I have always been a film fan. Growing up in the Panama Canal Zone, one of my Mother’s jobs for the Panama Canal Company was serving as the manager of the Balboa Theater. We used to watch initial screenings of movies together on the Big Screen as a private viewing while eating lunch from the Balboa Clubhouse. As a Spanish and Portuguese major I became a foreign film buff. As a college student and foreign language major, films like Dona Flor and Her Two Husbands and Gabriela reinforced this interest. My personal favourite is the Italian Movie, The Best of Youth., all six hours of it. I have probably seen the film three or four times. I have three daughters and only my youngest daughter has displayed any interest in foreign film. The older girls are big fans of The Walking Dead which leads me to the topic of this article, third party investment in life settlement contracts.
Life Settlement investments represent a $20 billion investment asset class. The life settlement investment opportunity involves the purchase of an existing permanent life insurance policy. Normally the purchase is made at a significant discount from the policy’s death benefit and for more than the policy cash value. The underlying life insurer of the policy is normally an investment grade life insurer. Therefore, the life settlement investment profile provides for investment return in the mind-teens with bond-like volatility and investment grade quality.
At this juncture, most of the investment capital has flowed from banks and other institutional investors; however, large U.S. domestic pension plans and endowments and foundations have not actively participated in this asset class in spite of the stable and attractive investment return profile due to the controversial social policy optics associated with the investment and speculation of the insured.
In the realm of private placement life insurance (PPLI) the lack of investment liquidity in the first seven-eight years creates an obstacle that life insurers are able to overcome for the payment of policy benefits through a policy endorsement that allows the life insurer to delay distribution until the policy has sufficient liquidity or alternatively, to distribute the policy benefits in kind.
The group private placement group variable deferred annuity contract offers substantial benefits in structuring institutional investment in life settlement funds. From the perspective of the domestic U.S. tax exempt investor – pension plan, endowment or foundation – the annuity contract masks the underlying investment in the life settlement fund. From a legal perspective, the underlying owner of the investment is the life insurer issuing the group annuity contract investing through its segregated account funds. These funds are statutorily owned by the life insurer and reported to life insurance regulators. The investment performance flows through to the group annuity policyholder that selects an investment in a life settlement sub-account.
From the perspective of a foreign investor, the group annuity contract overcomes the withholding treatment associated with the life settlement investments. This summary provides an overview of the benefits of the private placement group variable deferred annuity contracts.
What is a GAC?
The GAC in the context of this report is a private placement group variable annuity contract. The product is institutionally priced and available exclusively to accredited investors who are qualified purchasers. Registered versions of the GAC are frequently used in the IRC Sec 401(k) marketplace. From a tax standpoint, the contract is designed to be in complete compliance with IRC Sec. 72 (i.e. the tax law definition of an annuity), IRC Sec. 817(h) (I.e. the investment diversification rules for variable insurance products), and the Investor Control Doctrine. Note however that a GAC issued to a pension plan as defined in IRC Sec. 818(a) is not subject to the broad investment diversification rules of IRC Sec 817(h). From an ERISA standpoint, the life insurer issuing the annuity contract is an investment fiduciary and subject to ERISA’s fiduciary standards.
Administratively, the GAC is a single contract that has optional payout annuity purchase provisions. The contract provides pricing assumptions for these payout annuities.
The GAC marketplace for tax-exempt investors envisions two distinct private placement memoranda (PPM) – a qualified plan offering and a non-qualified plan offering. The GAC contract for the qualified plan marketplace is an unallocated single contract that provides no named annuitants within the contract but does provide annuity settlement options. Generally, the plan trustee is the applicant, owner, and beneficiary of the GAC. In the case of tax-exempt organizations that are not pension plans as defined in IRC Sec 818(a) such as an endowment or foundation, an allocated GAC contract is frequently used.
This contract provides for named annuitants and provides for sub-accounts for each of the primary annuitants. The primary annuitants represent a group of measuring lives that have some sort of professional affiliation with the tax-exempt organization. An example of this concept might be the professors of a large university on behalf of the university’s endowment. The tax-exempt organization is the applicant, owner, and beneficiary of the GAC. The primary annuitants have no legal interest in the GAC or its benefits. The primary annuitants are strictly measuring lives in the event an annuity payment must be made in the event of a death of a primary annuitant.
From the standpoint of the institutional investor, the investor is the applicant, owner and beneficiary of a GAC that features a customized investment fund, i.e. a life settlement fund. The investor pays a premium to the specialty life insurer issuing the GAC. The investor as a policyholder allocates the premium to the life settlement fund. For legal purposes, the life insurer is treated as the owner of the investment assets. The investment performance flows through policy for the benefit of the policyholder. The institutional investor that is an endowment, pension plan, or foundation would list the GAC as the investment asset on its balance sheet rather than the life settlement fund.
Taxation of Life Settlement Investments
Revenue Ruling 2009-13 and 2009-14 provides for the tax treatment of life settlement investments. Generally, investment gain up to the amount of inside buildup must be treated as ordinary income under the “substitute for ordinary income” doctrine. The balance of the investment gain may be treated as long-term capital gain income if the policy(ies) are held for longer than one year. The death proceeds associated with the life settlement investment are treated to taxation as fixed or determinable annual or periodical that is taxable under IRC Sec 881(a)(1) at thirty percent.
Tax Treatment of Annuity Income under U.S. Tax Treaties
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.
Effectively, the Treaty definition of an annuity supersedes the tax law definition of an annuity in IRC Sec. 72. The IRS has issued a favorable Private Letter Ruling (PLR 980612) examining this issue. A Private Letter Ruling is not law, and may not be relied upon by a taxpayer, but provides an indication of the IRS’ position on different tax issues.
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.
Tax Treatment of Annuity Income for Sovereign Wealth Funds
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 life settlements 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 life settlement 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.
Life settlements offer an appealing investment return profile – equity-like returns with bond-like volatility. Another way to look at it might be as an investment grade bond with junk bond yields. The GAC is a unique structure that has the ability to enhance institutional investment in life settlements. First, the socially sensitive institutional investor such as a pension plan, endowment or foundation has the ability to redirect the ownership of the investment in life settlements funds rather than take direct ownership in the investment asset. Nevertheless, the investment performance of the life settlement investment flows through to the policyholder. Second, the GAC eliminates the taxation on life settlement investments by foreign investors. The GAC offers a clear path to enhance institutional investment in the life settlement asset class.
Gerald Nowotny – Osborne & Osborne, PA
266 Lovely Street
Avon, CT 06001
Law Office of Gerald R. Nowotny