Over the past twenty years or so, “variable” life insurance and annuity contracts have become increasingly popular with U.S. citizens as income tax and estate planning tools. This popularity stems from certain advantages afforded these products under the Internal Revenue Code — both defer income tax on the internal build-up within the contract until the contract is paid out at a later date (internal build-up is the investment income that accumulates within a contract) thus allowing for income tax planning, and life insurance proceeds can be exempt from federal estate tax if properly structured.
There are technical rules and regulations that must be met for the policy to qualify under Section 72 of the Internal Revenue Code which govern the manner and taxation of payments from annuity contracts. A discussion of these technical rules is beyond the scope of this note, which instead focuses on the tax compliance requirements whichapply when a U.S. person purchases and then holds a foreign annuity contract, in the deferral or holding phase.
The Internal Revenue Code does not specifically define an “annuity contract” but, as mentioned above, regulates the contractual relationship under Section 72, including contracts that are considered to be annuity contracts in accordance with the customary practice of life insurance companies.1 There is no further definition of “customary practice” and no discrimination between domestic and foreign annuity contracts under Section 72, and thus the rules and regulations which concern variable annuities apply to any contracts which U.S. persons may purchase from U.S. or foreign carriers alike.
Accordingly, a number of foreign life insurance companies have developed U.S. tax-compliant policies for U.S. persons who wish to take advantage of the income tax and estate planning advantages of such policies. One attraction of a foreign policy is that it is not subject to certain investment restrictions imposed on domestic carriers under insurance laws of their home states. As a result, the foreign policy can still be U.S. tax-compliant, but may offer more flexible and diversified investment options. Another difference touted by foreign carriers is that they are not subject to U.S. income taxes, and are thus able to pass this cost saving to their policyholders.
During the past 10 years the legal environment has constantly changed. Although we are not tax advisers we have always informed our clients about the tax and reporting situation, and where the law was not clear we have recommended remaining on the safe side and reporting their policies. The good news about the past legal changes is that there are no open questions and the reporting situation is crystal clear:
Excise Tax: Form 720 (filing due date the end of the quarter for each investment)
In looking at this potential tax advantage of foreign insurers (or tax disadvantage of U.S. insurers), Congress chose to impose an excise tax on premiums paid to a “foreign insurer” for the insurance of various U.S. risks.2 For policies “of life, sickness or accident insurance or annuity contract”, a 1% excise tax is imposed on the “premium paid”,3 which means the gross premium without reduction for expenses or other policy-related costs. This excise tax is imposed whether the premiums are paid by a U.S. or foreign person, so long as the policy is attributable to the risks of a U.S. “insured”.
This excise tax liability must be reported, and the excise due must be paid, by filing Form 720 Quarterly Federal Excise Tax Return with the IRS. The tax return must be filed within a month from the last day of the quarter and must include all appropriate taxes due. For example, the first quarter of 2012 includes contracts purchased in January, February and March and Form 720 for this quarter is due April 30, 2012. The return can be submitted and tax paid by any person who makes, signs, issues or sells an annuity, or for whose use or benefit the same are made, signed, issued or sold; all are liable for the tax imposed by Section 4371.4 A number of U.S. income tax treaties provide an exemption to the U.S. excise tax for qualified insurers in the treaty partner country (contracting state). The availability of a treaty exemption is thus insurer specific, but it is important to note that where a treaty exemption applies, although the excise tax need not be paid, the requirement to File Form 720 still applies, including a treaty based disclosure which must be attached to the Form. It is also important to note that U.S. income tax treaties include a “limitation of benefits” clause and that the issuer of the annuity must be a bona fide resident of the contracting state” for the treaty exemption to apply.
It is also important to note Section 4371 includes record retention obligations. Finally, since tax laws are most commonly enforced by application of penalties, the IRS can impose penalties for filing a return late, depositing taxes late, paying taxes late, willfully failing to collect and pay tax or file an Excise Tax Return, negligence, and fraud, including double the amount of the tax where the IRS determines there was actual intent to evade the excise tax.5 These penalties are in addition to the interest charged on late IRS may not impose penalties for filing a return late if the taxpayer can show that the failure to file a timely return was due to reasonable cause. A showing of reasonable cause is made by providing an explanation of the reasons for the late filing attached to the return.
