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At the 2004 CALU annual meeting, CALU member Philip Friedlan and Washington, D.C. based lawyer John Adney, presented a work shop on cross-border issues associated with life insurance policies. In this CALU Report, Philip and John present, through two case studies, the issues faced by a Canadian resident moving to the United States, or a U.S. resident moving to Canada where life insurance policies are involved.
Table of Contents
The subject matter of this article was first presented as a seminar at the 2004 CALU annual meeting held in Ottawa, Ontario, May 2-5, 2004. A significant number of Canadians and Americans move back and forth across the Canada-United States border to live and work. In many cases, 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.
Using two case studies, this article will explore (as did the Ottawa seminar) the U.S. income tax and estate tax implications, the Canadian income tax implications and the planning relating to life insurance when a Canadian resident moves to the U.S. or a U.S. citizen or resident moves to Canada. The focus of this article will be the insurance tax issues and planning for those issues. First, a very brief overview of the relevant Canadian tax issues will be provided. We assume that the reader has familiarity with these rules. This overview will be followed by a more detailed overview of the U.S. tax issues. The cases will be described. We will then discuss the insurance tax and selected other tax issues related to the cases and some planning for these issues.
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The following is a list of areas of the Income Tax Act(1) and the draft legislation released on Oct. 30, 2003,(2) that are relevant to this article:
(a) exempt test and accrual taxation;(3)
(b) dispositions of life insurance policies;(4)
(c) taxation of segregated funds;(5)
(d) emigrating from Canada and immigrating to Canada;(6)
(e) non-residents holding life insurance policies issued on Canadian residents by insurers carrying on business in Canada;(7) and
(f) taxation of foreign insurance policies.(8)
The Canadian Draft Legislation is the latest version of the draft legislation implementing the 1999 Federal budget proposals that are intended to stop residents of Canadian from using foreign vehicles to avoid income tax on investment income.
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The discussion in this part 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, it taxes non-citizens 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 upon the worldwide gross estate of the decedent. Hence, if a non-citizen 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 subsequently.)
The scope of the U.S. taxing regime, and particularly its extra-territorial 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 such 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 policies. In very general terms, the U.S. definition, which appears in section 7702 of the Internal Revenue Code,(9) 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. Utilizing actuarial concepts and allowing a choice in its limits, the provision recognizes an instrument as a life insurance policy only if it is treated as such under the applicable law where it is issued (i.e., 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,(10) viewing that death benefit as a level amount,(11) or (2) the gross premiums paid for it do not exceed a guideline premium limitation based on its death benefit,(12) and that benefit at any time is at least a statutory multiple of the policy's cash value at that time.(13) Section 7702 is a complex, actuarially grounded provision written by lawyers, and hence often requires a multi-disciplinary effort to decipher its meaning.
Death benefit and 'inside buildup' As a general proposition, if the requirements of section 7702 are met with respect to a life insurance policy, the undistributed gain accruing to the cash value of the policy - the 'inside buildup' - grows tax-deferred, just as in the case of a policy complying with the exempt test in Canada. Further, there is no income tax on the policy's death proceeds.(14) On the other hand, should a policy fail the definitional requirements, either intentionally or unintentionally, there is accrual taxation of the inside buildup.(15) (This assumes, as does the case study described below, that no policy 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 policy, if a full surrender is made, or if a policy loan is taken, either from an insurer or from a bank by pledging the policy as collateral, there may be tax consequences. Whether, when, and how much such a transaction gives rise to income taxation depends upon yet other definition - the 'modified endowment contract' definition found in section 7702A of the Code.
Modified Endowment Contracts While 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, but in simple terms a MEC is a more heavily investment-oriented policy than the typical, 'garden variety' life insurance policy. Technically, a MEC is a policy that is paid-up with fewer than seven net level annual premium payments; since section 7702A's 7-pay test is measured by net premiums, it usually takes a minimum of eight or nine level annual payments to avoid MEC status. A policy that succeeds in avoiding that status is colloquially called a 'non-MEC.'
