Brother, Can You Spare a Dime?

Using Private Placement Variable Deferred Annuity (GAC) Contracts to Enhance the After-Tax Investment Return of Tax Exempt and Foreign Investors in Direct Lending Investments

Overview

Domestic and foreign institutional investors have increasingly turned to direct lending funds in an effort to increase fixed income investment returns in the face of decreasing bond yields over the last five years. The Barclay’s aggregate bond index has provided a return of 5-6 percent over the last several years while direct lending funds have returned 10-14 percent. These funds have been popular in Europe and have expanded popularity with large pension plans.

Domestic and foreign institutional investors in direct lending have to contend with tax considerations such as unrelated business taxable income (UBTI) and effectively connected income to a U.S. trade or business (ECI) which reduce the after-tax total return of these investments. This adverse tax treatment can reduce the overall benefit of direct lending investments for investors if these taxes need to be paid.

This article is designed to introduce and address a unique structure that generally has not been available to direct lending firms, and the large law firms that provide legal and tax structuring services for the direct lending fund sponsors. This structure will significantly enhance after-tax investment returns.

The group private placement variable deferred annuity (GAC) has been an effective structuring vehicle for real estate and a number of other alternative investment strategies for a number of years. Unfortunately, its use by institutional investors has not been widely publicized due to the fact that these investment offerings were largely made directly by life insurers using their wholly owned investment advisory firms without the use of intermediaries.

Over the course, of the last twenty or so years, at least $50 billion of investment transactions have been made through the GAC by insurers such as The Principal, Prudential, John Hancock, Met Life and others. In a legal environment where legal professionals tend to operate in their respective “silos” of expertise, it is time to embrace the use of new approaches and techniques to solve “tax leakage” problems.

Annuities 101- A Brief Overview

An annuity contract is a contract between the policyholder and insurance company to pay an annuity to the policyholder. Insurance companies offer two types of annuities – immediate and deferred. Immediate annuities provide a stream of payments at fixed intervals (monthly/quarterly/semi-annually or annually). The annuity is paid for a term of years or based on a life contingency such as “life only” or “joint and survivor” The payments end at the end of the fixed term or death of the annuitant (measuring life).

A deferred annuity is a deferral of that promise to make a series of payments to the policyholder. The deferral may be set for a fixed period of time. Many contracts list a maximum age of 85 or 90 for the deferral period. The account value in a “fixed” annuity is based upon the crediting rate based upon the insurer’s investment performance on general account assets. Most insurance general account investments are in investment grade bonds.

In a variable annuity the investment performance is based upon the on investment performance of separate account funds. These funds are segregated from the insurer’s general account assets traditionally, these funds are mutual fund clones or sub-accounts managed by investment management firms in the mutual fund industry. The investment performance for these accounts is a direct pass-through to the policyholder.

What is a Group Private Placement Variable Deferred Annuity?

The private placement version of this product is for accredited investors and qualified purchasers based upon the definition under federal securities law. Like PPLI, the products are institutionally priced with no surrender charges. The investment options include hedge fund, private equity and real estate options as well as traditional mutual fund-like options.

The institutional investor such as a pension plan, endowment, foundation or sovereign investor that purchases a private placement variable annuity purchases a group version of the product. This version features a class of annuitants and generally unallocated accounts. The institutional investor is the applicant, owner, and beneficiary of the group annuity contract. The policy features a group of annuitants (measuring lives) such as the officers and directors of a foundation.

Status as an annuitant within the contract does not confer any policy benefits or management and control of the annuity contract in favor of the annuitant. Furthermore, the policyholder is not required to annuitize, i.e. convert the account value to a stream of payments to the policyholder, over the annuitant’s lifetime. As a practical matter, institutional policyholders rarely (if ever) annuitize an annuity contract.

Dealer Status for Tax-Exempt and Foreign Investors

U.S. tax exempts and foreign investors and their investment advisors have a high degree of interest in tax structuring for investment in direct lending strategies that are effectively connected to a U.S. trade or business (ECI) or treated at UBTI. Generally, a foreign investor does not want to be in a situation where the investor has to file a U.S. tax return and come within the jurisdiction of the IRS or state tax authorities. The GAC would allow a foreign investor to avoid the IRS’ jurisdiction.

Generally ECI tax treatment results from financing activities such as mezzanine funds; funds that invest in distressed bank loans or similar securities that may involve loan origination; loan syndicate participation, secondary market purchases of revolving loans, commitment or other funding fees as well as participation on creditor committees. Fees from portfolio companies may also constitute ECI.

