Life Insurance on the
Move: Cross-Border Tax Implications and Opportunities for Canadian and
by John Adney and Philip Friedlan
Philip Friedlan, Friedlan Law, practices in
Date: Jun. 7, 2005
Insurance on the Move: Cross-Border Tax Implications and
Opportunities for Canadian and
By Philip Friedlan and John Adney
Many Canadians and Americans move back and forth across the Canada-United States border to live and work. Often the individual, his or her family members, or another entity will own life insurance on his or her life or the life of a family member. If so, unanticipated and sometimes adverse income tax consequences can result.
Using two case studies, this article will
explore the U.S. income tax and estate tax implications, the Canadian income
tax implications, and opportunities (if not necessities) for tax planning
relating to life insurance when a Canadian resident moves to the United States
or a U.S. citizen or resident moves to Canada. First, a brief overview and
comparison of the relevant Canadian and
Overview of Canadian Tax Rules
The section that follows provides a summary of the Canadian federal income tax law relevant to the case studies and to the planning commentary discussed later in this article.
The federal government of
A person resident in
There are no estate or gift taxes imposed in
The following is a list of areas of the Canadian Act and the draft legislation released on October 30, 2003,4 that are relevant to the discussion in this article:
(a) exempt test and accrual taxation;5
(b) dispositions of life insurance policies;6
(c) taxation of segregated funds;7
(d) emigrating from
(e) nonresidents holding life insurance policies issued on Canadian residents by insurers carrying on business in Canada;9 and
(f) taxation of foreign insurance policies.10
The Canadian Draft Legislation is the latest version of the draft legislation implementing the 1999 federal budget proposals that are intended to stop Canadian residents from using foreign vehicles to avoid income tax on investment income.
Life insurance policy -- A life insurance policy is defined to include an
annuity contract and a contract all or any portion of the insurer's reserves
for which vary in an amount depending on the fair market value of a specified
group of properties (that is, a segregated fund).11 What constitutes
a life insurance policy or an annuity contract under the Canadian Act would be
determined in accordance with the principles of statutory interpretation. It
seems likely that the typical types of life insurance policies available in the
Categorization -- Life insurance policies may be classified on a nontechnical basis into three general classes for the purposes of the Canadian Act: registered, nonregistered and segregated funds. Registered life insurance policies and annuity contracts are policies or contracts that are issued under deferred income plans, such as a registered pension plan.
A segregated fund of a Canadian life insurer
is the Canadian equivalent of a
A nonregistered policy is a policy other than a registered policy or the portion of a policy that is a segregated fund.
Nonregistered Life Insurance Policies -- The current life insurance policyholder tax rules,
which became law more than 20 years ago, created two classes of life insurance
policies, exempt policies and nonexempt policies. The former class of policies
is regarded by the government as primarily providing insurance protection, and
the latter class is regarded as being used primarily for investment purposes.
Nonexempt policies are generally not offered for sale in
Basic Rules -- The following summarizes the basic rules applicable to nonregistered life insurance policies (subject to elaboration below):
(a) a policyholder is taxed on the income occurring on the disposition of the policyholder's interest in a life insurance policy;13 and
(b) the income "earned or accrued" in a nonexempt life insurance policy is taxable annually on a policy-year basis to the policyholder.14
A capital gain or loss cannot arise regarding nonregistered life insurance policies.15
Exempt Test -- A life insurance policy is an exempt policy if it satisfies the exempt test found in the Income Tax Regulations.16 The exempt test limits the amount of cash/fund value that can be accumulated in a policy relative to its death benefit, the effect being to limit the amount of income that can be accumulated in a policy on a tax-deferred basis. If a policy does not satisfy those conditions, then it will be or will become a nonexempt policy, and, as indicated above, the policyholder will be subject to annual taxation on the income earned or accrued thereunder.
The exempt test is basically a comparison of the cash values (or more technically, the accumulating fund) of the actual policy to the accumulating fund of one or more standard policies known as exemption test policies (ETPs). In simple terms, a policy will satisfy the exempt test if its accumulating fund does not exceed the accumulating fund(s) of the notionally issued ETPs on a current, past, and projected basis.
The accumulating fund of the actual policy at any time is generally the maximum amount that the life insurer could deduct at that time as a reserve in respect of the policy in calculating its own corporate income tax under the Income Tax Regulations applicable to policies issued before 1996.17
An ETP is a hypothetical life insurance policy -- basically a 20-pay endowment at age 8518 -- that is stated by the Income Tax Regulations to be issued in respect of the actual policy at the time of issue and possibly at subsequent dates.19 Importantly for the application of the exempt test, the accumulating fund of an ETP is computed in accordance with the Income Tax Regulations,20 as is the ETP's death benefit, and the life insured thereunder is the life insured under the actual policy.21 As should be evident, the determination of the ETP's values requires both legal and actuarial input.
