Life Insurance on the Move: Cross-Border Tax Implications and Opportunities for Canadian and U.S. Policyholders
by John Adney and Philip Friedlan

Philip Friedlan, Friedlan Law, practices in Toronto. He received his law degrees from the University of Toronto (LL.B) and McGill University (BCL). John Adney is a partner in the Washington, D.C. law firm of Davis & Harman LLP.

Date: Jun. 7, 2005

Full Text Published by Tax AnalystsTM

Life Insurance on the Move: Cross-Border Tax Implications and
Opportunities for Canadian and U.S. Policyholders

By Philip Friedlan and John Adney


Philip Friedland

John AdneyMany 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 U.S. tax rules will be provided. The cases will then be described, after which we will discuss the insurance (and selected other) tax issues related to the cases, together with some planning for these issues.

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 Canada and its 10 provinces impose annual income taxes on individuals, trusts, and corporations. The federal statute regarding income taxes, capital taxes, and some related taxes is the Income Tax Act.2

A person resident in Canada must pay federal income tax on the person's worldwide income. A person who is not resident in Canada is subject to federal income tax on the person's taxable income earned in Canada for a tax year if that person was employed in Canada, carried on business in Canada, or disposed of taxable Canadian property at any time in a year or a previous year. Taxable Canadian property includes a life insurance policy in Canada, defined in the Canadian Act as a life insurance policy or annuity contract issued by an insurer on the life of a person resident in Canada at the time the policy or contract was issued or effected.3

There are no estate or gift taxes imposed in Canada. Rather, unlike the case in the United States (even during 2010, the sole year in which the U.S. estate tax is "repealed" under current law), the Canadian Act contains provisions that cause the recognition of unrealized gains in various assets in the year of an individual's death.

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 Canada and immigrating to Canada;8

(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 United States will be life insurance policies under the Canadian Act.

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 U.S. separate account. Segregated funds are made available by life insurers under a life insurance policy or annuity contract. Each segregated fund is treated as an inter vivos trust under the Canadian Act, and the income of the trust, including realized capital gains and losses, is allocated to a policyholder in accordance with the terms of the policy and is taxable currently to the policyholder.12 The rules applicable to segregated funds allow life insurers to offer products that are similar to mutual funds.

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 Canada (initially, at least) because of their unattractive tax treatment.

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 Canada by a Nonresident -- A nonresident of Canada must pay income tax on the nonresident's taxable income earned in Canada. That income includes the income arising on the disposition of a life insurance policy in Canada.37 The Canadian Act imposes some collection procedures to ensure payment of the income tax that is due from the income on those dispositions.38

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.

Overview of U.S. Tax Rules

The following discussion summarizes the U.S. tax rules relevant to the case studies and planning commentary in the balance of this article. The United States imposes income tax on its citizens wherever they reside, taking into account their income worldwide, and, generally applying the same rules, taxes noncitizens who reside anywhere within U.S. taxing jurisdiction. It also imposes estate tax at the death of a citizen anywhere, and at the death of a U.S. resident, based on the worldwide gross estate of the decedent. Therefore if a noncitizen takes up residence in the United States, he or she is taxed by the United States on worldwide income. (The effects of treaties and foreign tax credits will be addressed later.)

The scope of the U.S. taxing regime, and particularly its extraterritorial reach, is central in examining the tax treatment of life insurance policyholders who cross the border into or out of the United States. And for those policyholders, the key consideration is the U.S. tax definition of "life insurance contract."

Life insurance definition. The U.S. tax definition of life insurance is similar in concept and purpose to the Canadian exempt test: Both impose limits on the permitted investment orientation of life insurance contracts. Generally, the U.S. definition, which appears in section 7702 of the Internal Revenue Code,42 restricts the amount of cash value that a contract can provide in relation to its death benefit at any time, thereby distinguishing, for tax purposes, life insurance from annuities and investment products. Using actuarial concepts and allowing a choice in its limits, the provision recognizes an instrument as a life insurance contract only if it is treated as such under the applicable law where it is issued (that is, state law in the United States or the law of the non-U.S. issuing jurisdiction) and either: (1) its cash value at any time cannot exceed the net single premium for its death benefit at that time,43 viewing that death benefit as a level amount,44 or (2) the gross premiums paid for it do not exceed a guideline premium limitation based on its death benefit,45 and that benefit at any time is at least a statutory multiple of the policy's cash value at that time.46 In essence section 7702 allows a contract that is not more investment-oriented than a single premium, level-face endowment at age 95 to qualify as a life insurance contract for federal tax purposes. Like the Canadian exempt test, however, section 7702 is a complex, actuarially grounded provision written by lawyers and often requires a multidisciplinary effort to decipher its meaning.47