Lifetime distributions Not surprisingly, the taxation of lifetime distributions is more favorable in the case of a non-MEC than in that of a MEC. If a partial withdrawal is taken from a non-MEC, the tax basis of the policy, 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.(16) For this purpose (as well as upon full surrender), the gain in the policy is measured as the excess of the proceeds received over the investment in the contract (i.e., the premiums paid less any previously untaxed withdrawals).(17) (Premium payments are not deductible by an individual taxpayer, and they likewise are non-deductible by a business taxpayer if the business is an owner or beneficiary of the policy.(18)) Unlike the case in Canada, the tax basis of the policy 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.(19) This is true, moreover, whether or not the loan exceeds the tax basis, unlike the rule in Canada with respect to policy loans. Only if the policy 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,(20) and all pre-death distributions - partial withdrawals, surrenders of paid-up additions, and policyholder dividends paid in cash - are taxed on an income-first basis.(21) This is true of a loan taken from the insurer under the terms of a policy or from another party by pledging the policy as collateral. For this purpose, the income on the contract is defined as the gain (see above) unreduced by surrender charges.(22) Also, a 10% 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.(23) As a result, the penalty tax always will apply to a policyholder that is not a natural person.
In sum, for favorable life insurance treatment to apply with respect to a policy under U.S. tax law, the policy must meet the U.S. tax definition of life insurance and must not be a MEC. If the policy is a MEC, neither its death benefit nor its inside buildup will be taxed, but lifetime distributions made from the policy will not be advantageously taxed. Rather, they will receive the same treatment as distributions from deferred (i.e., non-annuitized) annuity contracts receive in the United States.
Variable life, COLI, and policy exchanges Three final points should be noted regarding the U.S. policyholder tax rules:
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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 citizen and residents. Bill owns two life insurance policies issued by Canadian life insurers. One of these 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. These policies are not and are not issued pursuant to a deferred income plan, such as a registered pension plan. It is assumed 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 which 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 of which will be redeemed by Prodco. The buy-out 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 with respect to 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, one of the Prodco shareholders. Sam, age 48, is a Canadian citizen and resident and, so far, is unmarried.
Sarah owns three life insurance policies 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 policy on Sarah's life issued by U.S. carrier, which is used to fund Sarah's non-qualified deferred compensation plan. Sarah and Usco also have entered into a 'split-dollar' arrangement with respect to Sarah's variable life policy. It is assumed that each of Sarah's policies 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 the 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 Prodco's Vice-President of Operations. She will retain her interest in Usco.
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The Canadian UL policy may or will have a number of typical features, some of which are relevant to the tax implications from a U.S. perspective. These 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.
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In general terms, when an individual leaves Canada, he or she is treated as having disposed of his/her assets at fair market value, thereby requiring the emigrant to pay tax in Canada on accrued gains. This general rule doesn't apply to Bill's personally-owned policies because these policies are life insurance policies in Canada (i.e., 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).(27) Thus, Bill can leave Canada without triggering any tax liability with respect to the policies.
If Bill disposes of an interest in the Canadian policies after he has moved to the United States, he and the insurer in respect of certain 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.(28) 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 have 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 this provision would not apply to the policies on Sam and Marcos' lives. In the unfortunate situation where, for example, Marcos was seriously ill, Bill's Prodco's shares may have a much larger value because the fair market value of Prodco-owned UL policy on Marcos' life may approach the death benefit of the policy. The share price as determined under the buy-sell agreement may have an effect on the value of the shares.