Dispositions -- As indicated above, if a policyholder "disposes" of an interest in a life insurance policy, the policyholder will be taxed on the gain -- the excess of the proceeds of the disposition over the adjusted cost basis (that is, the tax basis or ACB) to the policyholder of that interest immediately before the disposition.22 An interesting feature of the ACB of a life insurance policy is that it is reduced annually by the mortality cost for the year, as determined in accordance with rules and a mortality table specified in the Income Tax Regulations.23 The effect of the adjustment is to increase the income earned in the policy for tax purposes.
A disposition includes (but is not limited to) the surrender of a policy, a partial withdrawal, a policy loan,24 or the payment of a policy dividend.25 Some events are not dispositions, including the assignment of a policy as collateral for a loan and the termination of the policy as a consequence of the death of the life insured when the life insurance policy is an exempt policy.26 Also, a policy dividend that is used to pay a premium or purchase paid-up additional insurance, as well as the crediting of interest to a policy's accumulating fund, is not treated as a disposition. A special rule applies on a partial disposition (other than a policy dividend or policy loan): A pro rata portion of the accumulated income will be included in the income of the policyholder.27
Rollovers -- The transfer or distribution of an interest in a nonregistered life insurance policy of a deceased, Canadian resident policyholder to his or her surviving spouse who was resident in Canada immediately before the death may occur on a rollover basis (that is, without recognition of income).28 Similarly, an interest in a nonregistered life insurance policy may be transferred on a rollover basis from the holder to the holder's spouse or a former spouse in settlement of rights arising out of their marriage or conjugal relationship if the transferor and the transferee are resident in Canada at the time of the transfer.29 The transferor may elect to have either transfer occur in accordance with the ordinary rules. It should be noted that a spouse includes a qualifying common-law spouse of the opposite or same sex.
A more limited rollover is available for transfers of an interest in some nonregistered life insurance policies (but not annuity contracts) to the holder's child, grandchild, or great-grandchild.30
Taxation at Death -- As noted above, with respect to an exempt life insurance policy, a payment in consequence of the death of a life insured is not a disposition under the Canadian Act,31 and the death benefit is tax-free.
In the event of the death of the life insured or the policyholder under a nonexempt life insurance policy, there is a deemed disposition immediately before the death. As a result, the untaxed income accrued in the policy to the date of death will be included in the income of the policyholder in the year of death and will be subject to taxation. Even so, in the case of the death of the life insured, the mortality gain or the insurance element of the death benefit -- the net amount at risk -- will not be taxed.32
Immigrating to and Emigrating From Canada -- Specific rules apply when a taxpayer ceases to be or becomes resident in Canada.33 If a person ceases to be resident in Canada, the rules cause some accrued gains and losses in property to be recognized for income tax purposes.34 If a person becomes resident in Canada, the rules operate so that gains and losses in certain property that accrued before the person became resident in Canada will not be taxed under the Canadian Act.35 These provisions, however, do not apply to life insurance policies in Canada held by individuals or trusts.36
Disposition of an Interest in a Life
Insurance Policy in
Capital Dividend Account -- The capital dividend account of a corporation is a notional account to which some amounts are credited. The amount by which the death benefit received by a corporation under a nonregistered life insurance policy exceeds the ACB of the policy to the corporation immediately before the death is added to the corporation's capital dividend account.39 Amounts that are credited to the capital dividend account of a private corporation may be paid out to Canadian resident shareholders as tax-free capital dividends.40 Capital dividends received by shareholders who are not residents of Canada are subject to nonresident withholding tax.41
Foreign Insurance Policies -- The provisions of the Canadian Act concerning foreign insurance policies are discussed later in this article.
The following discussion summarizes the
The scope of the
Life insurance definition. The
Death benefit and inside buildup. As a general proposition, if the requirements of section 7702 are met with respect to a life insurance contract, the undistributed gain accruing to the cash value of the contract -- the inside buildup -- grows tax-deferred, just as in the case of a contract complying with the exempt test in Canada. Further, as in Canada, there is no income tax on the contract's death proceeds.48 On the other hand, should a contract fail the definitional requirements, either intentionally or unintentionally, there is accrual taxation of the inside buildup.49 (This assumes, as does the case study described below, that no contract involved is part of a tax-qualified retirement plan.) The same is true, of course, in the case of a policy that fails the Canadian exempt test.
