Background
Overview
This article addresses questions regarding the use of private placement variable deferred annuity (PPVA) contracts for non-resident alien high net worth investors with investments in the U.S. Additionally, the article will focus on PPVA contracts purchased by high net worth investors as a planning as a conduit for U.S. real estate investment and the application of FIRPTA as well as the impact of effectively connected income (ECI) to a U.S. trade or business.
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. Many tax treaties provide for reduced taxation for dividend and interest income of fifteen and ten percent respectively.
Article 18 of the Model Treaty 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. Most treaties (but not all!) provide for this favorable tax treatment for annuities.
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.
Private Placement Group Variable Deferred Annuities (GAC)
The PPVA is a private placement variable deferred annuity 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 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 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. PPVA contracts are taxed as a variable deferred annuity under the appropriate provisions of the Internal Revenue Code (IRC Sec 72 and IRC Sec 817(h)).
U.S. Tax Qualification for Annuities
Annuity 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).
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. 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.
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. As a result, the PPVA contract should be issued by an offshore life insurer that has made an IRC Sec 953(d) election to be treated as a U.S. life insurer. Alternatively, the PPVA may be owned within an irrevocable trust.
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.
IRC Sec 871(d) gives a non-resident alien the right to treat U.S. real estate investment as effectively connected income 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 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.
The application of FIRPTA provides a few exceptions for the withholding requirement. One exception applies to the sale of a principal residence and the amount of gain not exceeding $300,000. Another key exception applies with respect to publicly traded stock owning U.S. real estate with the selling shareholder owning less than five percent of the outstanding shares for the five year period preceding the sale. Another exception applies if the transferor ( such as a life insurance company separate account) provides a certification stating, under penalties of perjury, that the transferor is not a foreign person.
Also, an exception under FIRPTA applies if the transferor provides written notice that no recognition of any gain or loss on the transfer is required because of a non-recognition provision in the Internal Revenue Code or a provision in a U.S. tax treaty. IRC Sec 72 provides for non-recognition to the policyholder (investor) and insurance company. The majority of U.S. tax treaties with foreign nations provide that “annuity” income is not subject to U.S. income and withholding taxes.
The PPVA converts real estate investment income that would otherwise be subject to FIRPTA into annuity income which is exempt either under the provisions of a tax treaty or IRC Sec 892 for sovereign investments.
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.
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.
Strategy Example
Facts
Juan Valdez is a wealthy Mexican industrialist. The Valdez family office maintains an investment office in New York City and San Francisco that focuses on U.S. investment opportunities. The family office is looking to make significant investments in multi-family housing. The family uses a real estate investment advisor, Taurus Investments, an independent investment specialist, in multi-family housing to manage the investments. Taurus will have discretionary authority over all investment decisions.
Solution
Taurus will create a new fund that will be exclusively offered through the purchase of a PPVA contract. The PPVA will be a U.S. tax qualified annuity contract issued by an offshore life insurer, Acme Life, to the Valdez Family Trust, a New Zealand Trust. Acme has made an IRC Sec 953(d) election. The funds are transmitted directly to Acme and allocated to the Taurus Fund.
All of the income and gains within the annuity contract will not be subject to taxation or withholding taxes under Article 19 of the U.S. – Mexico Income Tax Treaty. The annuity proceeds will not be subject to U.S. estate taxation.
Summary
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.
The key requirement for preserving the character of annuity income for tax purposes is satisfaction of the federal tax requirements for variable insurance products, principally the Investor Control Doctrine and investment diversification requirements. If these requirements are met, the character of any investment income within the annuity income is transformed into tax-free annuity income.
