Private credit tax considerations: PwC

Jason Baker

Partner, Asset & Wealth Management Tax, PwC US

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Peter Sproul

Principal, Insurance Tax, PwC US

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Ryan Wilson

Director, Financial Markets & Real Estate Group, PwC US

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Insurance companies are increasingly investing in private credit to achieve higher yields while diversifying their portfolios. While this strategy may help to produce returns that align with their asset-liability management frameworks — particularly for life and annuity carriers — realizing its full potential requires a proactive approach to navigate tax complexities.

Insurers often partner with asset managers to utilize various structures, such as rated feeder vehicles, which may be useful in managing regulatory risk-based capital (RBC) obligations. Meanwhile, other insurers who haven’t partnered with asset managers are developing in-house capabilities or using insurance-owned asset management functions to navigate private credit investments effectively. Regardless of the approach, insurance companies typically are laser focused on financial modeling and regulatory considerations — but tax executives and CFOs who fail to appreciate related tax implications could face unanticipated challenges.

This is also true for asset managers who handle private credit on behalf of insurance companies, given that many insurers are relatively unfamiliar with this type of investment. To attract insurance company capital, asset managers need a basic understanding of typical insurer investment strategies. More importantly, they need to understand structures, investor profiles, assets held and the relevant tax considerations to develop a successful private credit product. It’s also critical to have well-defined processes for preparing and producing tax reports that meet the insurance company’s requirements.

Insurers, on the other hand, need to thoroughly document the investment, including tax technical considerations, such as expected book-tax differences, and the legal form, to tailor their internal processes effectively. Throughout the life cycle of the private credit investment, insurers also need to monitor returns and adjust investment decisions, potentially rotating out of certain asset classes or shifting to derivatives while striving for accurate and compliant tax reporting.

Here are key questions to consider.

What’s driving insurer’s increased exposure to private credit?

Insurers can be a reliable source of capital for asset managers, given life and annuity carriers’ ability to deploy capital into more illiquid and longer-term asset classes.

Private credit offers the potential to achieve higher yields relative to other asset classes and thereby support various insurance products. Certain structures can be designed to fit within the asset-liability management (ALM) construct and regulatory risk-based capital (RBC) guidelines set forth by the National Association of Insurance Commissioners (NAIC).

How are insurers gaining access to private credit?

Holding debt instruments or other investments directly on an insurer's balance sheet.

Holding both debt and equity in a structured vehicle (vertical exposure), which may or may not be treated as “stapled” for federal income tax purposes. However, if an insurer owns all tranches of debt and equity, the vehicle is typically disregarded for federal income tax purposes. (See below.)

Owning an interest in a feeder vehicle that invests in underlying credit funds, often structured as debt and equity interests in a partnership.

The debt tranches are typically rated by rating agencies. The form of the investment and its associated rating influence how much capital the insurer must keep in reserve, known as the risk-based capital (RBC) charge. These structures are typically designed to address RBC charge concerns. Recent updates from the NAIC, however, have changed how certain investments are classified. Some debt investments may fall into a different category, potentially leading to higher capital charges.

What does structuring look like in practice?

Insurance company leaders may look beyond direct ownership of assets to other investment vehicles that offer more flexibility in managing capital charges while still gaining exposure to underlying credit assets.

For example, some insurers may establish their own securitization structures — similar to collateralized loan obligations (CLOs) — where 100% of the debt and equity tranches are held by the insurance company. These vehicles can reduce the insurance company's risk-based capital (RBC) charge through holding debt tranches, which generally improves capital efficiency.

For tax purposes, the securitization vehicle is generally treated as a disregarded entity — as if it doesn’t exist. Accordingly, the insurance company must look through to the underlying loans to compute taxable income and disregard the securitization vehicle tranche activity, such as interest income from the debt tranches.

It’s important to note that additional complexities may arise if multiple parties invest in the vehicle or if the insurance company sells the tranches.

What are tax focus areas across the life cycle of an investment?

As demonstrated above, each structure has its own legal, regulatory and accounting considerations, as well as specific tax complexities. Insurance companies may face unique considerations.

It’s important to understand the participants in the transaction and whether the structure will be considered a partnership, a debt investment, a disregarded entity or another form of entity for tax purposes.

The type of structure will typically drive data obligations for the insurer and asset manager. If an asset manager manages a wholly owned structure, for instance, the manager may be responsible for preparing asset-level computations. Insurers and asset managers should discuss this at the beginning of the investment cycle.

An investment in rated notes will require upfront structuring and analysis of the instrument and arrangement to determine the US tax classification as debt or equity and the relevant required tax reporting.

Differences in treatment under NAIC statutory accounting, US GAAP and tax rules can pose operational challenges, such as the manual tracking of book and tax reporting across multiple tranches.

Special considerations apply, including under sec. 163(j), when insurers own both debt and equity instruments in a vehicle.

Potential tax implications may apply if the vehicle restructures the debt that it has issued, or debt instruments held by the vehicle are modified. 

Derivatives leveraged by insurers to manage certain risks, such as interest rate or credit risk, may introduce additional tax complexities. 

The treatment of distressed debt differs between the type of taxpayer holding the debt (for example, a partnership versus an insurance company). Insurers and asset managers should discuss significant debt events and the appropriate tax treatment, including the tax character of related income or loss.

Making the most of private credit 

Insurers will continue to expand capital investment in private credit through direct ownership and structured vehicles, introducing various tax challenges. Early coordination across all stakeholders is important in addressing those challenges.