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 U.S. income tax treatment of life insurance policyholders necessarily focuses on distributions during the lifetime of the insured. If a partial withdrawal is taken from a contract, a full surrender is made, or a policy loan is taken (either from an insurer or from a bank by pledging the contract as collateral), there may be tax consequences. Whether, when, and how much the transaction gives rise to income taxation depends on yet another definition -- the "modified endowment contract" definition found in section 7702A of the code.

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 Canada for policy loans. Only if the contract is surrendered or lapses without value while the insured remains alive will there be tax on the loan proceeds, and then limited to the gain as described above. Finally, there is no penalty tax for early withdrawals from or surrenders of non-MECs.

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 U.S. tax law, the contract must meet the U.S. tax definition of life insurance and must not be a MEC. If the contract is a MEC, neither its death benefit nor its inside buildup will be taxed, but lifetime distributions made from the contract will not be advantageously taxed. Rather, they will receive the same LIFO and penalty tax treatment as do distributions from deferred (nonannuitized) annuity contracts in the United States. In contrast, Canada taxes partial withdrawals on a pro rata basis rather than using either a LIFO or FIFO approach and without imposing a penalty tax, and thus Canada has no need for a MEC definition.

Variable life, COLI, and contract exchanges. Three final points should be noted regarding the U.S. policyholder tax rules. First, variable life insurance contracts in the United States operate under the rules just described.58 Unlike the case in Canada, the variable life contract's inside buildup is accorded income tax deferral. Second, corporate-owned life insurance or COLI policies follow the same rules. Those rules generally do not distinguish between individual and corporate policyholders and beneficiaries.59 Thus, in determining the income tax treatment of distributions, there is no concern with a capital dividend account in the United States as there is in Canada. Third, a contract may be exchanged for a new life insurance or annuity contract without triggering tax on any gain.60 The Canadian Act has no provision that allows for contract exchanges, although, as indicated above, it does provide that sometimes the exercise of a provision of a life insurance contract (but not an annuity contract) is not treated as a disposition.61

The Cases

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 Canada. Bill is the vice president of operations. The three partners have entered into a buy-sell agreement that provides that on their respective deaths, the shares of the deceased will be purchased in part by the surviving shareholders (a "criss-cross purchase" arrangement) and the balance will be redeemed by Prodco. The buyout is entirely funded by a corporate-owned UL policy on each of the partners issued by a Canadian life insurer. The three partners have been considering whether any of them should establish a shared ownership arrangement with Prodco regarding the COLI policies.

Our U.S. Family

Sarah, age 38, is a U.S. citizen and resident. She is divorced and has a minor child. Sarah is planning to marry Sam, a Prodco shareholder. Sam, age 48, is a Canadian citizen and resident and is unmarried.

Sarah owns three life insurance contracts on her life issued by U.S. carriers: fixed UL, variable UL, and term life insurance. She is the sole shareholder of Usco, a U.S. corporation, which carries on a successful business in the United States. Usco owns a UL contract on Sarah's life issued by a U.S. carrier, which is used to fund Sarah's nonqualified deferred compensation plan. Sarah and Usco also have entered into a split dollar arrangement regarding Sarah's variable life contract. We assume that each of Sarah's contracts and Usco's policy comply with section 7702 of the code at all times.

The Proposed Plan

Prodco is planning to expand into the United States. Bill and Mildred and their two minor children are planning to move to the United States, where Bill will run the U.S. operations of Prodco.

Sarah will marry Sam and move to Canada with her minor child. She will become vice president of operations of Prodco. She will retain her interest in Usco.

Canadian UL Product Features

The Canadian UL policy may have several typical features, some of which are relevant to the tax implications from a U.S. perspective. Those features are listed below:

(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.