Apart from definitional considerations, the
Modified Endowment Contracts. Although the name "modified endowment contract (MEC)," has a life insurance-sounding ring, it does not derive from standard insurance literature, being solely a creature of the code. The provisions of section 7702A constitute another complex, actuarially driven definition, yet in simple terms a MEC is a more heavily investment-oriented contract than the typical, garden variety life insurance contract. Generally a MEC is a contract that is paid up with fewer than seven net level annual premium payments, but because section 7702A's "7-pay test" is measured by net premiums, it usually takes at least eight or nine level annual payments to avoid MEC status. A contract that succeeds in avoiding that status is coloquially called a non-MEC.
Lifetime distributions. Not surprisingly, the taxation of lifetime distributions is more favorable in the case of a non-MEC than it is for a MEC. If a partial withdrawal is taken from a non-MEC, the tax basis of the contract, or investment in the contract is deemed to be recovered first, with gain, or income on the contract, being withdrawn only after the basis has been fully recovered.50 Informally this is referred to as first-in/ first-out (FIFO) taxation, on the premise that the premiums arrived in the contract before the interest or earnings credits were credited thereto. For this purpose as well as for a full surrender, the gain in the contract is measured as the excess of the proceeds received over the investment in the contract (that is, the premiums paid less any previously untaxed withdrawals).51 (Premium payments are not deductible by an individual taxpayer, and they likewise are nondeductible by a business taxpayer if the business is an owner or beneficiary of the contract.52 ) Unlike the case in Canada, the tax basis of the contract is not reduced by mortality or cost-of-insurance charges.
Further, if a loan is taken under or against
a non-MEC, it is treated merely as a loan, with no tax consequences solely
because of the borrowing.53 That is true, moreover, whether or not
the loan exceeds the tax basis, unlike the rule in
If, on the other hand, a lifetime distribution is made from a MEC, largely the opposite tax treatment applies. A policy loan is taxed as if it were a partial withdrawal,54 and all predeath distributions -- partial withdrawals, surrenders of paid-up additions, and policyholder dividends paid in cash -- are taxed on an income-first basis.55 (Informally, this is called LIFO, or last-in first-out taxation.) This treatment applies as well to a loan taken from the insurer under the terms of a contract or from another party by pledging the contract as collateral. For that purpose, the income on the contract is defined as the gain (see above) unreduced by surrender charges.56 Also a 10-percent penalty tax will apply to any distribution, including a full surrender, the only exceptions being for distributions after the taxpayer's death, disability, or attainment of age 59 1/2.57 As a result, the penalty tax always will apply to a lifetime distribution taken by a policyholder that is not a natural person.
In sum, for favorable life insurance
treatment to apply regarding a contract under
Variable life, COLI, and contract
exchanges. Three final points should
be noted regarding the
Our Canadian Family
Bill, age 45, and Mildred, age 43, have been married for 23 years. They have three children, ages 14, 17, and 19. They are all Canadian citizens and residents. Bill owns two life insurance policies issued by Canadian life insurers. One of them is a joint last-to-die universal life (UL) policy covering himself and his wife. The other is a term-to-100 policy on Bill's life that has no cash value. The policies are nonregistered life insurance policies. We assume that each of these policies is an exempt policy under the Canadian Act at all times.
Bill, Sam, and Marcus each hold one-third of
the shares of Prodco. Prodco is a Canadian-controlled private corporation that
carries on an active business in
Sarah, age 38, is a
Sarah owns three life insurance contracts on
her life issued by
The Proposed Plan
Prodco is planning to expand into the
Sarah will marry Sam and move to
Canadian UL Product Features
The Canadian UL policy may have several typical features, some of which are relevant to the tax implications from a
(a) several death benefit options, including insurance plus cash/fund value (known in the United States as an option 2 death benefit);
(b) a variety of accounts into which funds may be deposited, including equity-linked accounts;
(c) the right to substitute life insureds;
(d) a payout of the fund value/surrender value of the first life insured to die under a joint last-to-die policy;
(e) one or more accounts external to the policy to which funds in the policy may be transferred so that the policy will remain an exempt policy under the Canadian Act;
(f) the availability of a variety of life insurance riders;
(g) a disability benefit without mortality charges that pays out the cash surrender value upon the life insured meeting the criteria in the policy; and
(h) critical illness and long-term care benefits.
