Charmaine Ko, May 29, 2020
These tax-advantaged savings vehicles can result in a tremendous tax headache
Many Canadians with life insurance assume their policies will provide tax-free funds to support their beneficiaries. In the cross-border context, however, these generally tax-advantaged savings vehicles can result in a tremendous tax headache.
U.S. life insurance may appear attractive due to lower rates or greater potential returns in the policy’s cash value or death benefit.
In the worst-case scenario, however, estates are left to deal with additional taxes and penalties from years of unreported income over the life of an insurance product, and the beneficiaries end up with much less than what was intended.
For a life insurance product to be considered life insurance for Canadian and/or U.S. tax purposes, it must qualify under a series of complicated provisions and tests in their respective tax laws.
Tax problems can arise when a product that’s labelled as life insurance doesn’t meet the standards of the jurisdiction in which the owner is resident (when a Canadian resident purchases U.S. life insurance, for example, or when a U.S. citizen, green card holder or resident purchases Canadian life insurance).
This column discusses the potential tax problems when Canadians purchase U.S. life insurance; future columns will examine the potential tax problems when U.S. citizens who live in Canada purchase Canadian plans.
How to tell if a policy qualifies
The Canadian income tax rules set out a long, complex definition of what qualifies as a life insurance policy under Canadian income tax rules. The definition is so complicated that it requires an actuary to interpret.
The determination is made on a per-policy basis; therefore, the same person may own some policies that qualify and some that don’t.
In simplified terms, the determination is made by comparing each individual policy with the exempt test policy (ETP). The ETP is a hypothetical policy defined under the Canadian Income Tax Act that sets out the maximum accumulation of value allowable within a policy.
A policy has to be tested against the ETP at each policy anniversary. If the accumulation within a policy exceeds what is allowable, it is no longer an exempt policy for Canadian tax purposes and will become subject to tax.
In short, there’s no easy way to tell if a policy qualifies as life insurance in Canada. Canadians shouldn’t purchase a foreign life insurance policy unless the insurer can certify in writing that it qualifies. People who move to Canada and already own foreign life insurance should ask their insurer if it qualifies. Where a policy doesn’t qualify, they should consult a tax professional about their options.
Canadian tax on non-exempt policies
If a Canadian resident purchases a U.S. life insurance policy that doesn’t meet the Canadian definition, that policy won’t be tax exempt in Canada and the policyholder will have to pay Canadian tax annually on the income that accrues in the policy.
However, determining the amount of included income is not easy, as the amount is determined with respect to the policy’s premiums, cash surrender value and the present value of the death benefit. As a result, the policyholder may be subject to tax on an annual basis without any cash to pay the tax.
As the accrued income within the non-exempt policy will be subject to annual Canadian taxation, this would increase the Canadian cost base of the non-exempt policy. At the death of the insured, the death benefit of the non-exempt policy will be subject to tax if it exceeds the policy’s cost base.
Because of the different definitions of life insurance in the two countries, Canadians buying foreign life insurance should ensure the product qualifies under the Canadian definition to avoid complicated and expensive tax problems.
Charmaine Ko, JD, LLM, is a cross-border tax lawyer at Polaris Tax Counsel in Vancouver.