Bill will have to report to the Canada Revenue Agency his reportable properties if they have a fair market value greater than $25,000.(29) Life insurance is a reportable property.(30)
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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)(31) and as mitigated by any applicable foreign tax credits. Since Bill and Mildred own life insurance policies, it will be necessary for these policies to meet the U.S. definition of life insurance (section 7702 of the Code), and, preferably, for the policies to be non-MECs, in order 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, as it is questionable whether the policy will comply with section 7702 in a number of respects. First of all, to meet the definitional requirements, this 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, it will be necessary that the gross premiums paid for the policy have not exceeded, and do not exceed, the 'guideline premium limitation' for its death benefit.(32) Also, the death benefit will need to be at least the multiple of the policy's cash value that is specified in section 7702.(33) Bill's UL policy could meet these requirements, of course, but that is far from guaranteed, and to make such a determination would require actuarial testing (by someone - presumably not the issuing insurer). Second, the typical Canadian UL policy may contain certain provisions that are not found in U.S.-issued life insurance policies 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 followed in U.S. policies. In addition, the typical Canadian UL policy may provide for payment of the cash surrender value upon disability or critical illness of the insured. While section 7702 permits 'additional benefits' to accompany life insurance policies and to some extent addresses their treatment,(34) it is not at all clear how such payments would be accommodated. While 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).
Hence, it is quite possible that Bill's UL policy would not comply with section 7702, resulting in accrual taxation of its inside buildup.(35) If so, and the non-compliance 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.
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Before Bill and Mildred cross the border, then, they will need to determine whether or not Bill's UL policy complies with section 7702 of the Code. This will require a legal-actuarial analysis of the type that typically is done, and done only, by U.S. life insurers and their consultants. While Bill and Mildred presumably can hire such consultants to perform the necessary review, that undoubtedly would entail a non-negligible expense. If they do not wish to do this, they can simply assume that the policy is non-complying.
U.S-compliant policy If Bill's UL policy is ascertained to comply with section 7702 to date, albeit accidentally, then assuming Bill desires 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/or expensive undertaking. At the moment, it seems, the best answer likely will be for the policy to be exchanged for a new policy issued by a U.S. life insurer. (As noted above, such an exchange may be done in a tax-free manner.) The Canadian Act does not, however, contain a similar provision. Consequently, this 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 such a dual-compliant policy. The authors are not aware that any such policy exists at this time (other than by accident). 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.
Non-compliant policy If, on the other hand, Bill's UL policy is non-complying (whether through testing or by assumption) and thus is subjected to accrual taxation, 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 checked out before he disposes of his Canadian-issued policy. In such a 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) non-compliant with section 7702, or may become non-compliant in the future (i.e., absent the necessary section 7702 monitoring), it is appropriate to ask whether anything 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 so as 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 such a transfer won't 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 keep the U.S. non-compliant 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 to (1) an individual resident in Canada, other than a U.S. citizen, or to (2) 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 prior to Bill 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 their tool for holding their assets.(36) If the former turns out to be the case (i.e., the Canadian trust is a non-grantor trust under the U.S. income tax rules), the non-compliance 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 - as defined in the Code - then the policy's non-compliant status will be attributed to Bill and Mildred, and they will become taxable on the accrual of the policy gain.
While 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, e.g., 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.(37) (Bill, Mildred, or anyone else may pay the premiums, but not the trust.) Quite often in the United States, an irrevocable life insurance trust (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 non-grantor trust under the estate tax rules but as a grantor trust for income tax purposes, a structure that cannot be implemented where a non-compliant policy is to be held.
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After Bill and Mildred move to the United States, 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. Hence, 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 upon whether the policy was 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, it is possible to borrow against the cash value of a policy, either from the issuing insurer or a bank, and use the proceeds to make investments, provide retirement income, or pay personal expenses. If such borrowing is effected under a non-MEC, the proceeds are non-taxable (i.e., they are treated as loan proceeds) so long as the amount of the loan does not exceed the cash value, causing the policy to terminate or the loan to be called. If a policy was to terminate because of an excessive loan, 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. That said, it should be noted that in the United States, no interest deduction is available to an individual on borrowing where a life insurance policy is used to support the borrowing.(38) This is true whether the borrowing is from the insurer or a bank, and also is true of borrowing under COLI, subject to a limited exception aimed at providing relief for small businesses.(39) In view of this, life insurance borrowing plans in the United States assume that interest on the loans will be capitalized, not paid currently, and 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. While such benefits can be structured to be tax-free under the U.S. rules,(40) 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 with respect 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, among many other requirements, that the front page of the policy or long-term care rider declare that the instrument is intended to provide such qualified insurance.(41) 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. Hence, 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, 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,(42) triggering tax on all of the gain in the policy, and leaving somewhat unclear the manner in which the section 7702A (MEC) rules apply to the post-substitution policy. (In the United States, such a substitution typically be permitted, if at all, only in a business-owned policy, not in one owned by an individual.)