Generally, when an individual leaves
If Bill disposes of an interest in the
Canadian policies after he has moved to the
Bill will need to report to the Canada Revenue Agency his reportable properties if they have a fair market value greater than $25,000. 64 Life insurance is a reportable property.65
Bill Moves to the
When Bill and Mildred become residents of the United States, they will be taxed by the United States on their worldwide income, subject to the rules of the Canada-U.S. Income Tax Convention (1980)66 and as mitigated by any applicable foreign tax credits. Because Bill and Mildred own life insurance policies, it will be necessary for those policies to meet the U.S. definition of life insurance (section 7702 of the code), and, preferably, for the policies to be non-MECs to obtain the favorable tax treatment typically accorded to policies (as noted above).
The term life insurance policy covering
Bill's life, which we defined as a term-to-100 policy that has no cash value,
should comply with section 7702. It was recognized as a life insurance policy
under the laws of
More problematic is Bill's UL policy, because
it is questionable whether the policy will comply with section 7702 in a number
of respects. First, to meet the definitional requirements, the policy must fall
Therefore, it is quite possible that Bill's
UL policy would not comply with section 7702, resulting in accrual taxation of
its inside buildup.70 If so, and if the noncompliance occurred
before Bill became a
Bill Moves to
Before Bill and Mildred cross the border, they will need to determine whether Bill's UL policy complies with section 7702 of the code. That will require a legal-actuarial analysis of the type that typically is done by
U.S-compliant policy. If Bill's UL policy is ascertained to comply with
section 7702 to date, albeit accidentally, then assuming Bill wants for the
coverage to continue, he will need to arrange for the policy to remain in
compliance. In the absence of an insurer performing this task, maintaining
compliance will be a difficult and potentially expensive undertaking. At the
moment, it seems, the best answer under
An idea: the dual-compliant policy. A better solution, of course, would be for Bill to
acquire a new life insurance policy that complies with both the Canadian exempt
test and the
Noncompliant policy. If, on the other hand, Bill's UL policy is
noncomplying (whether through testing or by assumption) and thus is subjected
to accrual taxation in the
A transfer solution? If Bill's Canadian-issued UL policy is (or is assumed
to be) noncompliant with section 7702, or may become noncompliant in the
future, it is appropriate to ask whether anything should be done before Bill
and Mildred leave Canada to deal with the associated problems. Specifically,
can Bill transfer the policy to another individual or a trust resident in
From a Canadian perspective. Unfortunately, Bill cannot transfer the policy before
If a decision is made to retain the
U.S.-noncompliant policy in existence but separate its ownership from Bill or
Mildred, accepting whatever Canadian tax consequences that result, the policy's
ownership could be transferred (1) to an individual resident in
Even if the proposed trust is irrevocable and
resident outside the
Bill Moves to the
After Bill and Mildred move across the border, the
In addition to the rules noted earlier,
particular mention should be made of the
A second point worth mentioning concerns the
excludability of benefits under Bill's Canadian-issued policy, assuming it is
U.S.-compliant, to provide for long term care, disability income, or critical
illness. Although those benefits can be structured to be tax-free under the
Third, the substitution of a life insured
under a policy is treated as a taxable exchange under U.S. tax law,77
triggering tax on all of the gain in the policy and leaving unclear the manner
in which the section 7702A (MEC) rules apply to the post-substitution policy.
One final comment that should be made
regarding any U.S.-compliant policy that Bill and Mildred maintain or acquire
is that, in view of their overall wealth and the probable size of the policy's
face amount, they should engage in estate planning. In the
Bill Dies --
Suppose Bill dies in the United States while owning the Canadian-issued (but U.S.-compliant) last-to-die UL policy, Mildred becomes the owner as a consequence of Bill's death, and no death benefit is payable on the first death. Under the Canadian Act, that transaction will be a disposition at cash surrender value.78 The rollover available for the transfer of a life insurance policy between spouses will not apply because Bill and Mildred are not residents of Canada.79 Consequently, Bill's death may result in an income inclusion in
In this instance, on the other hand, the
The Role of the Canada-U.S. Income Tax Convention
and Foreign Tax Credits
The treaty has several provisions to reduce tax -- such as Article X -- Dividends, Article XIII -- Gains, and Article XXIXB -- Taxes Imposed by Reason of Death. There is no provision that deals specifically with life insurance. Under Article XIII of the treaty, gains arising on the alienation of personal property (such as shares) are generally taxable only by the state in which the alienator is resident, with some exceptions, including one dealing with individuals. The role of the treaty is noted below.
For foreign tax credits, generally the country of residence will give its residents tax credits for taxes imposed by another country on income sourced in the other country. The role of foreign tax credits also is noted below.
