investor will invest $75 million into the blocker corporation as debt and $25 million as equity. The debt will have an interest rate of 10 percent per annum.
The blocker corporation contributes $100 million for investment in one U.S. real estate asset. The fund holds the asset for two years and sells the asset for $160 million. From the gain, $148 million is distributed to the investors and $12 million is distributed to the general partner as carried interest. $100 million of the distributions is treated as a return of capital and $48 million is treated as gain.
The blocker corporation has taxable income of $26 million ($48 million less $21 million for two years of interest). The blocker corporation pays taxes of $10.4 million ($26 million * 40% federal and state). The blocker corporation has $137.6 million to distribute to shareholders after paying taxes.
The corporation distributes to the investors $75 million as repayment of debt and $25 million as a return on equity. An additional $22 million is distributed as interest. Under the applicable treaty, there is no withholding tax on interest income.
The remaining $15.6 million is treated as a dividend payment. Under the applicable treaty, each of the investors is subject to a 15 percent withholding tax on dividend income. The blocker corporation withholds $2.34 million from the distributions.
The total combined taxation is $12.74 million. The effective tax bracket is 26.54% ($12.74 tax liability divided by the $48 million profit). The tax rate that would have been applicable under the standard blocker structure would have been 54%.
Acme creates an insurance dedicated fund (IDF) with Corona Life, a Delaware domiciled life insurer, to invest in its private equity real estate venture into U.S. distressed real estate. The IDF is structured as a Delaware LLC. The only investor will be Corona Life on behalf of its policyholders and the Corona separate account. The GAC is U.S. tax qualified and will meet all of the requirements of IRC Sec 817(h) and IRC Sec 72.
Based upon the total premium (investment) commitment, Corona charges the policyholders 15 basis points per annum. Under each of the treaties, annuity income is not subject to U.S. income and withholding taxes. Therefore, neither Acme nor Corona will be required to withhold anything on its distribution.
Assume the same facts as the description above except for the fact, that the GAC structure has no tax leakage. As a result, the IDF will have an additional $12.74 million in investment income before the application of Corona’s fees. Corona’s fees over the two year period on a total investment of $300 million are $450,000 in Year 1 and $450,000 in Year 2.
Corona does not have any withholding tax obligation on the distribution of $147.1 million. The effective equivalent tax bracket on the same transaction is 1.875% (900,000 of insurance fees divided by $48 million). More importantly, none of the foreign investors are required to file a U.S. income tax return.
A cliché often attributed to Albert Einstein goes something like this “the definition of crazy is doing the same thing over and over and expecting different results”. Professionally, we tend to operate within our own professional areas of expertise where we use the same silo of solutions over and over again with the same results. And the results are not necessarily bad, but they can be even better.
In the area of foreign investment in U.S. real estate, the use of the standard blocker corporation is an ‘old trick”. The leveraged blocker corporation is a sophisticated and more complex version of the same technique with much better results. The cost of the leveraged blocker corporation is high as well. The complexity is also high.
The GAC provides better tax results by large measure than either of the two techniques. I know that I do this for a living but the GAC is not a complex product. It is the same product that many average Americans buy (albeit on a private placement basis).The range of tax issues is arguably more straight-forward although many foreign institutional investors are new to the private placement variable annuity- a much more conventional product. The tax treatment of the variable annuity is well settled even with foreign investors.
The use of the GAC with foreign real estate investment is a new structure by real estate tax professionals and their investment manager clients. However, the tax treatment of variable annuities is reasonably well settled. The GAC converts income that would otherwise be subject to withholding under FIRPTA and ECI into “annuity” which under most tax treaties is not subject to U.S. income and withholding taxes.
The next time that an investment manager (private equity or real estate) decides to create a new fund for foreign investors in U.S. real estate, consider the GAC as an investment structure that can dramatically enhance the after-tax return of the foreign investor.