This article was originally published in the August 2009 Life Settlements Review
Tax considerations determine the structure of paper backed by life insurance settlements ("LIS"). From an offshore perspective, double taxation treaties ("DTTs") exist between the United States of America ("US") and a number of offshore jurisdictions. From an onshore perspective, in addition to domestic US taxation rules, which are generally beyond the scope of this paper, it is important to consider the Internal Revenue Service ("IRS") rulings relating to LIS. One of the IRS rulings includes references to non-US persons and accordingly may impact DTT protections from which investors in LIS funds benefit.
The use of DTTs
A number of offshore jurisdictions offer the possibility of
domiciling a fund which would raise finance from investors in the
US and outside of the US, by issuing securities. The return for
investors, both with respect to the principal amount and coupon of
the investment, would be secured by an underlying pool of LIS
assets, acquired using part or all of the proceeds of the
securities issue. The securities could take the form of debt, in
which case investors would receive interest payments relative to
their noteholding, or equity, in which case investors would receive
distributions relative to their fractional ownership of the
offshore fund.
In each case, the purpose of a DTT is to identify and permit the
payment stream to an investor from the offshore fund to be
delivered without a need for the paying agent to withhold amounts
for income tax liability in the jurisdiction of the offshore fund.
Under the US-Ireland DTT, for example, the benefits of the DTT are
only accessible to qualifying persons. An Irish fund complying with
the provisions of section 110 of Ireland's Taxes Consolidation
Act 1997 would be a "qualifying fund." Interest paid by a
qualifying fund does not give rise to Irish income tax liability if
the recipient is not a resident of Ireland and is resident in
either the EU or a DTT jurisdiction. Accordingly, an Irish paying
agent would not need to withhold amounts relating to Irish income
tax liability on behalf of a US owner of the fund's
securities.
Revenue Rulings 2009-13 and 2009-14
Revenue Ruling 2009-13 and Revenue Ruling 2009-14 provided
guidance on the federal tax consequences of the sale, surrender or
maturity of life insurance contracts. Revenue Ruling 2009-13
contains three holdings, one relating to surrender of policies and
two relating to sales. The latter two holdings will be applied
adversely with respect to sales of policies which occur from August
26, 2009 onwards. In light of this, the industry has seen a marked
increase in life settlement sales (apparently this is also the case
with respect to surrenders). Presumably this will have resulted in
significantly increased paper workload for carriers. Consequently,
this may cause a backlog in applications to transfer the legal
ownership of policies which extends beyond August 26, 2009. It is
unclear whether the IRS will impose a tax liability upon a seller
of a policy in a situation where documentation transferring
beneficial ownership of a policy was executed prior to August 26,
2009, but the transfer of legal ownership was not completed until
after August 26, 2009.
Revenue Ruling 2009-14 relates to the maturity and/or sale of term
policies without cash surrender benefits. The third situation
examined in this ruling relates to the amount and characterization
of income recognized by a foreign corporation that is not engaged
in a trade or business within the US (including the trade or
business of purchasing, or taking assignments of, life insurance
contracts) upon the receipt of death benefits. The ruling holds
that such benefits constitute ordinary US source income. Gains
realized would be taxable at 30% under Section 881(a)(1) of the
Internal Revenue Code (i.e. fixed or determinable annual or
periodic income – "FDAP"). The position
relating to income from a sale of policies by the foreign
corporation to a third party was not addressed by the IRS in
Revenue Ruling 2009-14. The life insurance carrier, payment agent
or other administrator could therefore fall within the IRS's US
withholding agent rules and become responsible for withholding an
amount to represent the deduction from the taxable gain realized by
an offshore fund. The amount of the gain may not be verifiable by
the administrator. Moreover, the applicable DTT may contain
exemptions relating to FDAP, of which the administrator may need to
be aware. A further complication may arise where the beneficial
owner of the death benefit is a tax neutral US vehicle wholly owned
by the offshore fund.
Conclusions
There are a number of possible finance-raising structures involving
an offshore qualifying fund in a DTT jurisdiction, where payments
to investors are funded by death benefits accruing from the
underlying LIS portfolio. Such portfolio may be beneficially owned
by a US tax transparent subsidiary of the offshore fund and
administered by US service providers. Best practice guidelines will
need to be developed to deal with US withholding requirements in
light of relevant DTT protections applying to FDAP. Revenue Ruling
2009-14 should be supplemented to include gains upon sales of
policies by foreign corporations. In addition, it is unclear
whether Revenue Ruling 2009-13 requires completion and return of
change of ownership forms prior to August 26, 2009.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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