When Bill leaves
Bill Moves to the
Prodco UL Policies
It is important to note that Prodco is not,
on the facts of the case study, what
The case study facts noted that Bill (and his partners) are considering establishing a shared-ownership arrangement with Prodco regarding the COLI policies. Although this may be done in Bill's case -- nothing in U.S. law or practice would preclude it -- the U.S. tax ramifications of taking such a step would need to be evaluated under the comprehensive split dollar regulations issued in 2003.86 The shared ownership arrangement would be called a reverse split dollar arrangement in the United States. In this case, because Prodco would be paying Bill to "lease" the net amount at risk under the policy, it would be necessary to determine whether Bill received from Prodco more than the fair market value of that net amount at risk (viewed as yearly renewable term life insurance). If so, then to the extent of the overpayment, Bill would be treated as receiving a dividend from Prodco.
Bill Dies in
Prodco policy proceeds. If Bill dies while in the
Criss-cross purchase arrangement. Under the criss-cross purchase arrangement, Mildred, acting on behalf of Bill's estate, sells his shares to Sam and Marcos, presumably at fair market value. In the United States, no income tax attaches because, at Bill's death, the tax basis of Bill's Prodco shares in Mildred's hands is automatically reset at their fair market value (without imposition of income tax when the reset occurs), so that the sale to Sam and Marcos at that same value produces no taxable gain.87 Also there is no estate tax because, when Mildred receives the shares, the 100 percent marital deduction applies. If the shares were transferred at Bill's death to a nonspouse, on the other hand, there could be an estate tax liability.
Under the Canadian Act, the shares of Prodco
would be taxable Canadian property, so ordinarily Bill would be treated as
having disposed of the shares immediately before death at fair market value. As
a result, there would be a capital gain, taxable in
Share redemption. If Bill's shares are redeemed from his estate, there
will be no
Under the Canadian Act, the redemption would
result in a deemed dividend. The deemed dividend would be subject to
withholding tax. If Bill has been in the
Bill in the
Tax Issues and Planning
Prodco policy proceeds. As noted above, the death proceeds payable under the Prodco-owned UL policies upon Marcos's death would be received by Prodco tax-free under both Canadian and
Criss-cross purchase arrangement. Under the criss-cross purchase arrangement, upon Marcos's death Bill would purchase one-half of Marcos's shares in Prodco for a promissory note. Following completion of the purchase and sale, Prodco would pay a dividend on the shares and elect to treat the entire dividend as a tax-free capital dividend. It is assumed that there are sufficient insurance proceeds for the purpose.
Under the Canadian Act, the dividend Bill receives will be subject to nonresident withholding tax regardless of whether it is a taxable dividend or a capital dividend. Because Bill will hold more than 10 percent of the voting shares of Prodco, the withholding rate will be 5 percent by virtue of Article X of the treaty.
Share redemption. If Marco's shares of Prodco are redeemed following
his death while Bill is alive, the usual Canadian tax rules will apply. Under
Use of a holding company. Suppose Bill's Prodco shares are rolled into a
holding company before he leaves
Sarah's Contract --
UL Product Features
According to the facts of the case study, Sarah, a U.S. citizen who will be moving her residence to Canada, owns typical U.S. fixed UL and variable UL contracts and also a term life insurance contract, all issued by U.S. insurers. Those contracts are all assumed to comply with the
The variable life contract can comply with the U.S. definition of life insurance, with the result -- unlike a Canadian segregated fund product -- that accrual taxation of the inside buildup is avoided and the death benefits are U.S. income tax-free. To achieve that result, U.S. tax law requires that the policyholder not be in control of the separate account assets (the insurer must own them, legally and economically), a requirement known as the investor control doctrine.93 To enforce that requirement, the assets of the separate account, and of each underlying fund, must be diversified in accordance with regulations.94
Either of the above types of contracts may be owned by a business, with essentially the same income tax treatment as would apply to an individually owned contract. In the case study involving Sarah, Usco owns a fixed UL, COLI contract to help fund Sarah's nonqualified deferred compensation plan; the contract may include a change-of-insured provision or rider. Also as indicated above, a split dollar arrangement may be entered into between an employer and an employee in which a contract's premiums or benefits (or both) may be shared between the parties. In the case study involving Sarah, her variable UL contract is subject to such an arrangement with Usco.