A final comment that should be made with respect to any U.S.-compliant policy that Bill and Mildred maintain or acquire is that, in view of their overall wealth as well as the probable size of the policy's face amount, they should engage in estate planning. In the United States, this 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 will need to address the effect of the Canadian rules, unless an exemption is available under the Treaty (discussed below).
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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, this transaction will be a disposition at cash surrender value.(43) 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.(44) Consequently, Bill's death may result in an income inclusion in Canada. If Bill is out of Canada for a sufficient length of time, more than 10 years, there may be a treaty exemption.(45) It appears that this is not a transaction in respect of 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.(46)
In this instance, on the other hand, the United States will not impose income tax. Also, from an estate tax standpoint, while Mildred has now come into the ownership of property, there is a full marital deduction,(47) so that any property passing to her, including the last-to-die UL policy, would not be taxed as part of Bill's estate.
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The Treaty has a variety of 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 only taxable by the state in which the alienator is resident, with certain exceptions including one dealing with individuals.
With respect to foreign tax credits, generally the country of residence will give its residents tax credits for taxes imposed by the other country on income sourced in the other country.
When Bill leaves Canada, Prodco is a Canadian resident corporation and has no connection at the time with the United States. Therefore, nothing will occur with respect to the corporate-owned policies.
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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 with respect to the premiums paid by Prodco, because Prodco is paying premiums on its own property in Canada. It would be a different circumstance, of course, if Bill owned policies, perhaps in a criss-cross purchase setting, and Prodco were paying the premiums, since 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 the U.S. tax law would classify as a 'controlled foreign corporation' (CFC).(48) This 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% of Prodco (with each owning 10% or more of the company),(49) and if this were to occur, it would create a variety of U.S. tax problems, 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.(50)
The case study facts noted that Bill (and his partners) are considering establishing a shared-ownership arrangement with Prodco in respect of the COLI policies. While 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 will need to be evaluated under the comprehensive 'split-dollar' regulations issued in 2003.(51) The shared ownership arrangement would be called a 'reverse' split-dollar arrangement in the United States. In this case, since 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 have a dividend from Prodco.
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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 presumably is selling his shares to Sam and Marcos at fair market value, in the United States there is no income tax and no estate tax. 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), with the result that the sale to Sam and Marcos at that same value produces no taxable gain.(52) Also, there is no estate tax because, when Mildred receives the shares, the 100% marital deduction applies. If the shares were transferred at Bill's death to a non-spouse, 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, then the Treaty may protect that gain from taxation in Canada.(53)
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% owners of Prodco. In such a 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. A problem would arise, however, if some party related to Bill retained an interest in Prodco. In such a 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.(54)
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 or not the Treaty will operate to cause the dividend arising on what is legally a disposition of shares to be exempt from Canadian taxation.
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Prodco policy proceeds As noted above, the death proceeds payable under the Prodco-owned UL policies 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' death Bill would purchase one-half of Marcos' 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, since Prodco is paying a dividend to enable Bill's purchase of Marcos' shares, Bill will have a dividend from Prodco. This dividend will be includible in Bill's gross income, subject to U.S. taxation, to the extent of the earnings and profits of Prodco.(55) Of equal if not greater significance to Bill, following the purchase and redemption, Prodco is on the cusp of becoming Bill's CFC. This follows from the fact that Bill, now a U.S. taxpayer, has come to own 50% of Prodco, with Sam owning the other 50%. If that were to occur, as noted above, 50% 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 regarding the U.S. tax treatment of the Prodco-owned policies. 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. taxpayer(56) - recall that Sam is planning to marry Sarah, a U.S. citizen. If the U.S. ownership were to rise above 50% 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. Under the Canadian Act, the dividend Bill receives will be subject to non-resident withholding tax regardless of whether it is a taxable dividend or a capital dividend. Since Bill will hold more than 10% of the voting shares of Prodco, the withholding rate will be 5% by virtue of Article X of the Treaty.
