How to retain your account in a Foreign Financial Institution
A. Overview
In my last installment, I discussed the benefits of a private placement insurance contract (life insurance or annuity) issued by a life insurer domiciled in Puerto Rico – Isla del Encanto – for Americans living overseas.
Aside from providing tax-advantages, the Puerto Rican private placement insurance contract does not constitute a foreign account for FBAR and Form 8938 reporting purposes. The reason for this rests in the fact that as an American Commonwealth, Puerto Rico is not a foreign country under the regulations.
However, the bigger issue for many Americans living overseas is the inability to open or retain an account in a foreign financial institution. I have heard from a number of colleagues that this is a serious problem for Americans living overseas. As the U.S. continues to sign joint agreements with trading partners such as the UK, Germany, Holland, Japan, Spain et al, it is clear that the U.S. and OECD members are tightening the noose quickly on offshore funds .
This article will focus on how a private placement life insurance or annuity contract issued by a Puerto Rican domiciled life insurer can be used to retain an account with a foreign financial institution while meeting all of the compliance requirements of Uncle Sam. I did say legally!
B. Private Placement Insurance Products
Private placement insurance contracts are institutionally priced, customized variable universal life insurance and private placement variable deferred annuity contracts. The products are limited to accredited investors or qualified purchasers as defined under federal securities law.
These policies offer customized investment options for policyholders. The policies must be compliant under U.S. tax law for American citizens and resident aliens.
C. Tax Requirements for U.S. Insurance Contracts
One of the primary attributes of private placement insurance contracts is the ability to create a customized investment account within the policy. The policy must meet the investment diversification requirements of IRC Sec 817(h) and Treas Reg. 1.817-5. Prior to Rev. Rul 2003-91 and Rev.Rul 2003-92, the form of these customized accounts took two forms – (1) a Managed Account aka Asset Allocator Model (2) Insurance Dedicated Fund aka IDF.
The two revenue rulings specifically referred to insurance dedicated funds and not managed accounts. As a result the “higher ground” in the formation of funds within private placement contracts is the IDF. Nevertheless, some carriers believe that the asset allocator model is still a viable solution. The IDF is a fund created for variable insurance contracts. The only way to invest in the fund is through the purchase of a variable insurance contract – life insurance or variable annuity.
In the IDF, the insurance company is legally the owner of the investment asset and not the policyholder. The policyholder through a fund election form is able to designate which fund to allocate his account value. The policyholder receives the pass through of the investment performance.
D. FBAR, Form 8938 and Offshore Life insurance
The regulations are very clear that accounts in certain U.S. commonwealths such as Puerto Rico, Guam, American Samoa, U.S. Virgin Islands and the North Marianna Islands are not subject to the reporting requirements of FBAR and Form 8938. The account value or cash value of a foreign life insurance or annuity policy is a reportable item.
E. Creating an Account in a Foreign Financial Institution
In the last two years or so, Puerto Rico (PR) has updated its insurance legislation to encourage the formation of insurance companies operating internationally in Puerto Rico. In effect, Puerto Rico has become on “onshore –offshore” jurisdiction for insurance. Puerto Rico also has strong separate account legislation which segregates the assets in a variable life insurance or annuity contract from the claims of the insurer’s creditors. Under PR law, the policy assets are exempt from the claims of the policyholders creditors.
Several life insurers issue private placement U.S. tax compliant life insurance and annuity contracts. These companies absorb very little risk. Virtually all of the mortality risk is shifted to investment grade reinsurers. Additionally, the separate account or investment assets of the policy are custodied with large independent financial institutions.
The IDF may be structured as a foreign corporation or foreign LLC such as a Cayman corporation or LLC. Under the laws of the Cayman Islands, the investment income is not subject to taxation. The investment income received as the insurance company level is not subject to taxation for U.S. or PR tax purposes as the investment income is deductible as a contribution to the insurer’s reserves for corporate tax purposes. The policyholder is not taxable on this investment income as the policy is a U.S and PR. tax compliant policy.
The investment custodial account is created in the name of the foreign corporation or LLC. All of the interests in the foreign corporation are owned by the investment manager and the insurance company separate account. The only way to invest in the foreign corporation LLC is through the purchase of the variable insurance contract.
The account holder with the foreign financial institution is not a U.S. person, it is the foreign entity. Importantly, Passive Foreign Investment Company (PFIC) tax rules have an exception for active insurance companies.
Case Study
The Facts:
Alan Smith, age 50, is an American attorney that has spent the last twenty years in his firm’s London office as a legal expert in international trade. As a partner in the firm, Alan has enjoyed financial success. He maintains an investment portfolio managed by the London office of a Swiss investment banking firm. The investment account has a current value of $3 million.
The account is subject to the new reporting obligations outlined in FATCA – (1) FBAR and (2) Form 8938. The two countries have recently signed a joint agreement regarding the accounts of Americans.
The investment firm is pressuring Alan to transfer the account to another firm. Alan has been with his broker for the last twenty years and would like to retain the account with his broker.
The Strategy:
Alan creates a Nevis trust to serve as the applicant, owner and beneficiary a private placement variable deferred annuity contract issued by Acme Life, a specialty Puerto Rican life insurance company. The contract is U.S. tax compliant and features an insurance dedicated fund that is managed by the Swiss investment bank that currently manages Alan’s personal account. The investment mandate provides the investment bank with complete legal authority and discretion to “buy and sell” based on the investment objectives.
The account is structured as a Cayman LLC. The funds are custodied with a Swiss bank. The investment bank is the managing member and the insurance company separate account is the only other authorized member in the LLC. Alan assigns his investment account with his broker to Acme as an in kind or non-cash premium. The policy PPM features two investment accounts – (1) Acme Money Market Account and (2) Swiss Cheese Investment Fund (managed by Swiss investment Bank).
The policyholder is not subject to FBAR reporting or completion of Form 8938. Additionally, the foreign financial institution is comfortable with the idea that the IDF is not an American account subject to reporting to the U.S. Government. The investment income is not taxable, as it is held within a variable annuity contract that is U.S. compliant. It is also not taxable to the policyholder under the U.S.-UK Income tax treaty.
Summary
The strategy outlined above provides a practical and effective method that will allow Americans with foreign accounts within foreign financial institutions to retain an account with a foreign financial institution through a private placement insurance contact issued by a life insurer issued in Puerto Rico. Furthermore, the account and policy is not subject to reporting under FBAR and Form 8938. Additionally, the investment income within the policy is non-taxable in the UK and U.S. since the policy is a U.S. tax complaint policy.
Authors Note: The above article was written by Gerry Nowotny, a tax and estate planning attorney with a JD and LL.M in estate planning from the University of Miami School of Law.
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