Seeing the Forest through the Trees -- A New Method for Structuring Investment by Foreign Investors in U.S. Timber and Agriculture Funds

by Gerald Nowotny


Large institutional investors including pension plans and endowments and foundations have made significant investments in timberland over the last forty years. These same investors have also made significant investments in agriculture but to a lesser extent. The price per acre of farmland has appreciated dramatically over the last 70 years.  Institutional investment in U.S. timberland is often part of a global timber investment strategy. Needless to say, taxation is an important component in investment restructuring. Taxes represent a direct and significant reduction in the investment return of the investor.

This article is designed to outline an alternative investment structure for foreign investment in U.S. timberland and agriculture. The proposed investment structure is a private placement group variable deferred annuity contract (GAC). This structure is not only less costly but is also dramatically more efficient that the current structures being used by timber investment management organizations (TIMO).

The only problem that the GAC has is a lack of familiarity by TIMOs and the belief by TIMOS and investors alike is that the results are too good to be true. Hopefully, by the end of this article you will conclude that it is true.

Timber and Agricultural Investing

Since the mid-70’s large institutional investors began investing in timberland. This investment coincided with the passage of ERISA in 1974 which required a fiduciary obligation to diversify investments. The investment trend was from fixed income to stocks as well as commercial real estate. The ownership of timberland provided another investment diversification opportunity. Around the same time, forest product companies began to evaluate the strategic role of timberland holdings seeing the opportunity to sell their timberland and invest in wood-processing facilities. Pension funds and endowments and foundations became the logical buyers of this timberland.

Timberland has unique investment characteristics. It provides a hedge against inflation and provides investment returns that are non-correlated with stocks and bonds. Timber is a renewable resource that increases in value as trees mature. Investment returns are generated through timber sales, lease income and land sales. As of 2011 the amount of institutional investment in timberland approached $45 billion.

Agricultural investments have many of the same investment attributes as timberland – current income from leasing activities, crops and capital appreciation. The crops range from permanent cropland types such as almonds, apples, and walnuts. The range of corps can also include grapes, cranberries, pears and wheat. Agricultural investments provide an inflation hedge, and non-correlated investment returns to the stock market and current income.

Current Tax Structuring for Foreign Investment in U.S. Timberland and Farmland Investments.

Sophisticated tax structuring is generally involved in the investment activities of foreign private and sovereign investors in U.S. timberland and farmland investments that generate portfolio income that is subject to withholding taxation and FIRPTA withholding related to the sale of the underlying real estate.

The focus of this investment structuring generally at accomplishes several important tax and non-tax objectives:

  1. Avoidance of the need on the part of the foreign investor to file a U.S. income tax return and falling under the scrutiny and jurisdiction of the IRS.
  1. 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.
  1. Avoidance of withholding for FIRPTA on the underlying real estate
  1. Minimization of corporate taxation on the “blocker” corporation structure frequently used as part of this planning.

Taxation of Portfolio Income

IRC Sec 871 provides for a 30 percent withholding tax for fixed and determinable or periodic gains (FADP) unless a tax treaty provides for a lower rate of withholding. IRC Sec 871(h) provides an exemption for portfolio interest income. Dividends are frequently taxed at a 15 percent rate under many treaties.

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 Offshore 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 also 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 Standard U.S. Blocker Corporation Arrangement

A foreign investor may alternatively invest in a U.S. corporation that is taxed as a regular corporation. The U.S. Corporation invests into the fund. As a result, the foreign investor will avoid the need to directly file a federal tax return. Instead, the U.S. Corporation will file any federal or state tax returns that are needed.

Additionally, the U.S. blocker corporation will not be subject to FIRPTA withholding tax treatment. However, the U.S. blocker corporation will be responsible for any federal and state level corporate taxes. The top federal rate is 35 percent and the average state income tax rate is 5-8 percent. As a result, taxation in the blocker corporation could be taxed at a combined bracket of 35-40 percent. After the payment of corporate taxes, dividends distributed to the foreign investor will subject to withholding taxes.