FBAR Reporting- FinCEN Form 114 Report of Foreign Bank Accounts (filing deadline June 30, for previous year accounts)
The increased popularity of variable life and annuity contracts, and the recognition that these are powerful investment vehicles, has not gone unnoticed at the Treasury Depart-ment. These contracts have therefore been under increased scrutiny and Treasury has expanded the scope of investments required to be reported on FinCEN Form 114 Report of Foreign Bank and Financial Accounts – known as the “FBAR” – under the Bank Secrecy Act which requires U.S. persons to keep records and file reports where they maintain a relation with a “foreign financial agency”.6 Under Final Regulations implementing Section 5314 of the Bank Secrecy Act, the term “financial account” now includes “an account that is an insurance policy with a cash value or an annuity policy”.7 In order to be reportable, the policy must be “in a foreign country”, a term that presumably includes a policy issued by a foreign insurer.
These Final Regulations were enacted on February 24, 2011 and say this about timing: “The final rules contained in this document apply to FBARs required to be filed by June 30, 2011 with respect to foreign financial accounts maintained in calendar year 2010 and for reports required to be filed with respect to all subsequent calendar years”.
Accordingly, the U.S. owner of a foreign annuity contract should have included details of that contract in their 2010 FBAR filing (due June 30, 2011) and in subsequent years’ Non-willful failures to file an FBAR that the IRS determines were not due to reasonable cause are subject to a $10.000 penalty per violation. The civil penalty for willfully failing to file an FBAR can be as high as the greater of $100.000 or 50% of the total balance of the foreign account per violation.
A taxpayer who is late in filing an FBAR with regard to a foreign annuity policy owned in 2010 can apply for penalty relief based on reasonable cause. Some facts and circumstances which Treasury will consider in determining reasonable cause include the taxpayer’s having previous knowledge of the filing requirements (including any prior penalties), the level of complexity of the tax or compliance issue, and recent changes in the tax forms or law. Per these issues, it seems Treasury should accept a reasonable cause argument for taxpayers who simply did not know of the 2010 FBAR requirement as it applies to an annuity policy.
Specified Foreign Asset Reporting – Form 8938 (New Reporting Obligation – filing deadline due on the same day you file your individual return including extensions)
In March 2010, Congress passed the HIRE Act which included within it various provisions known as the Foreign Account Tax Compliance Act or FATCA. FATCA includes various reporting rules intended to make “foreign financial institutions” provide the IRS with information regarding their U.S. account holders. Also included in FATCA is new Code Section 6038D which requires U.S. taxpayers to report “specified foreign financial assets” on Form 8938 if the aggregate value of those assets exceeds $50.000 during the 9 This requirement is effective for taxable years beginning after March 18, 2010 (when the HIRE Act was enacted) – so in effect for tax year 2011.
Section 6038D and its regulations do not mention whether annuities issued by foreign insurers are considered “specified foreign financial assets”, but it is likely that the IRS treats these contracts as reportable assets which include “any financial instrument or contract held for investment that has an issuer or counterparty which is other than a United States person …”.10 In addition, IRS has issued a set of FAQs on its website11 in which it provides examples of specified foreign financial assets. The examples include “any interest in a foreign-issued insurance contract or annuity with a cash-surrender value”. Although these FAQs do not have force of law, IRS does have latitude in interpreting and enforcing laws and regulations and including an annuity within the family of “financial instruments held for investment” is certainly within the scope of their authority and discretion.
Thus, beginning with tax year 2011, U.S. persons with specified foreign financial assets in excess of $50.000, including life and annuity contracts with cash values, will have to file Form 8938 and report those assets.
Need professional help
Since penalties for not reporting or reporting wrongly can be draconian, we strongly recommend you get professional help. If you don’t have access to a CPA who is familiar with international investments and reporting, we are able to recommend skilled professionals who would be pleased to work with you. We maintain a network of experienced tax experts either in the U.S. or here in Switzerland.
Here in Switzerland we are working with with “U.S. Tax and Financial Services”, an international group of experienced CPAs. They can assist you with your filing and advise you on all international tax matters. Just let us know and we will be pleased to make an introduction to your personal U.S. Tax and Financial Services advisor.
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