Foreign Insurance Policies, the FIE Rules, and
When Sarah moves to
The rules contain specific provisions concerning foreign insurance policies held by Canadian residents.95 A foreign insurance policy is a policy not issued by an insurer carrying on business in Canada the income from which is taxable in Canada under Part I of the Canadian Act.96 If an insurance policy is caught by these provisions, the ordinary rules for the taxation of life insurance do not apply.97 Instead, the taxpayer will, in general terms, be taxed currently on the annual increase in the fair market value of the policy.98 The fair market value of a policy, the proceeds of disposition and amounts paid to a beneficiary are determined without reference to benefits paid, payable, or anticipated to be payable under the policy as a consequence only of the occurrence of risks insured under the policy.99
There are several exceptions to the application of the rules concerning a foreign insurance policy for a taxation year. If one or more of the exceptions applies for a tax year, the FIE rules do not apply to the policy for that year. The exceptions are as follows:
(a) Under the terms and conditions of the policy, the policyholder is entitled to receive only benefits payable as a consequence of the occurrence of risks insured under the policy, an experience rated refund of premiums for a year, or a return of previously paid premiums on surrender, cancellation, or termination of policy;
(b) the policyholder can satisfy the Canada Revenue Agency that the policy was an "exempt policy" on its anniversary day in the year or, if the policy is not an exempt policy, that the policyholder has included the accrual income arising under the policy for the year in the taxpayer's income for tax purposes for that year; or
(c) the policyholder is an immigrant individual who immigrated to Canada and acquired the policy more than 60 months before arrival in Canada, provided that no premiums in excess of the level that was originally contemplated at the time the policy was first acquired have been paid while the individual is resident in Canada or in the 60-month period preceding the arrival.100
As a preliminary matter, it will be necessary to consider whether each of Sarah's contracts is a life insurance policy under the Canadian Act. The definition of that term thereunder will not be helpful in this analysis. It is fair to say that the Canada Revenue Agency is likely to resort to provincial law to make that determination. For the rest of our analysis, we assume that Sarah's contracts are life insurance policies under the Canadian Act.
Sarah's term life insurance contract probably
will fit within the exception set out in paragraphs (a) and (c) above.
Regarding the fixed UL contract, however, it would be necessary to test the
contract to determine if it was exempt or nonexempt. How would the testing be
done? If the contract was nonexempt, how would the accrual income be
determined? It is unlikely that the
The variable UL contract will be particularly problematic because, for Canadian purposes, the contract is viewed as a combination of segregated funds and ordinary life insurance. Segregated funds are treated as trusts for tax purposes.101 It is unclear how the FIE rules would apply to the variable UL contract. For example, would the segregated funds under the contract be treated in the usual manner under the Canadian Act? And, consequently, would the contract not be subject to the FIE rules if the ordinary life insurance part of the contract satisfied the exempt test?
Sarah Moves to
When Sarah moves to
When performing the exempt test, and for all
other transactions or events regarding the
To apply the exempt test to Sarah's
Sarah Moves to
Under the split dollar regulations in the United States, Sarah may incur tax due to her arrangement with Usco, and should she also incur tax in Canada on the same arrangement (since Canada will tax her on her worldwide income), she should be able to obtain a foreign tax credit to alleviate at least one level of tax.
Apart from the need for and availability of
foreign tax credits, there should be no new U.S. tax issues for Sarah as she
moves to Canada. Despite her move, the code views her as remaining subject to
its provisions, encompassing her worldwide income, because she is a
In planning for her move, from a tax
standpoint, Sarah should beware of acquiring new life insurance
contracts unless they comply with both the Canadian exempt test and the
Usco, Sarah's wholly owned U.S. corporation, will remain resident in the United States, and so its taxation on the UL contract that it owns on her life, to help fund her nonqualified deferred compensation, will not change because she is moving to Canada. If, however, the insured changed under the COLI contract, the change would be treated as a taxable exchange, as previously noted.
Sarah Moves to
As just mentioned, Sarah should consider whether her
Another matter to address is the application
of the salary deferral arrangement, retirement compensation arrangement, and
employee benefit plan rules to Sarah's deferred compensation arrangement with
Usco. In addition, Sarah must determine if the split dollar arrangement with
Usco creates a taxable benefit in
There will likely be increasing cross-border movement of individuals. We see it happening, and we are likely to see more of it with the increasing globalization of commerce. This movement will not be solely between the
A dual-compliant life insurance policy would
help minimize some of the issues raised in this article. More fundamentally,
however, because the two countries' sets of rules governing the tax treatment
of life insurance do not integrate well, legislative changes and changes to the
treaty should be undertaken to alleviate the problems created when Canadians
and Americans move across the border with life insurance policies as assets.
The Canadian and
1 The subject matter of this article was first presented as a seminar at the 2004 annual meeting of the Conference for Advanced Life Underwriting meeting held in
2 R.S.C. 1985 (5th Supplement) c.1, as amended (referred to herein as the Canadian Act).
3 Definition of life insurance policy in
4 Notice of Ways and Means Motion and Explanatory Notes Re: Taxation of Non-Resident Trusts and Foreign Investment Entities released October 30, 2003 (referred to herein as the Canadian Draft Legislation).
