Many Canadians own some form of life insurance on the assumption that the insurance would provide tax-free funds to support their beneficiaries. While this is generally true, complex tax rules can lead to a different result in the cross-border tax context. What is thought to be a tax advantaged vehicle for savings and protection of one’s family can then in fact result in a tremendous tax-headache. In a worst case scenario, it may not be discovered until after the death of the insured individual that what was believed to be tax-free life insurance was not: the estate would then be left to deal with the additional taxes and penalties relating to years of unreported income over the life of the product, and the beneficiaries with much less than what was intended.
The root of the issue here is that in order for a life insurance product to be considered life insurance for Canadian and/or US tax purposes, it must actually qualify as such under a series of complicated provisions and tests under their respective tax laws. Tax problems can arise when a product which is labelled as life insurance does not qualify as such in the jurisdiction in which the owner is resident. E.g. when a Canadian resident purchases US life insurance, or when a US citizen, Green card holder, or resident purchases Canadian life insurance.
In this first installment, we will discuss the potential tax problems when Canadians purchase US life insurance. In subsequent installments, we will discuss the potential tax problems when US citizens who live in Canada purchase Canadian life insurance.
How to tell if the policy qualifies?
Unfortunately, there is no easy answer here unless the insurer themselves are able to provide you with this information. All types of life insurance are subject to the Canadian exemption test (e.g. term, whole life, and universal life). When purchasing foreign life insurance, the best thing to do is ask whether the life insurance meets the Canadian tax definition. In general, a Canadian should not purchase a foreign life insurance policy unless the insurer can certify in writing that it qualifies as life insurance in Canada. Individuals who move to Canada owning foreign life insurance should also inquire with their insurer.
Canadian exemption test
The Canadian income tax rules set out a long complex definition of what life insurance policy qualifies under Canadian income tax rules. The definition is so complicated that it requires an actuary to tell you whether a policy qualifies. The determination of whether a life insurance policy qualifies as life insurance for Canadian tax purposes is made on a per policy basis. Therefore, the same individual may own some policies which qualify and some which do not. Extremely simplified, the determination is made based on comparing each individual policy with the exempt test policy (ETP). The ETP is a hypothetical policy defined under the Canadian Income Tax Act which 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.
Canadian tax on non-exempt policies
As will be discussed in the following installment, the US has different rules than Canada as to what meets the formal definition of a life insurance policy. Therefore, if a Canadian resident purchases a US life insurance policy which fails to meet the Canadian definition, that policy is not tax exempt for Canadian tax purposes. The policyholder is required to pay Canadian tax annually on the income which accrues in the policy. However, the determination of the amount of includible income is not an easy one to make, as the amount of such taxable income is determined with respect to the policy’s premiums, cash surrender value, and the present value of the death benefit. The result is that 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 cost base of the policy.
Because of the differing definitions of life insurance in the two countries, Canadians buying foreign life insurance should ensure the insurance they are buying would qualify under the Canadian definition to avoid complicated and expensive tax problems.