Bill Leaves Canada -- Personal Canadian Tax Issues

Generally, when an individual leaves Canada, he or she is treated as having disposed of his or her assets at fair market value, thereby requiring the emigrant to pay tax in Canada on accrued gains. This general rule does not apply to Bill's personally owned policies because they are life insurance policies in Canada (that is, they are policies issued or effected by an insurer on the life of a person resident in Canada at the time the policy was issued or effected).62 Thus, Bill can leave Canada without triggering any tax liability with respect to these policies.

If Bill disposes of an interest in the Canadian policies after he has moved to the United States, he and the insurer, for some dispositions, will be required to follow the procedures imposed under the Canadian Act to ensure payment of any Canadian tax due as a result of the disposition.63

Upon leaving Canada, Bill will be treated as having disposed of and reacquired his Prodco shares at fair market value, thereby causing any accrued capital gains to be taxable in Canada. The corporate-owned UL policies on the lives of the three shareholders may need to be valued to determine the value of Bill's shares. Subsection 70(5.3) of the Canadian Act will operate to value the policy on Bill's life at its cash surrender value, but would not apply to the policies on Sam's and Marcos's lives. In the unfortunate situation when, for example, Marcos was seriously ill, Bill's Prodco shares may have a much larger value because the fair market value of the Prodco-owned UL policy on Marcos's life may approach the death benefit of the policy. The share price as determined under the buy-sell agreement may affect the value of the shares.

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 United States --
U.S. Personal Tax Issues

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 Canada, where it was issued, and because it lacks a cash value, its cash value cannot exceed the net single premium for its death benefit.

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 within the U.S. limits on cash values or premiums. As a UL policy, its cash value may exceed the net single premium for its death benefit, and so to meet the requirements of section 7702, the gross premiums paid for the policy from its inception must not have exceeded, and in the future must not exceed, the guideline premium limitation for its death benefit.67 Also the death benefit will need to be at least the multiple of the policy's cash value that is specified in section 7702.68 Bill's UL policy could meet those requirements, but that is far from guaranteed, and to make the determination would require actuarial testing. Second, the typical Canadian UL policy may contain some provisions that are not found in U.S.-issued life insurance contracts and the treatment of which under section 7702 is, accordingly, quite uncertain. The payment of a death benefit -- really, payment of the cash surrender value -- upon the first death under a joint life policy differs from the practice typically followed in the United States. Also, the typical Canadian UL policy may provide for payment of the cash surrender value upon disability or critical illness of the insured. Although section 7702 permits additional benefits to accompany a life insurance contract and to some extent addresses their treatment,69 it is not at all clear how the payments would be accommodated. Although the use of equity-linked accounts in the policy would not appear to cause insuperable section 7702 compliance issues, this aspect of the structure would necessitate some examination under the investor control doctrine of the U.S. tax law (described below).

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 U.S. resident, it seems likely that only the income arising after he became a resident would be taxable by the United States.

Bill Moves to United States -- Tax Planning Personal

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. life insurers and their consultants. Although Bill and Mildred presumably can hire those consultants to perform the necessary review, that undoubtedly would entail a nonnegligible expense. Or, they can simply assume that the policy is noncomplying.

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 U.S. tax law likely will be for the policy to be exchanged for a U.S.-issued contract. (As noted above, that exchange may be done in a tax-free manner.) The Canadian Act has no similar provision. Consequently, the exchange would be treated as a surrender of the UL policy and the acquisition of a new policy under the Canadian Act.

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 U.S. tax definition of life insurance. This would provide Bill with the greatest protection, both insurance-wise and tax-wise, for at some point Bill may return to Canada. The challenge is in finding a dual-compliant policy. The authors are not aware that any such policy is currently available from either a Canadian insurer or a U.S. insurer, although a session of the 2004 CALU Associates Members' Meeting held in Toronto on November 5, 2004, in which Mr. Friedlan and Mr. Craig Springfield (a partner of Mr. Adney) participated, explored the issues involved in creating such a policy. Perhaps an insurer may create one, or an actuarial firm could write and market a software program that would permit its border-crossing user to maintain dual-test compliance of his or her fixed UL policy.

