Offshore Variable Annuity

REPLY: One of the reports I have written is about offshore variable annuities, but it also includes an extensive introduction to the subject of annuities in general. The complete report is included in my paid subscribers' web site or it can be purchased in printed form or as an e-book. That report is about 55 pages long, so this response is only a very brief explanation of the U.S. tax treatment of foreign annuities.

These comments are only about annuity contracts that are not payments from a qualified retirement savings plan. (Such payments are usually fully taxable.) A fixed return annuity is one where the insurance company guarantees a fixed annual payment for a term of years or for the rest of the life of the annuitant and/or joint annuitants. Taxes are not due by the annuitant until the payments begin. At that time, a calculation is made of the portion of the estimated total payments (based on life expectancy) that will be a return of the amount paid for the annuity contract and the amounts that represent earnings from investing the cash value in the contract.When payments begin, a part of each payment is tax free and the rest is taxable.

With a variable annuity, the amount paid by the annuitant is invested in a variety of different kinds of investments similar to mutual funds. The annuitant is allowed to choose how much of the cash value is allocated to different kinds of funds -- such as a bond fund, a growth stock fund or a fund that invests in international stocks. These funds are only available through the insurance company and can't be purchased directly through a brokerage account. Because the income earned by the variable annuity is dependent on the performance of the investments, the amounts paid to the annuitant will vary and can't be predicted in advance.

When it is time for the insurance company to begin making payments to the annuitant, the amount paid for the annuity is divided by the life expectancy of the annuitant(s) to determine the portion of the payments each year that is a return of capital and therefore tax free. The amounts received in excess of that number are taxable.

An offshore annuity is simply an annuity contract that is issued by a life insurance company that is not licensed to do business in the U.S. In order to purchase an offshore annuity, the buyer (annuitant) must apply for the policy outside the U.S. However, if the terms of the policy meet the requirements of the IRS so that the policy qualifies as an annuity contract, then the same tax benefits are available as from a policy issued by a U.S. insurance company.

But there is a complication with respect to a fixed return deferred annuity issued by a foreign insurance company. Because of some regulations issued by the IRS early in 1998 (TD 8754, IRC 1275), fixed term contracts where the annuity payments begin at a future date are treated like a discounted bond or multiple year certificate of deposit. The income earned by the cash value is taxable on an annual basis. This regulation involves debt obligations, and a variable annuity is not a debt obligation. In addition, there is an exception for fixed return annuity contracts where the annuity payments begin within one year of the date the contract is issued.

"Interest" received from an offshore variable annuity is NOT taxed as a dividend and is not even treated as interest. It is treated as what the tax law calls "ordinary" income, similar to the income received from a retirement savings plan.

This may be more than you wanted to know, but it is also an extremely limited and brief explanation of a very complicated subject. For a more extensive explanation of the tax treatment of offshore variable annuities, see my report described at www.offshorepress.com/osva-info.htm

by Vern Jacobs

The comments in this memorandum are not intended to constitute an opinion regarding any specific tax issues because additional tax issues may exist that could affect the tax treatment of the tax issues addressed in this memo.

This memorandum does not consider or reach a conclusion with respect to those additional issues and was not written and cannot be used for the purpose of avoiding penalties under code section 6662(d) with respect to those issues outside the scope of the memorandum.

For further details see
www.offshorepress.com/vkjcpa/disclosurerules.htm