Share redemption If Marco's shares of Prodco are redeemed, 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 left 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. This 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 right back to Bill.(57)
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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 policies and also a term life insurance policy, all issued by U.S. insurers. These policies are all assumed to comply with the U.S. definition of life insurance. The features of Sarah's fixed UL policy will be very similar to those of the Canadian UL policy: death benefit options (including an option 2 death benefit structure); single life coverage (which we assume that her policy provides, but joint life first-to-die or last-to-die coverages are available); partial withdrawal and policy loan provisions; a right to pledge the policy for a loan, or otherwise to assign it; an optional premium deposit fund; a provision for dividend accumulations, if the policy is participating; and available annuity, family term, and long-term care riders (the last of these usually accelerates the policy's death benefit). Critical illness and disability income riders also may be available, typically providing additional benefits other than by accelerating the payment of policy cash values and death benefits.
U.S. variable UL policies' features typically include those listed above (or most of them). The main difference is that, instead of having the policy benefits being provided and guaranteed by the insurer's general account, the variable policy 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 a variety of 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 policy, constitutes the policy's cash value and is reflected in the policy'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. In addition, it is now common for such a policy 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 policy can comply with the U.S. definition of life insurance, with the result - unlike the case with the 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 this 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) - the 'investor control' doctrine(58) - and to enforce this requirement, the assets of the separate account, and of each underlying fund, must be diversified in accordance with regulations.(59)
In a business context, either of the above types of policies may be owned by a business, with essentially the same income tax treatment as would apply to an individually owned policy. In the case study involving Sarah, Usco owns a fixed UL 'COLI' policy to help fund Sarah's non-qualified deferred compensation plan; such a policy 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 policy's premiums or benefits (or both) may be shared between the parties. In the case study involving Sarah, her variable UL policy is subject to such an arrangement with Usco.
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When Sarah moves to Canada, she will own three policies that have been issued by U.S. carriers. Therefore, the foreign investment entity (FIE) rules in the Canadian Draft Legislation must be considered.
These rules contain specific provisions dealing with foreign insurance policies held by Canadian residents.(60) A foreign insurance policy is a policy not issued by an insurer in the course of carrying on business in Canada the income from which is taxable in Canada under Part I of the Canadian Act.(61) If an insurance policy is caught by these provisions, the ordinary rules relating to the taxation of life insurance do not apply.(62) Instead, the taxpayer will be taxed, in general terms, annually on the annual increase in the fair market value of the policy.(63) 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.(64)
There are several exceptions to the application of the rules with respect to a foreign insurance policy for a taxation year. If one or more of the exceptions applies for a taxation 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 policyowner 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 policyowner 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 owner 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 policyowner 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.(65)
Sarah's Policies As a preliminary matter, it will be necessary to consider whether each of Sarah's policies 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 seems likely to resort to provincial law to make such a determination. For the rest of our analysis, we assume that the policies are life insurance policies under the Canadian Act. It seems likely that Sarah's term life insurance policy will fit within the exception set out in paragraphs (a) and (c) above. With respect to the fixed UL policy, it would be necessary to test the policy to determine if it was exempt or non-exempt. How would this testing be done? If the policy was non-exempt, how would the accrual income be determined? It is unlikely that the U.S. carrier would assist or be able to assist with these issues. If the policy is old enough, it might fit within the exception set out in paragraph (c) above.
The variable UL policy will be particularly problematic because, for Canadian purposes, the policy is a combination of segregated funds and ordinary life insurance. Segregated funds are treated as trusts for tax purposes.(66) It seems somewhat unclear how the FIE rules would apply to the variable UL policy. For example, would the segregated funds under the policy be treated in the usual manner under the Canadian Act. And, consequently, would the policy not be subject to the FIE rules if the ordinary life insurance part of the policy satisfied the exempt test?