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 United States, then with one exception it should not be owned by Bill when he crosses the border. Rather, before departing Canada, Bill should dispose of the policy and, assuming the coverage provided by that policy is still needed (see the life insurance trust discussion below) and Bill remains insurable, a U.S.-compliant policy should be acquired once Bill and Mildred become resident in the United States. The exception applies if Bill has become uninsurable, a point that should be determined before he disposes of his Canadian-issued policy. In that case, Bill may well want to retain his existing policy even if it results in accrual taxation (in this case, too, refer to the trust discussion).

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 Canada to maintain the coverage provided under the policy without incurring adverse tax consequences?

From a Canadian perspective. Unfortunately, Bill cannot transfer the policy before leaving Canada to another party remaining in Canada without triggering tax on any accrued gain in the policy. The only tax-free rollover of the policy that is available is between Bill and Mildred, but that transfer will not alleviate the problems because they are both moving to the United States. If the policy contains a large amount of gain, Bill may be reluctant to trigger tax on the gain by virtue of a transfer, but the prospect of adverse U.S. tax consequences may make the policy's retention unacceptable, overcoming Bill's reluctance. If, on the other hand, there is no gain or only a small gain in the policy, the policy could be transferred without (or without much) tax consequence.

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 Canada, other than a U.S. citizen, or (2) to an irrevocable life insurance trust that would be resident in Canada. The beneficiaries of such a trust might include Bill and Mildred's 19 year-old son, who is remaining in Canada. Subsequent premiums could be paid by Bill, and in the future, the policy could be rolled out tax-free to the Canadian-resident son.

From a U.S. perspective. If the policy were transferred to an individual who is not a U.S. taxpayer before Bill's and Mildred's border crossing, the section 7702 consequences would be nil, since the policy never entered the United States, so to speak. Alternatively, if the policy were transferred to the proposed Canadian trust, the U.S. tax consequences would depend upon whether the trust is considered, from a tax perspective, to be truly independent of Bill and Mildred or to be their "grantor trust," that is, merely a tool for holding their assets.71 If the Canadian trust is a nongrantor trust under the U.S. income tax rules, the noncompliance of the policy would pose no U.S. tax concern, since again, it (or more specifically, the trust assets) never became subject to U.S. taxing jurisdiction. But if the policy is being held in a grantor trust for U.S. tax purposes, the policy's noncompliant status will be attributed to Bill and Mildred, and they will become taxable in the United States on the accrual of the policy gain.

Even if the proposed trust is irrevocable and resident outside the United States, it may nonetheless be treated as a grantor trust. To avoid such treatment under the Code, a number of rules must be observed, for example, Bill and Mildred must not be able to control the trust directly or indirectly, the trust property and income (if any) must not benefit them, and the trust property must never be able to revert to them except in very remote circumstances. So, to make this arrangement work from a U.S. tax perspective, there should be a third-party trustee, and among other important prohibitions to be honored, the trust property must not be the source of the policy premiums.72 (Bill, Mildred, or anyone else may pay the premiums, but not the trust.) Quite often in the United States, an irrevocable life insurance trust (or ILIT) is established as an advisable step in estate planning, and hence placing the Canadian policy in such a trust would not be considered unusual. One caution is worth noting, however: it is not uncommon for an ILIT to be structured as a nongrantor trust under the estate tax rules but as a grantor trust for income tax purposes, a structure that cannot be implemented where a noncompliant policy is to be held.

Bill Moves to the United States -- U.S. Personal Tax
Issues -- U.S.-Compliant Policy

After Bill and Mildred move across the border, the U.S. income tax treatment of transactions under any U.S.-compliant policy that they maintain or acquire would follow the rules noted earlier. Therefore, the death benefit under the policy would be income-tax-free (and could be estate-tax-free), while the tax treatment of any lifetime distributions, including loans under or against the policy, would depend on whether it is classified as a MEC.

