In the previous installment, we discussed the potential Canadian tax problems when a Canadian tax resident purchases a US life insurance policy. In this installment, we examine the same scenario in reverse – what happens when a US taxpayer purchases a Canadian life insurance policy which does not meet the complex US tax definition of life insurance.
As US citizens and Green card holders are subject to US tax no matter where they reside, this situation potentially applies to all US citizens residing outside of the US, including in Canada who buy Canadian life insurance. It could also be applicable where a Canadian moves to the US and becomes a US taxpayer. Here, we will discuss the US income taxation of nonqualifying policies and the US tax on foreign life insurance policies.
US exemption test
For US tax purposes, a life insurance policy is required to qualify as such under one of two actuarial tests in order to qualify as such for tax purposes: the cash value accumulation test and the guideline premium test. Extremely simplified, the cash value accumulation test limits the cash value of the policy in relation to the death benefit, while the guideline premium test limits policy contributions in relation to the death benefit.
It is generally not possible to know whether Canadian life insurance policies will meet these tests without either a determination by the insurer or a very expensive actuarial analysis. Given that the definition of what qualifies as a life insurance policy is not the same for Canadian and US tax purposes, what can happen is that a US taxpayer could purchase a Canadian life insurance policy which fails to qualify for US tax purposes, and vice versa. It should not be assumed that a policy which qualifies as life insurance for one country will qualify for the purposes of another. Unfortunately, a Canadian-resident US citizen would generally be hard-pressed to obtain a certification from their Canadian insurer that their Canadian insurance policy meets the US exemption test. Next, consider the US income tax consequences if the policy does not qualify.
US income taxation of non-exempt policies
Where a policy does not meet the US definition of a life insurance policy, the income on the contract of the non-compliant policy is included as ordinary income of the policy holder. Such amounts are taxable as ordinary income. Extremely simplified, the amount of income which will be subject to US tax annually on a nonqualifying policy takes into account not only the cash surrender value of a policy but also the death benefit amount. As a result, the tax may be incurred on phantom income to which the policyholder has no access. Like the determination of accrued income on a non-compliant policy for Canadian tax purposes, the determination of income on the contract amount is tremendously complicated and would require the services of an actuary to properly determine.
That said, term life insurance policies generally should not result in US income tax as they do not accumulate a cash value. However, any US person who intends on purchasing a Canadian whole or universal life policy should try to get confirmation from the insurer of the policy’s qualification. If that is not possible, it may be worthwhile to look into setting up an irrevocable life insurance trust (“ILIT”) to shelter the policy from US income taxation, which will be discussed in a subsequent installment.
At the death of the insured, the death benefit generally would not be subject to US tax even though the policy is a non-qualify policy.
US insurance excise tax
In addition to the potential US income tax complications discussed above, the US also imposes an excise tax on premiums paid for foreign life insurance issued on the life of a US citizen or resident. The amount of the tax is equal to 1% of premiums paid and should be taken into account when considering the cost of the foreign life insurance policy. The excise tax applies even where a foreign life insurance product qualifies as life insurance for US tax purposes. This tax is payable either by the foreign insurer or by the payer of the insurance premium and is reported on Form 720.
In short, US persons should be aware of the potential US tax problems of purchasing foreign life insurance. Those problems are twofold. First, where a policy doesn’t meet the complex definition of life insurance under the US tax rules there would be an income inclusion where the policy generates income. That means that unless the insurance company can confirm that the policy qualifies under the US definition, it is probably wise to avoid growth policies and stick to term. Second, there is a 1% tax on the premiums where the insured is a US citizen. In the following installment, we will discuss the use of ILITs, which in some cases may solve the US income tax (but not excise tax) problem of foreign life insurance.