The Leveraged Blocker Corporation

The leveraged blocker corporation is frequently used in private equity real estate transactions. The strategy is designed to convert ECI into portfolio interest which is exempt and dividend income. 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.  The interest payments reduce taxation at the corporate level.

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.

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.

The issue with respect to the use of leverage in U.S. blocker corporation investments with respect to timberland investments and agriculture is the lack of liquidity and relatively low income from these investments in order to make interest payments. Additionally, the blocker corporation is frequently structured with a high level of interest for the purpose of creating tax-free income and high interest payments to reduce corporate taxation at the blocker corporation level. The nature of the cash flows and projected investment return does not support the use of high interest debt at the blocker corporation level. Even in the best case scenario, the corporation will be taxed in the 23-25 percent level for federal purposes with an additional 5-8 percent for state tax purposes.

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).

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, i.e. you don’t have to be doing business with John Hancock in order to utilize this strategy. 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.

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.

FIRPTA is not applicable in the use of the GAC. The life insurer, a U.S. taxpayer, is the direct investor and owns the investment in its insurance company separate account under state insurance law. The foreign investor does not have a direct or indirect ownership interest in the U.S. real property. The foreign investor is policyholder that is able to receive the pass-through performance of an allocation of premium (investment) in a Timber Account managed by the TIMO.

Therefore, as long as the GAC is a U.S. tax qualified annuity, FIRPTA withholding should into apply. Furthermore, the life insurance company is able to take reserves deduction for any investment income that it receives in its separate account. Additionally, the FIRPTA rules provide for an exemption from FIRPTA withholding when there are no income taxes due.

Strategy Example

Timber Using a U.S. Blocker Corporation

Acme Investment Management is a timber investment management organization investing  in several different U.S. timber markets – Southeast; Northeast and Pacific Northwest. The fund is raising $100 million ($100 million ) from a UK pension plan. The investor will invest $100 million in the U.S timberland.

One structure being considered is a U.S. blocker corporation. The corporation is a Delaware limited liability company that will be taxed as a corporation.  Under the treaty, the dividend payments to the UK pension plan will be non-taxable to the pension plan. The ultimate liquidation of the corporation should also be non-taxable as a capital gain to the pension plan.  The timberland investments will be owned by the corporation and will not be subject to FIRPTA.

The intended timberland investment will produce current income of 5 percent or $5 million per year in  lease income and cutting rights. Acme expects to liquidate the holdings in twenty years with an expected price of $386 million based upon a 7 percent growth rate. The blocker corporation will be in a 35 percent tax bracket for federal purposes and 5 percent bracket for state purposes.

The blocker corporation will pay corporate taxes on income and gains on the timber investments before it makes dividend distributions. The combination of taxes will erode the expected investment return of 12%  by approximately to a net return of 7.2 percent.


Acme creates an insurance dedicated fund (IDF) with Corona Life, a Delaware domiciled life insurer, to invest in U.S. timberland. 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 25 basis points per annum. The total cost per year is $250,000 per year. Over the course of the twenty year life of the fund-the total projected GAC costs are $5 million. The total cost of the GAC is roughly equal to the investor’s tax liabilities using the blocker corporation in the first 2-3 years. 

The GAC will not have any withholding for FIRPTA. Under the treaty, 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. Corona does not have any withholding tax obligation on the income distributions of  any of the annuity payments or at liquidation of the investments. Corona is not subject to withholding under FIRPTA on the sale of the real estate.


In the area of foreign investment in U.S. real estate, the use of the standard blocker corporation is an ‘old trick” for foreign investment in U.S. real estate.

The GAC provides better tax results by large measure than either of the two techniques. The use of the GAC with timberland  is a new structure for foreign investors but is well known because of Hancock Natural Resource’s use for tax exempt investors.

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 a timber investment management organization decides to create a new fund for foreign investors in U.S. timberland or agriculture, consider the GAC as an investment structure that can dramatically enhance the after-tax return of the foreign investor.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Law Office of Gerald R. Nowotny | Attorney Advertising

Written by:

Gerald Nowotny

Law Office of Gerald R. Nowotny on:

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