In addition to the rules noted earlier, particular mention should be made of the U.S. income tax treatment of borrowing against life insurance cash values, long-term care and disability and critical illness benefits, and the substitution of lives insured. First, if Bill and Mildred were to borrow against the cash value of a non-MEC, either from the issuing insurer or a bank, and then use the proceeds to make investments, provide retirement income, or pay personal expenses, the proceeds generally would be nontaxable -- that is, they are treated as loan proceeds. If, however, the amount of the loan were ever to exceed the cash value, causing the policy to terminate, all of the gain in the policy would become taxable, including amounts previously borrowed, producing a disastrous result. Short of that, a plan to borrow against the cash value of a non-MEC can be made to work well from a tax standpoint. It should be noted that in the United States, no interest deduction is available to an individual on borrowing when a life insurance policy is used to support the borrowing.73 That is true whether the borrowing is from the insurer or a bank, and it also is true of borrowing under COLI, subject to a limited exception aimed to provide relief for small businesses.74 In view of that, life insurance borrowing plans in the United States assume that interest on the loans will be capitalized, not paid currently, and they instead focus on using the cash value of the policy in a tax-free manner. Insofar as Bill has a plan with that objective, it can be made to work in the United States.

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 U.S. rules,75 benefits paid from the Canadian policy by reducing its cash value probably would not be excludable from income taxation in the United States. For an exclusion to apply to life insurance cash values that are paid to cover long term care, it is necessary for the benefit to meet the definition of qualified long-term care insurance, and to meet that definition it is necessary for the front page of the policy or long- term care rider to declare that the instrument is intended to provide such qualified insurance.76 That would not be true of Bill's policy, of course, so that an exclusion for the long-term care benefit would not be available. Further, there is no provision in U.S. tax law allowing life insurance cash values to be converted into tax-free health insurance benefits, which would include disability income and critical illness benefits. Therefore, if the cash value of Bill's policy is paid out on account of his disability or critical illness, it will simply be taxed as an ordinary, potentially taxable distribution of cash value.

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. (In the United States, that substitution typically is permitted, if at all, only in a business-owned policy, not in one owned by an individual.)

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 United States, that is typically done to preclude an undue estate tax burden. If they do so, an estate planner likely will advise them, as a first step, to transfer both of their Canadian policies -- term as well as UL -- into an ILIT. Before taking that step, however, they must address the effect of the Canadian rules, unless an exemption is available under the treaty (discussed below).

Bill Dies -- U.S.-Compliant Canadian Last-to-Die
UL Policy

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 Canada. If Bill is out of Canada for more than 10 years, there may be a treaty exemption.80 It appears that this is not a transaction for which the insurer would comply with the procedure imposed under the Canadian Act to ensure payment of any Canadian tax due as a result of the disposition.81

In this instance, on the other hand, the United States will not impose income tax. Also from an estate tax standpoint, although Mildred has now come into the ownership of property, there is a full marital deduction,82 so that any property passing to her, including the last-to-die UL policy, would not be taxed as part of Bill's estate.

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.

Bill Leaves Canada -- Tax Issues -- Business

When Bill leaves Canada, Prodco is a Canadian resident corporation and has no connection at the time with the United States. Therefore, from a Canadian tax standpoint, there will be no tax consequences concerning the corporate-owned policies.

Bill Moves to the United States -- Tax Issues --
Prodco UL Policies

From a U.S. tax standpoint, there are no immediate policy-level issues for the Prodco UL policies occasioned by Bill and Mildred's move across the border. Prodco and its COLI policies remain solely in Canada, even though Prodco soon may begin doing business in the United States. There is no dividend to Bill and therefore no amount taxable by the United States on the premiums paid by Prodco, because Prodco is paying premiums on its own property in Canada. It would be different, of course, if Bill owned the policies, perhaps in a criss- cross purchase setting, and Prodco were paying the premiums, because that would give rise to a dividend to Bill.

It is important to note that Prodco is not, on the facts of the case study, what U.S. tax law would classify as a controlled foreign corporation (CFC).83 That will be true as long as Sam and Marcos continue to reside in Canada and have a one-third interest each with Bill in Prodco. Prodco could become Bill's CFC if he, together with other U.S. taxpayers, owned more than 50 percent of Prodco (with each owning 10 percent or more of the company).84 If that were to occur, it would create several U.S. tax issues, one of which would concern the policies Prodco owns that meet the Canadian exempt test but do not meet the U.S. definition of life insurance. If Bill owned an interest in a CFC, the CFC's earnings and profits essentially would be taxable to Bill as if distributed currently in a cash dividend.85

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 United States -- Tax Issues

Prodco policy proceeds. If Bill dies while in the United States, the proceeds of the UL policies held by Prodco will be tax- free under the Canadian Act (and U.S. tax law).