5 Section 12.2 of the Canadian Act and sections 306-310 of the regulations made under the Canadian Act (referred to herein as the Income Tax Regulations).
6 Section 148 of the Canadian Act.
7 Section 138.1 of the Canadian Act.
8 Section 128.1 of the Canadian Act.
9 Section 116 of the Canadian Act.
10 Proposed section 94.2 including proposed subsections 94.2(10) and (11) of the Canadian Draft Legislation.
11 Definition of life insurance policy in subsections 248(1) and 138(12) of the Canadian Act.
12 Section 138.1 of the Canadian Act.
13 Subsection 148(1) and paragraph 56(1)(j) of the Canadian Act.
14 Subsection 12.2(1) of the Canadian Act.
15 Subparagraphs 39(1)(a)(iii) and 39(1)(b)(iii) of the Canadian Act.
16 Definition of exempt policy in subsection 12.2(11) of the Canadian Act and subsection 306(1) of the Income Tax Regulations.
17 Paragraph 307(1)(b) of the Income Tax Regulations.
18 Paragraph 306(3)(d) of the Income Tax Regulations.
19 Paragraphs 306(3)(a) and (b) of the Income Tax Regulations.
20 Paragraph 307(1)(c), paragraph 307(2)(c) and subsections 307(3), (4), and (5) of the Income Tax Regulations.
21 Paragraphs 306(3)(c) and (d) of the Income Tax Regulations.
22 Subsection 148(1) of the Canadian Act.
23 Definition of adjusted cost basis in subsection 148(9) of the Canadian Act and subsections 308(1) and (1.1) of the Income Tax Regulations.
24 Definition of disposition in subsection 148(9) of the Canadian Act.
25 Paragraph 148(2)(a) of the Canadian Act.
26 Definition of "disposition" in subsection 148(9) of the Canadian Act.
27 Subsection 148(4) of the Canadian Act.
28 Subsection 148(8.2) of the Canadian Act.
29 Subsection 148(8.1) of the Canadian Act.
30 Subsection 148(8) of the Canadian Act.
31 Paragraph (k) of the definition of disposition in subsection 148(9) of the Canadian Act.
32 Paragraph 148(2)(b) of the Canadian Act and paragraph (d) of the definition of proceeds of disposition in subsection 148(9) of the Canadian Act.
33 Subsections 128.1(1) and (4) of the Canadian Act.
34 Paragraphs 128.1(4)(a) and (b) of the Canadian Act.
35 Paragraphs 128.1(1)(a) and (b) of the Canadian Act.
36 Paragraph 128.1(1)(b), paragraph 128.1(4)(b), and paragraph (l) of the definition of excluded right or interest in subsection 128.1(10) of the Canadian Act.
37 Subsection 2(3) and 115(1) of the Canadian Act.
38 Subsection 116(5.1), (5.2), (5.3), and (5.4) of the Canadian Act.
39 The definition of capital dividend account in subsection 89(1) of the Canadian Act.
40 Subsection 83(2) of the Canadian Act.
41 Paragraph 212(2)(b) of the Canadian Act.
42 Internal Revenue Code of 1986, as amended (referred to herein as IRC or the code).
43 IRC section 7702(a)(1) and (b). This limit is referred to as the cash value accumulation test.
44 IRC section 7702(e)(1).
45 IRC section 7702(a)(2)(A) and (c).
46 IRC section 7702(a)(2)(B) and (d) (subsection (d) sets forth multiples, known as the cash value corridor, ranging from 250 percent through the insured's age 40 down to 100 percent when the insured reaches age 95).
47 Section 7702, along with section 7702A discussed below, is addressed in a comprehensive manner in DesRochers, Adney, Hertz, and King, Life Insurance & Modified Endowments (Society of Actuaries, 2004).
48 IRC section 101(a)(1). Further, even if section 7702 is violated, the net amount at risk still passes to the beneficiary tax-free (see IRC section 7702(g)), as with a Canadian policy that is nonexempt. In certain instances, however, the death benefit can be taxable, such as when a policy has been transferred for value (see IRC section 101(a)(2), including exceptions provided therein).
49 IRC section 7702(g). An unintentional failure based upon reasonable error may be waived by the Internal Revenue Service under IRC section 7702(f)(8).
