The purpose of life insurance is to provide tax-free funds to those we love in the event of our passing. Ultimately, we want the policy to offer more than just money; we want it to deliver peace of mind. When a family loses a loved one, the intensity of emotion is enough to deal with, but the inevitable flood of financial obligations that result can add insult to injury.
Many Americans and Canadians with cross-border ties have policies based in both countries. While this may seem like a good idea (for example, a Canadian may want to avail themselves of a lower premium rate available through a U.S. policy), the taxation is rarely straight forward. It’s not uncommon for beneficiaries to find out the hard way that a policy they assumed was tax-free will actually be heavily taxed in their country of residence. In some cases, the family may even owe penalties as a result of years of unreported income.
Tax problems arise when the policy doesn’t meet the standards for life insurance as set out by the jurisdiction where the owner resides. In today’s blog post, we’ll outline the trickier aspects of this complicated subject, paying close attention to the different concepts in Canada and the U.S.
Canadians with U.S. life insurance
Canadian income tax regulations present a lengthy definition of what qualifies as life insurance within Canada. It’s even determined per-policy, since it’s so detailed. Ultimately, the determination is made by comparing the policy to the Exempt Test Policy (ETP), which is a hypothetical “ideal” policy defined by the Income Tax Act. At each policy anniversary, the policy must be tested against the ETP. If the policy’s accumulation is greater than what is allowable in the ETP, it will be subject to tax.
As a rule, Canadians should avoid foreign policies unless the insurer can provide written proof that the policy qualifies within Canada. Individuals who move to Canada while holding foreign policies should speak to a tax professional to gain clarity on what can be done to reduce taxation.
In the event that a U.S. policy doesn’t meet the Canadian standards, the policy is not tax-exempt and the holder needs to pay Canadian tax on the income accrued on an annual basis. That being said, it can be complicated to even determine the amount of included income. Details taken into consideration include the policy’s premiums, value of death benefit, and the cash surrender value. Obviously, this increases the cost of the policy for the holder, and in the event of a death, the policy will be subject to taxation if it is in excess of the cost base.
Americans with Canadian life insurance
Regardless of where they reside, American citizens and green card holders are subject to U.S. tax. Thus, Americans living in Canada who purchase Canadian life insurance policies, and even Canadians who move to the U.S. and become taxpayers will need to pay attention to the regulations regarding taxation.
Similar to within Canada, U.S. policies must qualify under two actuary tests:
Cash value accumulation test
Places a limit on the cash value of the policy as it relates to the death benefit.
Guideline premium test
Places a limit on policy contributions as it relates to the death benefit.
Generally speaking, the insured will need to obtain a determination by the insurer or an actuarial analysis (which is costly) to determine whether Canadian policies will meet the requirements of the above tests.
If the policy does not qualify, the income on the non-compliant policy must be included as ordinary income of the owner. The determination of the amount that will be subject to taxation is calculated by taking into account the cash surrender value and the death benefit amount.
In general, since they do not accumulate cash value, term life insurance policies shouldn’t result in U.S. income tax. That being said, it’s wise for U.S. individuals considering a Canadian policy to secure confirmation first from the insurer, or to set up an irrevocable life insurance trust to shelter the policy from US income tax. Upon the death of the insured, the death benefit would not likely be subject to tax, even in the case of a non-qualifying policy.
U.S. excise tax
There also exists an excise tax on premiums for foreign life insurance that is issued to a U.S. resident or citizen. The tax is 1% of premiums paid, and applies even when a foreign life insurance policy does qualify within the U.S. tax standards. The tax is reported on a Form 720 and payable by either the insurer or the payer of the premium.
Read the fine print
Given the possible complications associated with the purchase of foreign life insurance policies, individuals with cross-border ties should thoroughly examine whether the policy qualifies within their place of residence prior to purchasing. To avoid undue taxation, it may make sense to only work with domestically issued policies. In the event that you are the holder of a foreign policy, reach out to one of our tax professionals today. Together, you’ll be able to execute a strategy to minimize taxation and utilize the advantages of the policy.