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When Sarah moves to Canada, she will be treated as having disposed of each her assets, including the U.S. policies, at fair market value and to have reacquired them at that fair market value.(67)
For purposes of performing the exempt test, and for all other transactions or events relating to the U.S. policies, it seems necessary to convert the U.S. dollar amounts into Canadian dollars. This is the position of the Canadian Revenue Agency.(68)
With respect to the exempt test and applying Canadian rules to the U.S. policies, an actuary will be needed. It will likely be very difficult to apply the Canadian rules to the U.S. policies. The tax treatment of the variable UL policy, as noted earlier, is particularly unclear. With respect to the split-dollar arrangement, a benefit may be conferred on Sarah as a shareholder or as an employee of Usco.
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Under the split-dollar regulations, 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 Internal Revenue Code views her as remaining subject to its provisions, encompassing her worldwide income, because she is a U.S. citizen. With respect to her life insurance policies 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 policies 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, mentioned earlier in this article, in place of both her fixed UL policy and her variable UL policy; such an exchange could be accomplished tax-free while Sarah is subject only to taxation in the United States. With respect to her existing fixed UL policy, she should ascertain if the policy complies with the Canadian exempt test, and if it does, learn how that status may be maintained. Another possibility may be to transfer her existing policies (or at least her variable life policy, 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 such a step would give rise to difficulties for her when she reaches Canada (recall the prior discussion of the proposed non-resident trust and FIE rules) or pose insuperable U.S. gift tax consequences. If none of the above is done, Sarah should consider terminating her non-term policies and her split-dollar plan.
Usco, Sarah's wholly owned U.S. corporation, will remain resident in the United States, and so its taxation with respect to the UL policy that it owns on her life, to help fund her non-qualified deferred compensation, will not change by virtue of the fact that she is moving to Canada. If, however, the insured changed under the policy, the change would be treated as a taxable exchange, as previously noted.
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As just mentioned, Sarah should consider whether her U.S. policies, if not Canadian compliant, can be made so. This will likely be a very difficult, if not impossible, task. One of the issues to be concerned about when a U.S. policy is transferred to an irrevocable trust is, as noted, the application of the proposed non-resident trust and FIE rules in the Canadian Draft Legislation.
Another matter to deal with is the application of the salary deferral arrangement, retirement compensation arrangement and the employee benefit plan rules to Sarah's deferred compensation arrangement with Usco. In addition, Sarah will need to determine if the split-dollar arrangement with Usco creates a taxable benefit in Canada.
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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 certainly 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 relevant to life insurance are complex, are not well-integrated, and are not specifically addressed by the Treaty. It is very difficult to plan around these rules; however, some planning options are possible.
A dual-compliant life insurance policy would be of assistance in minimizing some of the problems raised in this article. More fundamentally, however, because the two countries' sets of rules governing the tax treatment of life insurance do not integrate very 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 co-ordinate taxes on death, so perhaps they will do the same, some day, for the rules on the taxation of life insurance.
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Philip Friedlan is a CALU Associate member and may be contacted at pfriedlan@friedlanlaw.com.
John Adney is a partner in the Washington, D.C. law firm of Davis & Harman LLP. He may be contacted at jtadney@davis-harman.com.
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(1) Income Tax Act, R.S.C. 1985 (5th Supplement) c. 1, as amended (referred to herein as the 'Canadian Act').
(2) Notice of Ways and Means Motion and Explanatory Notes Re Taxation of Non-Resident Trusts and Foreign Investment Entities released Oct. 30, 2003, (referred to herein as the 'Canadian Draft Legislation').
(3) Section 12.2 of the Canadian Act and Sections 306-310 of the Regulations made pursuant to the Canadian Act.
(4) Section 148 of the Canadian Act.
(5) Section 138.1 of the Canadian Act.
(6) Section 128.1 of the Canadian Act.
(7) Section 116 of the Canadian Act.
(8) Proposed Section 94.2 including proposed subsections 94.2(10) and (11), of the Canadian Draft Legislation.
(9) Internal Revenue Code of 1986, as amended ( referred to herein as 'IRC' or the 'Code').