50 IRC section 72(e)(5)(A) and (C).
51 IRC section 72(e)(6).
52 IRC section 264(a)(1).
53 IRC section 72(e)(4)(A), (5)(A), and (C).
54 IRC section 72(e)(10)(A), applying IRC section 72(e)(4)(A) to MECs.
55 IRC section 72(e)(10)(A), applying IRC section 72(e)(2)(B) and (3)(A) to MECs.
56 IRC section 72(e)(3)(A)(i). Also under section 72(e)(11), all MECs issued during the same calendar year to the same policyholder are aggregated, that is to say, they are treated as a single contract for purposes of measuring the gain taxable on a withdrawal from any one of such MECs.
57 IRC section 72(v).
58 See IRC section 7702(f)(9); see also IRC section 817(d) and (h).
59 Treas. reg. section 1.101-1(a)(1).
60 IRC section 1035(a).
61 Paragraph 148(10)(d) of the Canadian Act.
62 Paragraph 128.1(4)(b), paragraph(l) of the definition of excluded
right or interest in subsection 128.1(10), the definition of life insurance
63 Section 116 of the Canadian Act.
64 Section 128.1(9) of the Canadian Act.
65 Definition of reportable property in subsection 128.1(10) of the Canadian Act.
66 Convention Between Canada and the United States of America with Respect to Taxes on Income and Capital, signed at Washington, D.C. on September 26, 1980, as amended by the protocols signed on June 14, 1983; March 28, 1984; March 17, 1995; and July 29, 1997 (referred to herein as the treaty).
67 IRC section 7702(a)(2)(A) and (c).
68 IRC section 7702(a)(2)(B) and (d).
69 See IRC section 7702(f)(5).
70 IRC section 7702(g).
71 IRC section 671 et seq.
72 IRC section 677(a)(3).
73 IRC section 264(a)(4).
74 IRC section 264(a)(4), (e).
75 See IRC sections 104(a) and 7702B.
76 IRC section 7702B(g)(3) (incorporating IRC section 4980C(d)).
77 Rev. Rul. 90-109, 1990-2 C.B. 191.
78 Subsections 148(1) and (7) of the Canadian Act.
79 Subsection 148(8.1) of the Canadian Act.
80 Paragraphs 4 and 5 of Article XIII of the treaty.
81 Subsection 116(5.4) of the Canadian Act.
82 IRC section 2056(a).
83 IRC section 951 et seq.
84 IRC sections 957(a) and 951(b), respectively.
85 IRC section 951(a).
86 See Treas. reg. section 1.61-22.
87 IRC section 1014(a).
88 Paragraphs 4 and 5 of Article XIII.
89 IRC section 302.
90 IRC sections 301(c) and 316.
91 IRC sections 951(b) and 958(b) (incorporating the rules of IRC section 318).
92 IRC section 551 et seq.
93 See Rev. Rul. 2003-91, 2003-33 IRB 347, and predecessor rulings cited therein.
94 IRC section 817(h); Treas. reg. section 1.817-5.
95 Proposed subsections 94.2(10) and (11) of the Canadian Draft Legislation.
96 Proposed paragraph 94.2(10)(c) of the Canadian Draft Legislation.
97 Proposed paragraph 94.2(11)(a) of the Canadian Draft Legislation.
98 Proposed subsections 94.2(3) and (4) and paragraphs 94.2(11)(a) and (b) of the Canadian Draft Legislation.
99 Proposed paragraph 94.2(11)(f) of the Canadian Draft Legislation.
100 Proposed paragraph 94.2(11)(c) of the Canadian Draft Legislation.
101 Section 138.1 of the Canadian Act.
102 Paragraphs 128.1(1)(b) and (c) of the Canadian Act.
103 See Canada Revenue Agency Document No. 2004-0065391C6 dated May 4, 2004 -- The Canada Revenue Agency's response to Question 1 at the CALU 2004 Annual Conference.
END OF FOOTNOTES
Tax Analysts Information
Code Section: Section 264 -- Nondeductible Premiums; Section 101 -- Death Benefits; Section 72 -- Annuities; Section 72(v) -- Endowment Contract Distributions; Section 1035 -- Exchanges of Insurance Policies; Section 7702B -- Long-Term Care; Section 951 -- Controlled Foreign Corporations; Section 957 -- CFC Definitions; Section 958 -- CFC Stock Ownership; Section 551 -- Foreign PHC Tax (R)
Subject Area: Corporate taxation
Estate, gift and inheritance taxes
Financial instruments tax issues
Individual income taxation
Insurance company taxation
Industry Group: Financial counseling
Author: Adney, John; Friedlan, Philip
Tax Analysts Document Number: Doc 2005-6863 [PDF]
Tax Analysts Electronic Citation: 2005 TNT 108-17