Many of the tax structures currently used are very complicated and deliver results with a moderate to high degree of tax leakage.  The GAC has the potential to deliver very compelling results to the foreign investor private or sovereign wealth fund.

The GAC has the unique ability to convert the character of ECI for tax purposes into “annuity” income which is not subject to U.S. income and withholding under virtually all of the double tax treaties with the United States. Annuity income is specifically exempt from UBTI for tax exempt investors.  No other tax structure is without any tax leakage, low administrative cost and technical simplicity, e.g. once you understand what a variable annuity is and how and why it works.

The GAC is able to capture and convert all of this taxable income into non-taxable “annuity” income.  A life insurer is taxable on all of its investment income within the separate account and is able to take a reserves deduction for all of its investment income within the separate account.

A foreign investor is taxable in theory on annuity distributions or surrender of the annuity contract. Without the benefit of a tax treaty, a foreign policyholder would be subject to a 30 percent withholding tax under IRC Sec 871(a). Virtually all of the double tax treaties exempt annuity income from income and withholding tax treatment for U.S. purposes. Furthermore, planning exists that would allow an annuity policyholder without the benefit of a tax treaty to obtain similar results.

Sovereign wealth funds are taxed under IRC Sec 892. IRC Sec 892 treats an annuity contract as a domestic security whose income is tax exempt. As a result, the GAC has the ability to convert direct lending income that might be taxed as ECI into tax exempt income. Equally as important from a non-tax standpoint, the use of the GAC eliminates the need to file a federal and state tax return and also eliminates K-1 reporting to the foreign investor.

The GAC is a complete solution to this problem.  The life insurance company separate account is considered the legal owner of the investments and as a U.S. taxpayer, is not subject to any of the foreign withholding taxes under IRC Sec 1446. The quarterly distributions paid by the direct lending to the insurance company separate account are not subject to any withholding taxation.

The annuity provisions of the Model Income Tax Treaty have been incorporated in the majority of existing tax treaties.  Article 18 of the Model Income Tax Treaty provides favorable treatment for annuity income.

The Model Treaty provides that annuity income is only taxed in the home jurisdiction and not subject to taxation or withholding in the U.S.  Most pension plans will not be subject to taxation in the home jurisdiction. Many foreign jurisdictions also provide favorable taxation for life insurance and annuities.

Tax treaty definition of an annuity is quite basic in most cases. In a few of the newer treaties, the tax benefits are only applicable to annuities that are beneficially owned by individuals in a manner similar to IRC Sec 72(u).

Treaty provisions override the 30 percent withholding tax imposed under IRC Sec. 871. These overrides may apply even if it is determined that the annuity is not a valid annuity under U.S. tax law but nonetheless a valid “annuity” under the definition within the tax treaty.

As a practical matter, I believe that it is nonetheless advisable to issue a GAC that complies with the requirements of U.S. tax law.  For a high net worth investor, the policy should be issued by an offshore carrier that has made an IRC Sec 953(d) election. This carrier level election treats the offshore carrier as a U.S. taxpayer eliminating any withholding obligation for ECI.

Additionally, the annuity contract is not considered a U.S. sitused asset for federal estate tax purposes eliminating any potential estate tax exposure for the foreign investor.

IRC Sec. 892 provides an income tax exemption to foreign governments, which invest in domestic stocks, bonds, and “other domestic securities”. This income tax exemption does not extend to investment in direct lending and commercial activities including real estate.

However, Reg.1.892-3T(3) defines “other domestic securities” to include annuity contracts.  Therefore, a properly structured annuity with a direct lending investment option will not be subject to the normal taxation and withholding requirements for ECI and U.S. real estate investments or FIRPTA withholding requirements.

The character of the income is converted to annuity income, which is exempt income for the foreign government under IRC Sec. 892.  Additionally, the foreign government will not a tax filing income at the federal or state level.

Summary

Direct lending investments are very attractive investments in general. Total returns significantly exceed the bond market; however, UBTI or ECI take a significant “bite” out of the total return of direct lending investment. The GAC as an investment structure eliminates this tax bite. The GAC provides an effective structure without leakage for tax exempt and foreign investors. Funding structuring attorneys and investment management firms involved in direct lending investments should consider the GAC as the most efficient tax structure for tax exempt and foreign investors involved in U.S. direct lending activities.

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