(10) IRC section 7702(a)(1) and (b).
(11) IRC section 7702(e)(1).
(12) IRC section 7702(a)(2)(A) and (c).
(13) IRC section 7702(a)(2)(B) and (d) (subsection (d) sets forth multiples ranging from 250% through the insured's age 40 down to 100% when the insured reaches age 95).
(14) IRC section 101(a)(1). In certain instances, however, the death benefit can be taxable e.g., where the policy has been transferred for value (see IRC section 101(a)(2), including exceptions provided therein).
(15) IRC section 7702(g). An unintentional failure based upon reasonable error may be waived by the Internal Revenue Service pursuant to IRC section 7702(f)(8).
(16) IRC section 72(e)(5)(A) and (C).
(17) IRC section 72(e)(6).
(18) IRC section 264(a)(1).
(19) IRC section 72(e)(4)(A), (5)(A) and (C).
(20) IRC section 72(e)(10)(A), applying IRC section 72(e)(4)(A) to MECs.
(21) IRC section 72(e)(10)(A), applying IRC section 72(e)(2)(B) and (3)(A) to MECs.
(22) IRC section 72(e)(3)(A)(i).
(23) IRC section 72(q).
(24) IRC section 7702(f)(9); see also IRC section 817(d) and (h).
(25) Treas. Reg. section 1.101-1(a)(1).
(26) IRC section 1035(a).
(27) 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.
(28) Section 116 of the Canadian Act.
(29) Section 128.1(9) of the Canadian Act.
(30) Definition of 'reportable property' in subsection 128.1(10) of the Canadian Act.
(31) Convention Between Canada and the United States of America with Respect to Taxes on Income and Capital, signed at Washington, DC on Sept. 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').
(32) IRC section 7702(a)(2)(A) and (c).
(33) IRC section 7702(a)(2)(B) and (d).
(34) See IRC section 7702(f)(5).
(35) IRC section 7702(g).
(36) IRC section 671 et seq.
(37) IRC section 677(a)(3).
(38) IRC section 264(a)(4).
(39) IRC section 264(a)(4), (e).
(40) See IRC sections 104(a) and 7702B.
(41) IRC section 7702B(g)(3), incorporating IRC section 4980C(d).
(42) Rev. Rul. 90-109, 1990-2 C.B. 191.
(43) Subsections 148(1) and(7) of the Canadian Act.
(44) Subsection 148(8.1) of the Canadian Act.
(45) Paragraphs 4 and 5 of Article XIII of the Treaty.
(46) Subsection 116(5.4) of the Canadian Act.
(47) IRC section 2056(a).
(48) IRC section 951 et seq.
(49) IRC sections 957(a) and 951(b), respectively.
(50) IRC section 951(a).
(51) See Treas. Reg. section 1.61-22.
(52) IRC section 1014(a).
(53) Paragraphs XIII(4) and (5) of the Treaty.
(54) IRC section 302.
(55) IRC sections 301(c) and 316.
(56) IRC sections 951(b) and 958(b) (incorporating the rules of IRC section 318).
(57) IRC section 551 et seq.
(58) See Rev. Rul. 2003-91, 2003-33 I.R.B. 347, and predecessor rulings cited therein.
(59) IRC section 817(h); Treas. Reg. section 1.817-5.
(60) Proposed subsection 94.2(10) and (11) of the Canadian Draft Legislation.
(61) Proposed paragraph 94.2(10)(c) of the Canadian Draft Legislation.
(62) Proposed paragraph 94.2(11)(a) of the Canadian Draft Legislation.
(63) Proposed subsections 94.2(3) and (4) and paragraphs 94.2(11)(a) and (b) of the Canadian Draft Legislation.
(64) Proposed paragraph 94.2(11)(f) of the Canadian Draft Legislation.
(65) Proposed paragraph 94.2(11)(c) of the Canadian Draft Legislation.
(66) Section 138.1 of the Canadian Act.
(67) Paragraphs 128.1(1)(b) and (c) of the Canadian Act.
(68) 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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