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 Canada. If Bill has been in the United States for more than 10 years at the time of his death, however, the treaty may protect that gain from taxation in Canada.88

Share redemption. If Bill's shares are redeemed from his estate, there will be no U.S. tax consequences if Bill has been fully redeemed out so that Sam and Marcos now are each 50 percent owners of Prodco. In that case, the redemption is treated as a sale of Bill's shares, and the analysis is the same as that just discussed in connection with the criss-cross purchase. An issue would arise, however, if some party related to Bill retained an interest in Prodco. In that case, the redemption payment from Prodco (whether or not funded by the COLI policies) generally would be taxed as a dividend in the United States.89

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 United States for more than 10 years, an issue to consider would be whether the treaty will operate to cause the dividend arising on what is legally a disposition of shares to be exempt from Canadian taxation.

Bill in the United States -- Marcos Dies --
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 U.S. tax laws.

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.

From a U.S. tax standpoint, because Prodco is paying a dividend to enable Bill's purchase of Marcos' shares, Bill will have a dividend from Prodco. The dividend will be includible in Bill's gross income, subject to U.S. taxation, to the extent of the earnings and profits of Prodco.90 Of equal if not greater significance to Bill, following the purchase and redemption, Prodco is close to becoming Bill's CFC. That follows from the fact that Bill, now a U.S. taxpayer, has come to own 50 percent of Prodco, with Sam owning the other 50 percent. Also it would be important to consider whether, under the U.S. tax rules, any of Sam's shares could be attributed to a U.S. taxpayer91 -- recall that Sam is planning to marry Sarah, a U.S. citizen. If the U.S. ownership were to rise above 50 percent of Prodco under the CFC rules, CFC treatment of Bill's interest (and possibly that of other U.S. taxpayer-owners of Prodco) would result. In that case, 50 percent of Prodco's annual earnings and profits would become taxable to Bill as if distributed currently in a cash dividend, and there would be concern about the U.S. tax treatment of the Prodco-owned policies.

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 U.S. tax law, because the redemption occurs completely in Canada, there is no tax impact in the United States.

Use of a holding company. Suppose Bill's Prodco shares are rolled into a holding company before he leaves Canada in an effort to avoid the receipt by Bill of a dividend under the criss-cross purchase arrangement and taxation of the dividend in the United States and withholding tax in Canada. Unfortunately, that will not have the desired effect from a U.S. tax standpoint: After the purchase, Bill would have a foreign personal holding company taxed in a manner similar to a CFC, so that the dividend would come back to Bill.92

Sarah's Contract -- U.S. Fixed UL and Variable
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 U.S. definition of life insurance. The features of Sarah's fixed UL contract will be similar to those of the Canadian UL contract: death benefit options (including an option 2 death benefit structure); single life coverage (which we assume that her contract provides, although joint life first-to-die or last-to-die coverages are available in the United States); partial withdrawal and policy loan provisions; a right to pledge the contract for a loan, or otherwise to assign it; an optional premium deposit fund; a provision for dividend accumulations, if the contract is participating; and available annuity, family term, and terminal illness and long-term care riders (the latter two usually accelerates the contract's death benefit). Critical illness and disability income riders also may be available, typically providing additional benefits other than by accelerating the payment of cash values and death benefits.

U.S. variable UL contracts' features typically include those listed above (or most of them). The main difference is that, instead of having the benefits being provided and guaranteed by the insurer's general account, the variable contract will have its basic benefits -- the cash values and the death benefit on the principal life or lives insured -- provided by a separate account of the insurer, which in turn typically will invest in several insurance-only mutual funds. The separate account, which is protected from the claims of the general account's creditors, does not guarantee the cash values or the death benefits, but passes through the investment performance of the underlying funds (net of specified charges), the aggregate of which, as allocated to a particular contract, constitutes the contract's cash value and is reflected in the contract's death benefit. The policyholder will have the ability to allocate and reallocate premiums and cash values across the funds in which the separate account invests. Also, it is now common for such a contract to include one or more investment options supported by the insurer's general account, which provides guaranteed benefits, to which the policyholder may allocate amounts.

