Strategic Investment Tax Planning for Non-Resident Aliens Using Private Placement Variable Annuities – Part II

by Gerald Nowotny
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Overview

Part I of this article addressed the potential benefits of private placement variable annuities (PPVA) for wealthy non-resident alien taxpayers. Generally, tax treaties make all of this possible. As a result, annuities are not subject to U.S. income taxes and withholding taxes overriding the onerous taxation of IRC Sec 871(a) – a 30 percent withholding tax. PPVA contracts are institutionally priced providing for a cost structure that is between 25-75 bps per annum depending upon the size of the assets within the annuity. The point – the cost of the PPVA is far less than cost of taxation even at the preferential rates for interest and dividends under many treaties. For income that is taxed at ordinary rates such as Effectively Connected Income to a U.S. trade or business, there is no better tax structure than the PPVA.

Part II of this article will advance the strategy even further by analyzing the creation of a small life insurer by the client in order to issue the PPVA contract as well as other insurable risks. This strategy is a sophisticated strategy that by definition is for wealthier and more sophisticated clients. The amount of “brain damage” involved in understanding and implementing the strategy is not that great. Said another way, the possibility of creating tax-free income and avoiding U.S. transfer taxes should be sufficient incentive to undergo an insurance lobotomy.

Background

Many wealthy non-resident aliens (NRA) have invested in the U.S. in commercial real estate as well as U.S. businesses. The current economic turmoil suggests that many European investors are also investing in U.S. real estate as a safe haven. Many new Chinese millionaires are looking for ways to invest in the U.S. as well. In spite of the difficult economic situation currently in the U.S., foreign investors see the U.S. as the most politically stable country on the planet.

From a tax perspective, this type of income is treated as effectively connected to a U.S. trade or business (ECI) for U.S. tax purposes. ECI is subject to a 25 percent withholding tax. When a NRA sells U.S. real estate, it is subject to FIRPTA which imposes a withholding tax obligation on the Buyer.

The current economic environment suggests tax rates are increasing. The Bush tax cuts expire at the end of 2012. The top marginal tax rate increases along with the long term capital gains rate. Dividends will be taxed as ordinary income. These tax cuts occur before any new legislation is put before Congress.

The Problem

NRAs with real estate and business holdings in the U.S. are generally taxed at ordinary taxes. FIRPTA, a real estate withholding tax, applies on the sale of U.S. real estate, and a 35 percent withholding tax applies on business income.

Additionally, many of these assets are subject to U.S. federal estate taxes which apply for estates in excess of $60,000.

The Solution

The strategy calls for the creation of a small closely held life insurance company that is owned by the NRA or a family trust. The insurance company makes a tax election to be treated as a U.S. taxpayer. The life insurer issues a PPVA contract to the family trust of the NRA. An insurance fund within the PPVA invests in U.S. real estate. Under the provisions of the Internal Revenue Code and annuity provisions of most tax treaties, the taxable real estate income is converted in tax-free “annuity” income.

Most foreign jurisdictions which have the benefit of a tax treaty with the U.S. enjoy favorable tax provisions for annuity income. Under these treaty provisions, annuity income is not subject to U.S. income or withholding tax. Annuity income without the benefit of a tax treaty provision would be subject to a 30 percent withholding tax under IRC Sec 871(a).

A Private Placement Variable Annuity (PPVA) contract is an institutionally priced deferred variable with customized investment options. PPVA contracts are virtually "no load" annuity contracts. The customized investment options may include alternative investments including real estate. A PPVA contract may feature a real estate account that invests in U.S. real estate. The cost of the PPVA contract is 25-75 bps annually – a lot less than the marginal tax rate!

An offshore life insurance company may make an election under IRC Sec 953(d) to be treated as a U.S. taxpayer for the insurer's tax purposes. In effect, the offshore is equivalent to a domestic life insurer for corporate tax purposes. It is the life insurer's separate account which is the investor in the real estate fund within the PPVA contract.

A small life insurer under IRC Sec 806(a) receives special income tax treatment - a 50 percent deduction on investment income. The insurer may operate as a multi-line insurer that also issues property and casualty coverage to the Client's operating businesses in the U.S. as well as foreign jurisdictions. Property and casualty reserves must be less than 50 percent of the total reserves under IRC Sec 806.

The small life insurer may be owned by the foreign family in an offshore trust. The shares will be outside of the estate for U.S. estate tax purposes. The insurance contract - PPVA contract - will also be a non-U.S. sitused asset under IRC Sec 2105. The real estate income within the PPVA contract converts ECI to "annuity" income which is exempt under most tax treaties with the U.S. The offshore insurer will also pay little or no U.S. taxes.

  1. Create closely held insurance company treated as a small life insurer. Domicile insurer in U.S. Virgin Islands, Puerto Rico or Bermuda or Cayman. Carrier operates as a multi-line insurer.

2. Insurer sells surplus lines coverage and reinsurance to NRA owned operations focusing on self-insured risks. Premiums are tax deductible for NRA tax purposes. Insurer not taxed or very low taxes on premium income.

3. Insurer issues fixed or private placement variable annuity to Trustee of family trust owned in New Zealand. In kind (non-cash premiums paid through transfer of title to insurer.

4. FIRPTA and ECI not applicable due to continued ownership by Bermuda insurer which is IRC Sec 953(d) electing.

5.  U.S. -NRA Home Country Tax Treaty exempts annuity income. Real estate income converted to annuity income exempting it from taxation.

6. Interests in LLCs and LPs owning existing U.S. real estate may be transferred to the offshore insurer as an in kind premium for the purchase of a PPVA contract.

Summary

The closely held insurance company provides a sophisticated solution for wealth NRA who own businesses and real estate in their home country and the U.S. The solution reduces home country taxation and shifts funds to a safe jurisdiction which is treated as a U.S. Commonwealth with special tax status. Alternatively, the insurer makes a U.S. tax election in a jurisdiction such as Bermuda or Cayman. The insurer is also able to issue annuities maximizing a benefit within the tax treaty and as a result convert business income into exempt annuity income.

This is a sophisticated concept with a hundred "moving parts". This executive summary was intended to demonstrate the possibilities and under-utilization of private placement insurance structures by wealthy non-resident alien investors.

Written by:

Gerald Nowotny
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