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
Sarah's U.S. Contracts

When Sarah moves to Canada, she will own three contracts that have been issued by U.S. carriers. Therefore the foreign investment entity (FIE) rules in the Canadian Draft Legislation must be considered.

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

Sarah's Contracts

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 U.S. carrier would assist or be able to assist in answering these questions. If the contract is old enough, it might fit within the exception set out in paragraph (c) above.

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 Canada -- Canadian Tax Issues --
U.S. Contracts

When Sarah moves to Canada, under the Canadian Act she will be treated as having disposed of each of her assets, including the U.S. contracts, at fair market value and to have reacquired them at that fair market value.102

When performing the exempt test, and for all other transactions or events regarding the U.S. contracts, it seems necessary to convert the U.S. dollar amounts into Canadian dollars. That is the position of the Canada Revenue Agency.103

To apply the exempt test to Sarah's U.S. contracts, actuarial assistance will be needed, and even then, it will likely be very difficult to apply the Canadian rules to the U.S. contracts. The tax treatment of the variable UL contract, as noted earlier, is particularly unclear. Regarding Sarah's split dollar arrangement with Usco, a benefit may be conferred on Sarah as a shareholder or as an employee of Usco, with tax consequences under the Canadian Act.

Sarah Moves to Canada -- U.S. Tax Issues and

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 U.S. citizen. Regarding her life insurance contracts in particular, the usual rules will apply from a U.S. tax standpoint, as will the usual precepts of income and estate tax planning.

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 U.S. tax definition of life insurance. In her case, the ideal solution would be the acquisition of a dual-compliant policy, as mentioned earlier, in place of both her fixed UL contract and her variable UL contract, since an exchange could be accomplished tax-free while Sarah is subject only to taxation in the United States. As to her existing fixed UL contract, she should ascertain if the contract complies with the Canadian exempt test, and if it does, she should learn how that status may be maintained. Another possibility may be to transfer her existing contracts (or at least her variable life contract, if it is to be retained) to an ILIT resident in the United States, which could also serve in her estate planning in the United States, unless that would give rise to difficulties for her when she reaches Canada (recall the prior discussion of the proposed nonresident trust and FIE rules) or pose insuperable U.S. gift tax consequences. If none of the above is done, Sarah should consider terminating her nonterm contracts and her split dollar plan.

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 Canada -- Canadian Tax Planning

As just mentioned, Sarah should consider whether her U.S. contracts, if not Canadian-compliant, can be made so. That will likely be a very difficult task. One of the issues to be concerned about when a U.S. contract is transferred to an irrevocable trust is, as noted, the application of the proposed nonresident trust and FIE rules in the Canadian Draft Legislation.

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 Canada.


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 United States and Canada, but much of it will occur between the two countries and will accelerate over time because of their proximity and close ties. Therefore, the issues raised in this article will be heightened in their significance. At the same time, the rules for life insurance are complex, are not well integrated, and are not specifically addressed by the treaty. Although it is difficult to plan around these rules, some planning options are possible.

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 U.S. governments only recently managed to amend the treaty to attempt to coordinate taxes on death, so perhaps they will do the same someday for the rules on the taxation of life insurance.


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 Ottawa, Ontario, May 2-5, 2004. CALU is a conference of the Financial Advisors Association of Canada, a nonprofit association with members engaged primarily in the provision of life and health insurance. CALU's mandate is to maintain a constructive dialogue with governments concerning advanced life underwriting issues and to provide a professional development forum for CALU members as well as other professionals in the financial services field. Members of CALU are licensed practitioners providing financial services and life insurance and related financial products to their clients or are personnel involved in the design and development of financial products and services.

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 Canada in subsections 248(1) and 138(12) of the Canadian Act.

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 policy in Canada in subsections 138(12) and 248(1) of the Canadian Act.

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.


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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)
Geographic Identifier: United States
Subject Area: Corporate taxation
Estate, gift and inheritance taxes
Financial instruments tax issues
Individual income taxation
Insurance company taxation
Multijurisdictional 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